Canadian Banking Industry & Derivatives

1. Canadian Banking Industry & Derivatives Edwin Cheung Isaac Schweigert Sharan Brar Tolek Strukoff

2. Agenda • Economic & Market Analysis - Sharan • Risk Management Environment - Sharan • Royal Bank of Canada - Isaac • Bank of Montreal - Edwin • Canadian Imperial Bank of Commerce - Tolek

3. Economic & Market Analysis

4. Industry Structure • Competition • Market Dynamics

5. Competition • The Canadian banking system is mature, sophisticated and highly competitive • 14 domestic banks; 33 foreign bank subsidiaries; 20 foreign bank branches • They collectively manage over $1.7 trillion in assets

6. Market Dynamics • The six large Canadian banks manage over 90% of total bank assets • Banks operate through an extensive network of branches and automated banking machines (ABM’s) • Canada has the highest # of ABM’s per capita • Industry experiencing consolidation

7. Products Produced • Products • Technology • Substitutes

8. Products A bank performs the following activities: • accepts deposits • grants commercial loans Bank Act 1954 & 1967 allowed: • granting of mortgages and consumer loans Bank Act 1992 allowed: • operation of trust and securities subsidiaries • banks to be involved in wealth management

9. Technology Technology is significantly altering the structure of the Canadian bank industry • Internet • product innovation to improve services • Canada is a leader in automated banking

10. Substitutes • credit unions • foreign banks • small virtual competitors • small region-specific/culturally specific institutions

11. Cost and Revenue Structure • Revenue Sources • Cost Structure

12. Revenue Sources • Interest Income is a major source • Importance of non-interest income is increasing • Fees for mutual fund management, credit cards, derivatives trading, cheque processing, foreign exchange

13. Cost Structure • Operations • Human Resources

14. Firm Strategy & Future Growth • Investment in technology and product innovation • Cost efficiency/alliances/consolidation • Expansion of customer base • Wealth management, corporate and investment banking • Expansion to select international markets

15. Regulatory Environment • Bank Act • Regulation modified every 5 years to stay current and allow flexibility • Office of the Superintendent of Financial Institutions • Restrictions in ownership

16. Regulatory Environment • International Monetary Fund • Canada Deposit Insurance Corporation • Canadian Securities Institute (educational requirements) • Provincial securities regulators • IDA & MFDA

17. Risk Management Environment

18. Risks Major Risks: • Market Risk • Credit Risk • Liquidity Risk Measurement: • Statistics • Economic Capital

19. Techniques & Products Techniques: • Hedging Products: • Swaps • Futures (Currency) • Options

20. Prospects & Hazards Prospects for Effective Risk Management: • Banks in the business of RM • Complicated Hazards • Large position sizes • Complex • Significant values at risk • Operational risk • Many external factors: interest rates, exchange rates

21. RBC

22. Divisions of RBC • RBC Banking • RBC Royal Bank • RBC Centura (USA) • RBC Investments • full service and self-directed brokerages • private banking • RBC Dain Rauscher (USA brokerage) • RBC Insurance

23. Divisions of RBC • RBC Capital Markets • financial services to companies and government • hedge funds and private equity • RBC Global Services • Transaction processing for mutual and hedge funds • Custodian for CI Mutual Funds, AIM and Mackenzie

24. Net Income by Segment

25. Factors Affecting Future Results • Credit, market, liquidity, insurance, operational and other risks • Health of economy, businesses and capital markets • Monetary policy in Canada and USA • Competition • Statute and regulatory changes

26. Risks to be Managed • Credit • Market • Liquidity • Insurance • Operational

27. Economic Capital • Calculation of equity needed to underpin the risk • based on solvency and debt ratings • Calculated for credit, goodwill & intangibles, non-trading market risk, insurance, fixed asset and trading market risk

28. Economic Capital

29. Value at Risk (VaR) • Used to manage trading risks • RBC uses a 99% confidence level and back tests 500 previous days

30. Credit Risk • Includes off balance sheet • Diversify loans by type and geography • $1 billion in credit protection (2002) • $300 million in derivatives (2002)

31. Credit Quality • Major area of risk • Moving to lower-risk mortgages and less business loans • Purchased $1 billion in credit protection in 2002 • Only deal with reinsurers with AAA rating • Largest domestic loan concentration is Ontario • Largest international loan concentration is USA

32. Worldwide Revenues

33. Market Risk • Interest rate • Credit spread - from bonds and credit derivatives • FX - brokerage, investment, trading, arbitrage and proprietary trading • Trading activities - market making, arbitrage in interest rate, FX and equity markets

34. Liquidity Risk • Managed dynamically • Overseen by the Liquidity Crisis Team • Hedged with a pool of unencumbered, high-quality assets • Marketable or can be pledged as collateral

35. Liquidity Management • $155 billion in liquid assets (41% of total assets) • RBC maintains a high credit rating to have best possible access to capital • Contingent liability plan • Securitize assets to diversify funding base

36. Securitization • $1.7 billion of government guaranteed mortgages in 2002, $2.4 billion outstanding • $1.7 billion of credit card receivables through an SPE

37. Insurance Risk • Product design and pricing risk • Claims administration risk • Underwriting risk • Liability risk

38. Asset/Liability Management • Interest rate risk can be linear and non-linear • Linear risk is hedged with interest rate swaps • Non-linear risk comes from embedded options in products offered

39. Off Balance Sheet • Guarantees and standby credit letters • Leases on premises and equipment • Derivatives which RBC is a counter party with other institutions and in trading • $10.6 billion in credit risk • Special Purpose Entities

40. Special Purpose Entities • Used to securitize credit card receivables • Non-operating and have no employees • Also provide SPE services to clients • Issue paper to purchase the assets from RBC • Issued in SPE name, $20.6 billion o/s

41. Derivatives • Most are FX forwards, interest rate and currency forwards, FX and interest rate options and credit derivatives • Margin requirements and premiums recorded as assets • Use hedge accounting for own derivatives if applicable

42. Derivatives • Most relate to sales and trading activities • Market-making, positioning and arbitrage • No significant dealing in leveraged derivatives • Used for hedging and investing

43. Hedges • Fair Value Hedge-interest rate swaps • Cash Flow Hedge-interest rate swaps • Foreign exchange investments in subsidiaries • FX forwards • US dollar denominated liabilities

44. Hedges • Hedge mortgages by securitization • $3.7 billion in 2002, $1.7 billion sold to investors • Redeemable deposits hedged with interest rate options

45. BMO

46. Comprehensive risk governance Enterprise-wide Risk Management Effective process & models Qualified risk professional

47. Integrated Risk Management • Management of risk is integrated with the management of capital and strategy • Capital at Risk (CaR)

48. Total Capital Risk by Risk Type • Strategic 11% • Operational 24% • Credit 38% • Market 27%

49. Direct Risk Management • Credit Risk • Market risk • Liquidity and Funding Risk • Operational Risk

50. Credit Risk • Is the risk of loss due to the failure of a borrower, endorser, guarantor or counterparty to repay a loan of honor another predetermined financial obligation