IBA Basel II and Strategic BS Mgnt_SS

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IBA Basel II and Strategic BS Mgnt_SS Powered By Docstoc
					                             NOVEMBER 2005


Executive summary
   With BIS 2 changing the way in which banks view risk, there is a greater focus on
    “economic” performance rather than previously used “accounting” measures of

   Maximizing shareholder value requires not just a focus on returns, but a focus on
    the risk taken in generating those returns, to assess whether it exceeds the cost
    of required capital

   Viewing risks on an “economic”, rather than “regulatory” or “accounting” basis,
    provides banks with a common measure with which to compare contribution to
    shareholder value (SVA) from competing asset classes

   Importantly, SVA links risks and returns in a direct and quantifiable manner which
    will allow managers at all levels of the firm to make more informed choices on
    the allocation of scarce capital resources

   JPMorgan is pleased to share some of our key experiences in how a bank can apply
    such a holistic balance sheet management framework to achieve strategic

                                       026550-001                                  IBA   1
Implications of Basel II

                           026550-001   IBA   2
Basel II has led to reevaluation of capital framework
across the world
  "Basel II will provide one of the biggest structural shocks to the banking industry for decades. Is the industry
                                                                                  Mercer Oliver Wyman, Dec 2003

   Basel I                                  Basel II                                  Economic capital
    Static risk weights based on asset      More closely aligns regulatory           BIS II doesn't address concentration
      type, i.e., sovereign, banks, corp,      capital with economic risks               risk explicitly
      etc.                                                                                Single name, industry, country
    No distinction within risk weighting                                              Economic capital framework based
                                             Distinguishes capital charge by asset
      bands for asset quality                                                            on internal models
                                               quality based on rating agency
       "One size fits all"                                                               PD, LGD, EAD
    Amendment ('97) allows for use of                                                    Maturity, correlation
                                             External ratings correspond to PD
      VaR to estimate market risk                                                         Spread migration
                                            Internal Ratings Based                     Does not rely on calibration
    However, measurement of credit
      risk remains rudimentary               Foundation: Allows banks to                established by regulator, i.e., not
                                               estimate PD while LGD and EAD are         average risk
    Does not distinguish between
      market, credit or operational risk
      per se                                 Advanced: Allows banks to estimate
                                               PD, LGD and EAD

     Rudimentary                                     Capital framework                                       Advanced

                                                        026550-001                                                      IBA    3
The Three Pillars of Basel II
  Pillar 1                       Pillar 2                       Pillar 3

  Requirements for calculation
                                       Supervisor’s Role          Disclosure requirements
     of regulatory capital

   Use of rating, loss           Banks to assess solvency      Greater disclosure of risk
    exposure and risk              relative to risk               profile, capital structure
    mitigation                                                    and risk management
                                  Supervisory review of risk
   Explicit requirement for       management and capital
    operational risk capital       practices

   Quantitative aspects          Solvency assessment           Improved transparency
    critical for capital           covers ALL risks
                                                                 Expectations
                                  Application of supervisor
                                                                 Consistency with
   Fresh look at control          judgement critical
    practices                                                     accounting and local
                                                                  regulatory requirements

                                         026550-001                                      IBA   4
Risk Management sophistication tends to improve
shareholder value generating ability of banks

                              Maximize                                                              Economic
                             Shareholder                                                             capital

                                                                                                Active portfolio
  Capabilities of the Bank

                                                                                IRB advanced   distribution of risk
                              stability                       IRB               Lend & Hold
                                                           foundation           with Hedging

                               Losses      Standardized                                                    Small/local banks

                                                                                                        Mid size/regional banks
                                           Lend & Hold
                                                                                                          Large global banks

                                                          Risk management sophistication

                                                                   026550-001                                                     IBA   5
Net sector impact is expected to be neutral, however
balance sheet composition will determine outcome
  Risk weights by asset class
                       BIS I                            BIS II
  Asset class                          Standard                  IRB Foundation    Capital change
  Mortgages            75%                 35%                     1%–78%

  Retail              125%                 75%                     4%–88%

  SME                 100%                 75%                     5%–180%

  Corporate           100%            20%–150%                     8%–210%

  Securitization   52.5%–102.5%      20%–1,250%                   12%–1,250%

  NPL                 100%                150%                         ?

