Making Sense of Increased Capital Requirements

1. Risk Minds June 2012 Making Sense of Increased Capital Requirements By J.V. Rizzi The opinions expressed herein are those of the author. They do not reflect the views of CapGen Financial.

2. Table of Contents • Change • Reaction • Reality • Impact • Response • Conclusion

3. Change

4. The Change(BIS III and Dodd Frank) (Capital goes where it is welcome… • Message: more capital, more liquidity and less risk • Specifics - tightened capital definition - increased RWA weights - more liquidity limit illiquid assets restrict unstable funding - increased capital requirements BIS IIIDodd Frank (well capitalized) CE 2  4.5 [5+] T1 4  6 > 6 TC 8  8 > 10 Buffer 0  2.5 -- Lev 0  3 > 5 • Why - Banking as an industry failed - Clear that prior capital rules were insufficient …and stays where it is treated well)

5. Reaction

6. The Nonsense (Do you want to believe what you see… • Higher Capital Requirements • Put aside more reserves • Curtail lending • Impede growth • Decrease ROE • Increased Funding Cost • Un-American …or what I am telling you?)

7. Reality

8. The Reality (Facts ignored… • Set aside • Confuses liquidity reserves with funding mix • Increased funding cost • Limited given proportion of equity in capital structure • Ignores cost of forced capital raise at distressed price • Reduced ROE • Cost of equity is not fixed • Key is the spread between ROE and cost of equity • Un-American • “The policy goal should be a healthier banking system, rather than high returns for banks’ shareholders and managers with taxpayers picking up the losses and economies suffering the fallout.” • Bankers resistance of higher capital requirements: capital shifts risk from taxpayer to capital provider • Vested interest in subsidies and compensation– especially for banks with weak franchise value and • Debt overhang: benefits to debtholders …do not cease to exist.)

9. Impact

10. Impact (You cannot lever up a sow’s ear into a silk purse… • Business Model • Balance sheet mix • Capital generation and growth • Shareholder distributions • Restructuring • Shrink • Break-up • Merge • Capital structure …you may think you can during the good times, but…)

11. CAPITAL STRUCTURE

12. Stakeholder Views of Capital Differ (Is the glass half full or half empty… • Capital focus is primarily on tangible equity capital and capital replenishment capabilities. • Concern on through the cycle capital and buffers • Are focused on capital discipline and allocation • Capital Returns and bonuses Rating Agencies Regulators Shareholders Management … it depends on whether you are pouring or drinking)

13. Introduction (Once set… Strategic Capital Budgeting (CEO) Volatility Liquidity Return Opportunities Capital Structure CFO Capabilities Risk Management (CRO) Risk Appetite Correlations Performance External Stakeholders Governance Shareholders Risk/Return Regulators Rating Agencies …Capital structure is continuously monitored and revised)

14. Overview (Capital structure is important not because it creates value… • Set capital structure independent of regulation • Except for banks with limited franchise value and suffering from debt overhang • Enough capital to pursue strategy and weather cash flow shortfall • Positive relationship between value and equity thru the cycle • Long term decline from insufficient capital going into crisis outweighs short term leverage benefit • Major determinant of capital is the market and rating agencies • Most banks hold more than regulatory minimum • Framework • Estimate financing surplus or deficit through the cycle • Surplus- shareholder distributions • Deficit- raise additional capital • Ratings requirements • Agencies • CAMELS • Peers … but because getting it wrong destroys value.)

15. Capital Structure – Integration of Capital and Risk Management (Risk never disappears…. Mix of securities (Capital Structure) and Risk Management Products • Capital structure optimization is the purpose of risk management – 2 sides of same coin • Risk management is capital structure in disguise • Risk management as synthetic or substitute equity • Risk transfer transfer (Cause) • Risk Finance (Effect) • Integration of corporate finance and risk management • Cost/Benefit analysis regarding use of risk management or risk finance • Issue is whether it is more efficient to (self insure) hold capital or to use risk management to eliminate the risk cause …someone is always on the other side of the trade)

16. Capital Guidelines (How much is enough?… S&P: RAC Very strong >15% Strong 15/≤ X <10% Adequate 10 ≤ X < 7% Moderate 7% ≤ X < 5% Weak 5% ≤ X < 3% Very Weak >3% CAMELS – “C” and “A”:Classified Assets/T1 + ALL 1 - O ≤ X ≤ 25% 2 – 26%< X ≤ 40% 3 - 41% < X ≤ 80% 4 - 81% ≤ X ≤ 100% 5 - > 100 …it depends

17. Scenarios: To Assess Possible Strategies Against Capital Structure Robustness (Can I survive and tolerate….. Financial policy implications: • The upside (U) and base (B) cases generate excess capital which points toward shareholder distributions • The downturn (D) scenario suggests possible changes in risk appetite and the development of appropriate contingency plans to maintain ratios, sell assets and raise capital. Forward looking Core Tier 1 development under alternative scenarios (Stress testing) • U • - - - - - - - - - - - - - - - - - - - - - - - - • B • - - - - - - - - - - - - - - - - - - - - - - - - Return Capital Raise/release Capital Core Tier 1 Ratio Probably Unlikely May be May be Probably Unlikely D T …the worst plausible outcome?)

18. In a ‘sustained severe recession’ scenario, contingency measures may be required to meet target capital ratios Capital Ratios Assumptions Observations Downturn scenario is based on a net profit decrease of EUR __ bln relative to the reference case to EUR __ bln in __, a drop of __bln to __bln in __ and recovery thereafter. Decrease in RWA of EUR __ bln in __, __ bln in __ and a __% growth through __ and __ due to lower credit demand and reduction due to FX devaluation. Divestitures __ according to plan (reference case) Dividend payout of __ for __, __ thereafter Share buyback as announced for __ and ongoing neutralisation of stock dividend, but no additional buybacks. The ratios as presented would trigger a regulatory response as the Tier Total ratio is < __%. Additionally, ratings would be pressured resulting in possible downgrade. The scenario would lead to a significant shortfall from the 6.0% Core Tier 1 ratio target. Compared to the mild recession, additional contingency measure to replenish the capital meet target ratios would be required, e.g. Suspend or reduce dividend Suspend stock dividend neutralisation Increase divestment programme Time

19. Elements of Strategy Based Capital Structure Management (Risk and capital as inputs into strategic planning….) Choice of Markets with Attractive economics in which the organization enjoys a competitive advantage Risk the organization is willing and able to accept in pursuit of its strategy Risks underwritten and retained Capital relative to Ratings Agencies, Regulators and peers Actual Capital Return capital to shareholders when actual capital exceeds need, or raise capital when exceeds actual capital Allocation to business units based on an economic capital determination Strategy Risk Appetite Risk Assessment Capital Need and Capital Assessment Capital Plan Capital Allocation (…and not just consequences)

20. How Much? (Better to be approximately right… …than precisely wrong.) LNYC Pre-Depression Banks (20%) REITS (29%) Asset Value Losses/Cushion (7% / 7%) 15-20% Depending on risk of Business Model High CRE Derivatives/ Trading

21. Conclusion

22. Conclusion (Capital structure as a Process… • Need to incorporate capital structure and risk considerations as an input versus consequence of strategy • Capital as cost of risk • Return as cost of capital • Risk as cost of return • Capital structure links strategy, risk and return–represents total risk exposure an organization is capable of accepting and retain in pursuit of its strategy • Market factors have a larger impact on bank capital structure than regulation … Not a Number)