University of Essex 26 March 2010

1. The Financial Crisis and the Future of Risk Management Paul Ingram- Global Head of Market Risk, RBS University of Essex 26 March 2010 The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of RBS Group

2. Who do you blame for the recent market crisis? The Banks? The Regulators? The Government? Risk Managers? | 2

3. In this presentation I will highlight some of the contributory factors that led to the recent market crisis, and promote discussion regarding what could be done to reduce the severity of any future crises. Background | 3

4. A very low interest rate environment persisted throughout the early 2000s. This was Chairman Greenspan’s response to the bursting of technology bubble and 9/11 Sowing the seeds | 4

5. During the 2000s, Global financial imbalances increased, China became a more significant exporter and a more significant influence in global financial markets, as it sought to invest its current account surplus. Sowing the seeds | 5

6. Surplus nations (e.g. China) sought to invest their excess funds into liquid marketable securities. This permitted the US to issue a significant amount of debt at historically low spreads. Sowing the seeds | 6

7. The demand for US Treasuries from surplus nations, the low Federal Funds rate and low inflation meant that the real yield on highly-rated securities was low. Investors demanded securities that provided enhanced yields but had high external credit ratings Banks were therefore keen to provide new securities which had the same ratings as Treasuries, but provided an enhanced yield. Sowing the seeds | 7

8. Agency (Fannie Mae/ Freddie Mac) mortgages in the US had long been structured into ABS in order to facilitate the growth in home ownership. Packaging mortgages into bonds with an implicit US government credit protection proved very popular with investors. As the agencies had fairly strict lending criteria, the demand for these securities was strong and hence yields were not significantly above Treasuries. Sowing the seeds- Asset Backed Securities (ABS) | 8

9. As investors continued to chase yield there was a demand for ABS collateralised upon mortgages to riskier borrowers. This increased the supply of mortgages to portions of the US economy that had never previously been homeowners (often at artificially low “teaser” rates) Banks who facilitated the original mortgage loans were less concerned about the ability of the borrower to repay, as they were transferring the credit risk onto the investors. Furthermore, the perception was that house prices would continue to rise, permitting homeowners to refinance with the increased equity in their homes. Motivation for non agency RMBS | 9

10. Boom and Bust • This was mirrored by a perception that the UK economy had reached a stable equilibrium • “As I have said before Mr Deputy Speaker: No return to boom and bust.” Gordon Brown, Chancellor of the Exchequer- March 2006 | 10

11. “Sub prime” (and Alt-A) mortgages had previously constituted a reasonably small proportion of total mortgage issuance, however with the demand from investment banks, this issuance grew significantly through the middle of the 2000s A move toward sub prime | 11

12. Regulation of banks and other financial institutions had moved away from an intrusive assessment of risk, to a principles-based approach where regulators placed more trust in institutions internal controls Determination of the required levels of capital became increasingly calculated based on models which were calibrated to current market conditions (which were benign) and did not cover all sources and nuances of risk that banks were exposed to Capital ratios across the banking industry were permitted to reduce over time to a level at which the whole banking industry was at risk in the event of a systemic event. Sowing the seeds- Bank Regulation | 12

13. The amount of capital issued by banks (especially the investment banks) did not grow in line with their balance sheets. i.e. they became more highly leveraged over time Sowing the seeds- Leverage | 13

14. Many banks also set up special purpose companies whose role it was to facilitate the creation of highly rated assets for investors. Examples of this included Securitisation vehicles Structured Investment Vehicles (SIVs) Conduits/ Asset Backed CP vehicles The size of these off balance sheet vehicles were significant, more significantly many of the structures funded illiquid assets with short-term debt that needed to be rolled over regularly SIVs reached a peak of $425bn, The ABCP market peaked at $1.2trn Sowing the seeds- off balance sheet assets | 14

15. Derivative Product Companies were set up to be AAA rated derivative counterparties- the motivation was that banks would reduce their capital requirements through entering into derivatives with a AAA rated entity Additionally AAA rated firms (monolines, insurers etc) that were not regulated in the same manner as banks were able to sell credit protection to banks in very large volumes. Sowing the seeds- off balance sheet assets | 15