  Equity              125%                100%                   200%–400%+

  Market risk                               VaR                       VaR

  Operating risk       NA         15% of Gross income     12–18% of Gross income


                                       026550-001                                           IBA     1
Asian banks face the following balance sheet
   Credit concentration risk
     Majority of credit exposures tend to be concentrated within the domestic environment
     Significant exposures concentrated in the middle to lower rated credit grades
     Industry diversification is limited to the industries available domestically

   Increased competition in domestic lending opportunities resulting in diminishing returns: The
    more attractive segments from a risk adjusted point of view will be main targets for banks
    potentially resulting in margin compression, i.e. retail and SME lending

   Relative low risk adjusted returns of domestic lending opportunities: Significant part of existing
    domestic lending opportunities may have low risk adjusted returns, e.g. Corporate lending

   Ability to diversify and improve overall portfolio composition

   Flexibility to select asset classes with risk adjusted returns commensurate with the bank’s
    strategy without having to compete

                                               026550-001                                         IBA    7
BIS II may render a number of valuation and strategic
implications, giving rise to balance sheet
repositioning needs
  Valuation                                                     Strategic
   Markets will begin to factor in capital structure            Managing historic relationships in light of need
    modification requirements                                     to reprice low profitability credits

   Focus on return on capital will increase as                  Greater competition already being felt in higher
    returns and risks can be more closely followed                risk adjusted return businesses—consumer
    by the investing community
                                                                 Higher stock valuations arising from better risk
   Justifying low return on capital business                     adjusted performance will better position some
    segments may be required                                      for expansion through acquisition

   Need to continue focus on fee income                         Larger groups will be able to pool resources to
                                                                  better fund IRB transition

                         Balance sheet repositioning implications
                          Need to focus on risk adjusted returns will more clearly
                            highlight benefits of some asset classes over others

                          Greater need to deploy excess liquidity in most risk adjusted
                            profitably way, while also generating meaningful profit

                                                   026550-001                                                 IBA    8
Strategic importance

                       026550-001   IBA   9
There will likely be a greater alignment of risk and
reward as banks increasingly focus on economic as
opposed to accounting profits
      If A - B is positive, the bank makes a profit, but may not improve shareholder value
      If A - B is bigger than C, the bank improves shareholder value (SVA positive)

                                      Assets                Liabilities & Capital

         The income generated
                                                                                           The cost of funding the
         on an asset depends on
                                                                                            assets depends on the
          the interest rate and
                                                                                           mix of instruments used
              fees charged

                                                                          operating         The amount of capital
                           Interest                                       expense      B   depends on the riskiness
                           and fee                                                          of the assets and the
                                                                          Cost             cost of capital depends
                  A        income
                                                                          of capital   C         on the mix

   Therefore to improve SVA, the bank must:
     Improve yield on assets at current risk level
     Reduce cost of funding assets without increasing ALM risks
     Reduce the current risk level (capital) without reducing return, or lower cost of
       regulatory capital

                                               026550-001                                                   I B A 10
Shareholder value added provides the framework to
align incentives across the entire bank …
   Single performance measure aligning various interests of employees,
   management and shareholders
                                         Risk adjusted operating profits    minus               Capital charge

                                                                                                   

                    Shareholder =   Risk adjusted              Liquidity

                                                                                    Equity at risk          Cost of equity
                    Value Added      asset yield1               funding

                                           Asset                                       Risk                    Capital
                                        allocation                                  management               management

                                                 Financial value
                                                  (book value)               +                Franchise value
                                                                                          (discounted future SVA)

  ¹ Includes charge for expected loss

                                                               026550-001                                                 I B A 11
… and allows banks to evaluate risks and returns at
every level of the company

                                              Return on economic capital of whole firm
                 Bank                         Incorporates diversification benefits of combined
                                                   business portfolio

                                              Compare returns on economic capital of individual
             Business division                     business units
                                              Determine optimal areas to invest additional capital

                                              Identify single name and industry concentration
                 Credit portfolio                  issues within a portfolio
                                              Optimal reinvestment strategies

                                              Price individual deals / customer relationship
    Individual           Individual
                                              Determine return of individual products
    customer            transaction
                                              Prioritize products for use of client capital limits

                                      026550-001                                                      I B A 12
Interrelated nature of each process requires issues to
be addressed in totality at the most senior level
                                       Increase yield on the asset portfolio without
                                       increasing risk or decrease risk on the asset
            Minimize(liquidity cost)   portfolio without reducing return                       Maximize(asset yield)
            Constraints (assets)        Identify positive and negative SVA loans              Constraints (risk level)
                                        Develop alternative asset strategies

  ALM                                                                                  Economic capital
  Structure liabilities to match and                                                   Ensure economic capital is accurately
  support asset base with the lowest                                                   measured and efficiently allocated
  funding cost available                                  SVA                           Assess current calculation
   Measure current ALM position                      Maximization                        methodology
   Develop strategies to improve                                                       Suggest refinements to current
     efficiency                                                                           model

           Minimize(capital cost)                                                           Minimize(risk level)
           Constraints (risk level)    Capital management                                   Constraints (asset yield)

                                       Determine most efficient mix of capital to
                                       ensure the lowest cost
                                        Establish target credit rating
                                        Develop strategies to improve capital mix
                                        Hold capital commensurate with risks

                                                        026550-001                                                        I B A 13
The balance sheet management framework enables
identification of value creation opportunities
     Asset alternatives        Assets                              Liabilities                Capital alternatives

  Cash securitization           Gross Loans                        Deposits               Equity
   In addition to providing      Large Corp.                      Short-term borrowing    Increase Tier 1 equity
    term funding,                 SME                              Term borrowing           capital via a single
    securitization can                                                                        strategic partnership or
                                  Consumer                         Other
    release capital by                                                                        group of financial
    reducing RWA                NPL                                                          investors
                                Securities
  Synthetic securitization      Land and buildings                 Equity                 Hybrid capital
   Releases capital via a      Fixed Assets                       Hybrid Tier 1           Perpetual instruments
    synthetic transfer of                                           Tier 2                   can replicate many
    risk using credit                                                                         features of equity,
    derivatives (reduces                                                                      while offering lower
    RWA)                        Due to the leveraged nature of a bank’s balance sheet,       cost and tax-efficiency
                                 liability-side solutions support significantly greater
                                 capacity than asset-side alternatives
  REIT                                                                                      Subordinated debt
   Sale and lease back of      Example                                                     Subordinated debt
    land & buildings can                                                                      offers a very efficient
                                  For every $1 of capital raised, a bank can lend
    result in a gain in Tier                                                                  means of achieving
                                    $12.5 of RWA
    1, and a reduction in                                                                     target CAR objectives
    RWA                           For every $1 of RWA reduce, a bank releases $0.08          while limiting cost

                                                      026550-001                                                  I B A 14
For most banks, asset allocation and capital
management are the most relevant opportunities to
enhance shareholder value
                                                                                                                                                                                                                                                                                                       3                                                                                 ALM
                                                                                                                                                                                                                                         Assets                        Liabilities

                                                         1                          Asset Allocation                                                                                                                                      Cash                         Deposits                                                                                  As s et Liability M anagement                                                         #5 Implementation: Execution steps
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           2 00 3 10 0 8 -m ark fo llett CF O su m ma ry re p ort H0 3 /46 8 5

                                                                                                                                                                   2 00 3 10 0 8 -m ark fo llett CF O su m ma ry re p ort H0 3 /46 8 5
                                                                                                                                                                                                                                          Short term                   Short-term borrowing                                                                                  1.         Given the n eed to retain low cos t dep osits a nd g enerate fee income, W oo ri s hould
                                                                                                                                                                                                                                                                                                                                                                                           broa den its product alterna tives to offer E quity-linked depos its
                                                                                                                                                                                                                                                                                                                                                                                             W oori s hould laun ch the p roduct in th e firs t half of 2004 , and ta rget to rais e at leas t
                                                                                                                                                                                                                                                                                                                                                                                              K R W50bn in its firs t tap o f th e market
                                                                                                                                                                                                                                                                                                                                                                                             Add itio nal offering s fo r 20 04 s hou ld then be plan ned with th e terms ad justed bas ed