16. Growth in lending to riskier counterparties • In order to continue to meet very high Return on Equity targets, banks increased their leverage, and also extended credit to riskier counterparties than previously often with very thin spreads • These loans were often secured against collateral that had escalated in value significantly (Commercial Real Estate, Residential property) or had mechanics that made full repayment contingent upon ever increasing asset values (e.g. leveraged loans, payable in kind (PIK) notes) • Banks also warehoused significant volumes of assets on their balance sheet for onward securitisation into ABS and retained the economic risk of the most senior portions of securitisations (often through derivative transactions) • This could be seen as the start of the breakdown of the “originate to distribute” banking model. | 16

17. So what were the warning signs? Belief that “boom and bust” was over Low interest rates Consistent asset growth High risk appetite Increase in product complexity without an increase in investor sophistication Perception that property was a “safe” investment | 17

18. So what were the warning signs? Capital was highly model driven Lack of proactivity in risk management High level of herd-behaviour Overall levels of capital were historically low Regulatory and risk management practices accorded with the view that risk was low Increase in liquidity mismatches | 18

19. What happened next? • In late ‘06 several research notes were published regarding the US sub prime market. • Several market participants became more active in the CDS markets, betting on the failure of sub prime bonds (ABX). • Through to the middle of ‘07 these doubts continued and the lack of confidence spread to the funding markets, where funding spreads started to rise • Liquidity popped in Aug ‘07, this caused significant issues for institutions that relied on wholesale funding • General mistrust in the valuation of illiquid structured assets, and the liquidity of counterparties continued to raise the costs of funding | 19

20. The scale of the market movements | 20

21. The scale of the market movements • TED spread, i.e. the spread between US 3m T-bills and US 3m LIBOR rose significantly | 21

22. What happened next? • Doubts over valuation and liquidity continued to mount in early 2008 and the market turned its attention to banks that were most affected. • Northern Rock had to turn to the UK government for liquidity in Sep ’07 and was nationalised in Feb ‘08 • In March ’08 JP Morgan rescued Bear Stearns from bankruptcy with the assistance of the US government • Throughout the summer of 2008 banks rushed to issue capital to shore up their balance sheets, losses continued to mount as Alt-A borrowers, commercial real estate and leveraged loans started to show weakness | 22

23. Panic and the rescue • Lehman Brothers was the next most vulnerable institution and after rescue talks with the Korean Development Bank, then BoA and lastly Barclays fell, it was forced into bankruptcy on 15 Sep ’08 • The house of cards started to tumble with Merrill’s selling itself to BoA, Wachovia to Wells Fargo, HBOS to Lloyds. Morgan Stanley and Goldman Sachs came very close to losing their independence • Governments had to step in to rescue RBS, AIG and the Icelandic banks and then provide capital for many major financial institutions. | 23

24. Pre-crisis characteristics • Crises share similar factors, a fundamental mis-pricing of risk driven by a combination of: • A new “paradigm” • Disconnect with the underlying economics • Greed and hubris | 24

25. Pre-crisis characteristics | 25

26. Current regulatory response • More capital • More conservative modelling • More transparency • More independent challenge | 26

27. Crisis intervention • Moral hazard • Loss of confidence • Loss of legitimacy | 27

28. Ideas for improvement • Countercyclical capital measures- ensure banks hold more capital when markets are benign • Penalise excessive leverage or funding mismatches • Focus on bespoke risk management- ensuring that practices are fit for the institution • Take action on systemic liquidity risk • Intervene in markets to control macro-economic risk? | 28

29. Thoughts for investors • There is no such thing as a free lunch • Understand the investment proposition • Consider what could happen in a stress event • Who will provide you with liquidity? | 29

30. Key learning from all crises • DON’T: • believe in new paradigms • buy or sell anything you don’t understand • rely entirely on models, ratings or market prices • assume you can sell at the market price, or at all • assume anything will remain the same forever • get carried away- think about the underlying economics!! | 30