                                                                                                                                                                                                                                                                        Borrowings
                                                        As s et allocation

                                                                                                                                                                                                                                          Fixed income
                                                                                                                           #5 Implementation: Execution steps
                                                                                                                                                                                                                                                                                                                                                                                              on the o utcome of the firs t pro duct iss ue

                                                                                                                                                                                                                                                                                                                                                                               2.         To lowe r its cos t of fundin g, W oori sh ould swap exis tin g K RW (flo atin g) fund s to U S D
                                                                                                                                                                                                                                                                                                                                                                                           LIBOR (paid in KR W )

                                                                                                                                                                                                                                                                                                           B AL AN C E SH EE T OP TI M I ZA TI O N PR OJ EC T
                                                                                                                                                                                                                                                                                                                                                                                             At toda y’s rate s, s uch a s wap wo uld s ave W oori appro ximately 1.00% per a nnum
                                                             New Exposure                                                              Existing Exposure
                                                                                                                                                                                                                                                                                                                                                                                              on the cos t of its funding (ass uming s tab le d ifferential in interes t rates between

                                                                                                                                                                                                                                                                        Foreign currency
                                                              Pos itive SVA                                                            Negative SVA

                                                                                                                                                                                                                                          Gross Loans
                                                                                                                                                                                                                                                                                                                                                                                              KR W a nd US D)
                                                              High return on capital                                                   Low return on capital
                                                              Stronger credit rating                                                   Concentrated Industries                                                                                                                                                                                                               3.         Given the s teepne ss o f th e U S D forward s wap curve, W oo ri s hou ld e nter into arrears
                                                              Diversified                                                              Customers at the limit                                                                                                                                                                                                                            s wa ps in order to lowe r its credit spre ad
                                                                                               Exposure s that                                                                                                                                                                                                                                                                               The upcoming Lower Tier 2 is sue of a pproximate ly US $300mm s hould be us ed to

                                                                                               genera te positive
                                                                                                                                                                                                                                                                                                                                                                                              execute an arre ars s wap in Q 4 2003

                                                                                                                                                                                                                                            Large Corp
                                                                                               SVA and strong
                                                                                                                                                                                                                                                                                                                                                                                             An arre ars s wa p in the cu rrent market is like ly to lower W oori’s sp read by

                                                                                    1          re turn on c apital ne ed                                     2
                                                                                               to replace e xposures                                                                                                                                                                                                                                                                          app roximately 0.30% per annum over a 5-year period
                                                                             New Exposures     that currently                                        Existing exposures
                                                                                                                                                                                                                                                                                                                                                                                             Add itio nal exis ting expos ures s hould be cons idered to ass es s which swaps are
                                                                                               genera te ne gative
                                                                                               SVA due to high                                                                                                                                                                                                                                                                                app ropriate for an arrea rs overlay

                                                                                                                                                                                                                                            SME

                                                                                                                                                                                                                                                                        Foreign currency
                                                                                               ca pital requirements                                   Negative SVA
                                                                                positive SVA
                                                                                               and low return

                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          W OO R I B A NK                                   15

                                                             Assets   Capital
                                                                                                                                          Assets   Capital
                                                                                                                                                                 return                                                                     Consumer                     borrowings
                                                                                                                                                                                                                                                                        Long Term Borrowing
                                                                                                                                                                  W OO R I B A NK                                      6

                                                                                                                                                                                                                                                                                                       2                                                               Capital Mgt.
                                                                                                                                                                                                                                                                       Capital                                                                                                                                                                                                                2 00 3 10 0 8 -m ark fo llett CF O su m ma ry re p ort H0 3 /46 8 5

                                                                                                                                                                                                                                                                                                                                                                   C apital manag ement                                                                   #5 Implementation: Execution steps

                                                                                                                                                                                                                                                                        Equity
                                                                                                                                                                                                                                                                                                                                                                                          An incremental KR W 500bn H yb rid Tier 1 is sue over th e ne xt 6 months , and an
                                                                                                                                                                                                                                                                                                                                                                                           incremental KR W 1,30 0bn Lower Tie r 2 over the next 18 months

  Asset strategies
                                                                                                                                                                                                                                                                                                                                                                                                     Economic capital                      Regulatory capital                 New regulatory capital

                                                                                                                                                                                                                                                                                                                                                                        Target capital position — December 2004

                                                                                                                                                                                                                                                                        Hybrid Tier I                                                                                   11% CAR
                                                                                                                                                                                                                                                                                                                                                                                                                             Economic Capital   Regulatory capital


                                                                                                                                                                                                                                                                                                              B AL AN C E SH EE T OP TI M I ZA TI O N PR OJ EC T

   Aim to improve risk adjusted returns by diversifying

                                                                                                                                                                                                                                                                        Tier II

                                                                                                                                                                                                                                                                                                                                                                         7% Tier 1

                                                            domestic exposure through investing in international
                                                                                                                                                                                                                                                                                                                                                                                                    1,000                                                                                     4,900


                                                                                                                                                                                                                                                                        Tier 3
                                                            investment grade exposures                                                                                                                                                                                                                                                                                     Economic capital    Economic capital
                                                                                                                                                                                                                                                                                                                                                                                                                  (hybrid) Tier 1
                                                                                                                                                                                                                                                                                                                                                                                                                                      Lower Tier 2         Upper Tier 2    Tier 3      Optimal capital

                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             W OO R I B A NK                                    11

                                                                                                                                                                                                                                                                       Capital strategies
                                                                                                                                                                                                                                                                        Supplement Core Tier I with cost effective Tier II
                                                                                                                                                                                                                                                                           capital to support growth

                                                                                                                                                                                                                                                          026550-001                                                                                                                                                                                                                     I B A 15
Balance sheet management

                           026550-001   I B A 16
Principles of economic capital management
   Solvency—the most important principal is to ensure there is a sufficient equity buffer at all times
    to cover unexpected losses experienced in the course of business

   While maintaining solvency, it is necessary
    to strike a balance between meeting
    expectations from stakeholders and the                                  Investors
    external environment                                                   Regulators
                                                                         Rating agencies
     Regulators                                                             Capital
     Bond Holders
     Depositors                                            External stakeholders perspective     Shareholders perspective on equity
                                                            on equity                              Emphasis on the bank’s ability to
     Shareholders                                           Emphasis on bank’s debt servicing     generate returns on the
                                                              capacity                              shareholder’s funds
     Rating agencies                                        Need banks to maintain large         Need banks to maintain minimal
                                                              equity base to absorb potential       level of equity base
     Analysts                                                economic losses

   After determining economic capital needs, optimize capital structure by selection of available
    capital instruments to minimize cost of regulatory capital (subject to meeting various regulatory
    and external expectations)

   Manage shareholder value
     Improve economic performance of the bank as benchmarked by return On equity, risk adjusted
       return on capital and shareholder value added

                                               026550-001                                                                      I B A 17
Banks have actively used non-dilutive capital to
bridge the difference between economic
requirements and target CAR
   DBS Group capital ratios                                                                     Standard Chartered Plc capital ratios
           Tier I          Tier II          S&P           DBS has actively                             Tier I          Tier II          S&P           The capital policy is to
                                                            managed its capital                 20%                                                      maintain a Tier I ratio of
   22%                                            AA-¹                                                                                         AA-¹
                                                            structure                                                                          A+
                                                                                                                                                         7—9% and CAR of 12—14%
                                                  A       MAS guidelines have                  15%
                                                                                                                                               A       Its aggressive use of Tier
   17%                                            A-                                                                                           A-
                                                            changed from a minimum                                                             BBB+
                                                                                                                                                        II capital, going to limits
                                                  BBB       Tier 1 ratio of above 10%                                                          BBB      of 50%, has resulted in
   11%                                                      to now a minimum of 7%              10%                                                     high return on equity for
                                                          DBS has made use of                                                                          its shareholders
    6%                                                      Hybrid Tier 1 capital as             5%                                                    It has further improved
                                                            well as Upper Tier 2 to                                                                     returns and capital
    0%                                                      boost its capital                    0%                                                     adequacy through the
         1997       1999    2001     2003                   adequacy                                  1997       1999    2001     2003                  issue of innovative
                                                                                                                                                        Hybrid Tier I capital
  ¹ Current rating, post-upgrade on 10 Jul, ’05

   HSBC Plc capital ratios                                                                      Chinatrust Commercial Bank capital ratios
           Tier I          Tier II          S&P           HSBC seeks to maintain a                     Tier I          Tier II          S&P           Post the SE Asian crisis
   15%                                                     prudent balance between              15%                                                     Chinatrust has raised
                                                  AA-¹     the different types of                                                              AA-¹     Tier I capital to shore up
                                                  A+                                                                                           A+
                                                           capital                                                                             A
                                                                                                                                                        capital adequacy
                                                  A-      With the advantage of                10%
                                                                                                                                               A-      With reduced levels of
                                                  BBB+                                                                                         BBB+
                                                           higher returns using                                                                BBB
                                                                                                                                                        subordinated capital
                                                           leverage, it uses a 8.25%                                                                    after 1998, it recently
   5%                                                      Tier I benchmark for its              5%                                                     issued US$500mm of UT
                                                           long-term capital                                                                            II capital in the form of
                                                           planning                                                                                     perpetual preference
                                                          It has also made use of                                                                      shares
   0%                                                                                            0%
         1997       1999    2001     2003                  innovative Hybrid Tier I                   1997       1999    2001     2003
  Source: Company reports, Central Bank website                                                ¹ Current rating, post-upgrade on 10 Jul, ’05

                Other balance sheet management techniques have also been used by international banks,
                            which will be explained in more detail in the following sections
                                                                                  026550-001                                                                               I B A 18
Economic capital estimates are driven based on the
asset quality composition of the bank’s credit
   Breakdown of Wholesale portfolio                                                        Assumed credit rating distribution of
   by industry (% of notional)                                                             loan portfolio
    60%                                                                                    40%                                                 34.7%
    40%                                                                                                                        25.3%
                                     16.2%                                                 20%
             2.7%                                                 1.6%                                                                 5.0%
     0%                                                                                          0.8%   0.8%   1.2%                                    0.7%
             Agri.&     Manuf. &   Real estate    Util. &         Others                    0%
   (20)%     mining      comm.      & constr.    services                                        BBB+    BBB   BBB-    BB+      BB     BB-      B+      B-

  Hypothetical distribution for illustrative bank                                         Based on hypothetical portfolio and JPM assumptions on remainder
                                                                                          of loan portfolio

   JPMorgan estimated the credit economic capital of the loan portfolio needs
   at a range of target ratings for a 1 year horizon (% of notional exposure)
               9.2%                          10.2%

               BBB-                          BBB                                      A                         AA                            AAA
                                                            Target credit rating for hypothetical bank
  Based on JPMorgan internal capital model

                                                                         026550-001                                                                    I B A 19
Economic capital requirements vary depending on the
overall asset quality of the industry segments
    Although capital requirement of BIS is 8% for each risk asset, economic capital requirements can differ
    Hypothetically, a diversified corporate loan portfolio may contain different capital requirements for
      different sectors
       For example, the transport and logistics segment has significant economic capital requirements
         resulting in significant capital charges (as you would have to hold 21.7% in equity for each dollar you
         lend to this segment)
       For example, risk pricing for the abovementioned segment would be significantly higher than the risk
         pricing for petrochemicals, which only require 4.3% economic capital

   Economic Capital requirements for a hypothetical bank with a large
   corporate loan portfolio (% of Notional)

      BIS 8%        9.5%
                                 7.7%        6.7%         7.4%                          7.6%                                 7.4%
   requirement                                                             6.2%

                 Agribusiness   Building    Commerce   Construction     Energy &        Food &      Petro-      Property    Telecom   Transport &
                                Materials                                  Basic       Beverage   chemicals   Development              Logistics

  Hypothetical corporate bank portfolio, based on JPMorgan internal capital model; LGD assumed to be 70%

                                                                  026550-001                                                              I B A 20
The traditional business model for banks results in
balance sheets that are relatively static

     Gather deposits               A typical bank’s deposit franchise provides low cost funds

                                   Extend credits to existing customers—overtime, top accounts receive most
      Extend credits

     Hold to maturity              Overtime, concentration builds up (industry, geography, single names)

   Potential portfolio concentration
  Industry                                       Single name                               Geography
                                                                              Top 100                  Int'l
            Others                                                            ~ 15%                    2%
                                                                                                           ~ 98%
                                   Top 3                 85%

  Note: Industry and geographic concentration based on hypothetical Asian bank portfolio

                                                                 026550-001                                     I B A 21
During unpredictable and adverse business cycles,
banks could suffer from concentration risks

  NPL ratio                                                                                Provisions/loans

   50%                                            Manifestation of                                     10%
                                                 concentration risk

   40%                                                                                                 8%

   30%                                                                                                 6%
                                                 23%                         24%
                     Average in Asia                           19%
   20%                                                                19%           18%                4%

   10%                                                                                                 2%

    0%                                                                                                 0%
             1995        1996      1997   1998   1999          2000   2001   2002   2003      2004
  Source: Hypothetical bank data

                                                  026550-001                                           I B A 22
In recognition of such risks, banks have begun to shift
towards a more dynamic business model

                            Decision to lend based on total value of client, bundle products
     acquire customer

      warehouse risk
                            Lending and risk taking decisions delinked, warehouse if necessary

           risk             Package risk and sell through capital markets, free up capital
                                                                                                 Capital turnover
                                                                                                  Diversify risk
     Redeploy capital       Deploy capital in the most efficient manner possible

      Maximize risk         Structured investments portfolio, M&A, distribute to shareholders,
     adjusted returns       etc.

        “Today, credit distress in banks can be traced predominantly to one factor:
        under-diversification in corporation credit portfolios. Notably, a bank’s risk
    adjusted profitability is materially influenced by its corporate-credit portfolio’s state
           of diversification, because diversification has the power to reduce risk
                  without diminishing expected returns.” Standard & Poor's

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Diversification reduces concentration and volatility,
allowing a bank to take risk efficiently
  Illustration: Scenario I
  Capital at risk                           10                      140            Depending on risk of (i)
                                                                     10              existing portfolio and (ii)
                             30                                      30
                                                                                     investment, final portfolio may
           100                                                      100              be different
                                                                                      Scenario I: total risk is 140
                                                                                      Scenario II: total risk is 115

     Existing portfolio   Investment   Concentration            Final portfolio    Impact of risk concentration
                                                                                     increases risk profile

  Illustration: Scenario II                                                                             Concentration

                                                                                    Risk level
  Capital at risk                                                    115
                                             15                                                          Standalone
                             30                                      15                                investment risk
           100                                                       100

                                                                                   Scenario II adds diversified risk
     Existing portfolio   Investment   Diversification          Final portfolio      minimizing total risk

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Balance sheet management case study

                         026550-001   I B A 25
JPMorgan assisted a leading Korean Bank in its
balance sheet optimization initiative
                                                                                            SVA        =       Operating profit - (required capital x capital cost¹)

    The objective of the assignment was to develop

       strategies for improving shareholder value

                                                                                      Asset yield                                     Risk level     Capital funding
    JPMorgan used the current composition of the
       balance sheet as a starting point and SVA

       (“Shareholder Value Added”) methodology as our

                                                                                                                Liquidity                 Risk              Capital
                                                                                    Asset allocation           management
       framework                                                                                                  (ALM)
                                                                                                                                       management         management

   The project was divided into 4 sections driven by the SVA formula
   Asset allocation              Capital management                     ALM                                                          Risk assessment
   Increase yield on the asset   Determine most efficient               Structure liabilities to                                     Accurately measure the
   portfolio without             mix of capital to ensure               match and support asset                                      risk in the balance sheet
   increasing risk or decrease   the lowest cost                        base y with the lowest
   risk on the asset portfolio                                          funding cost available
   without reducing return
    Identify positive and        Measure current cost of               Measure current ALM                                         Involves determination
      negative SVA loans           regulatory capital at the              position                                                     of the quantum of
    Develop alternative asset     bank                                  Develop strategies to                                        economic capital
      strategies                  Develop strategies to                  improve efficiency                                          Insights into model for
                                   improve the mix                                                                                     allocating risk-weightings
                                                                                                                                       as per BIS II
  ¹ Cost of equity
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Asset allocation
  Category                                                 Objective                                                                               JPMorgan solution
                                  Identify asset that would help the bank:                                                   Improve the risk/return profile of asset portfolio
                                          Reducing negative SVA                                                                   by
                                          Earn higher return on capital                                                                    Sell exposure to low SVA and highly concentrated
                                                                                                                                             exposures, while invest excess economic capital in
                                          Diversify its loan portfolio
                                                                                                                                             SVA positive assets
                                                                                                                                            Increase global credit exposure to improve margins
   Asset                                                                                                                                     and diversification by investing in global portfolio
                                  Execute transformation of the bank’s asset                                                 Consider hedging some negative SVA assets via
                                    portfolio                                                                                  synthetic securitization
                                                                                                                              Synthetic securitization is the most cost-effective
                                                                                                                               method to execute the strategic transformation of
                                                                                                                               the bank’s asset portfolio

                       New assets                                                                                                       Existing assets
  1.                   Return on Capital                                   + 58.9%                 2.                                   Return on Capital                                     + 2.5%
                       SVA contribution                                    + 45.5%                                                      SVA contribution                                     - 10.9%
  Fitch Industry breakdown                       Regional breakdown                                Portfolio overview                                          Industry stratification

                                                                                                     Portfolio Notional: KRW2,550bn                                         Wholesale &                Compound &
                                                                                                     No of Obligors                                                                                    Construction
                                                                                                                                                                           Textile-tree-                     Finance
                                                                                                     Number of Unique Borrowers                                          paper & others                    First metal
                                                                                                                                                                                       Metal & Fishery & food
                                                                                                     Number of Unique Chaebols                                                       Machinery manufacturing

                                                 Fitch industry breakdown for “Others”             Chaebol stratification                                      Domestic rating stratification (%)
                                                  Building and materials                  2.1%                                    Curitel Daelim
                                                  Business services                       2.0%                               CJ             Daewoo                            41.89            40.05
                                                  Cable                                   1.2%                                                Hanjin
                                                  Consumer products                       1.5%                                                Hyundai Motor
                                                                                                              Unaffiliated                                        18.06
                                                  Farming and agricultural services       1.2%                                                LG
                                                  Gaming, leisure and entertainment       1.1%
                                                  Healthcare                              1.0%
                                                  Lodging and restaurants                 0.6%                                Tong Yang                            AA          A               BBB              BB            B
                                                  Packaging and containers                0.6%
                                                  Pharmaceuticals                         0.4%

                                                                                                                                                                                                                          I B A 28
                                                  Textiles and furniture                  0.4%
SVA analysis of existing portfolio
  ROC by industry sector
                                                                                     Construction (SME)

                                                                                                                                           Positive SVA
                      203              185
          40.0%                                                                       (small co)    74            Textile
                                                                                        120                    (largecorp  )
                           Wholesale &                   161                                               48                       20
          30.0% Wholesale & Transport
                Transport                                                                                                 23    Textile
                             (SME)                                        Assembly
                (small co)                                                 (SME)                     Compound &               (small co)
                                                  Construction                                         Nonmetal Assembly
                                                    (SME)                                   of capital (SME) (small co) 21
  ROC %

          20.0%                                                                      Cost
                                       162                                                              63
                                                                    149                                                      Fishery

                                                                                                                                           Negative SVA
          10.0%             186                                                              100                             (SME)
                                           (largecorp)     Compound &                             Construction
                                                             Nonmetal                              (largecorp)
          0.0%          Wholesale &                         (largecorp)
                          Transport                                                                                  45         21
                         (largecorp)                                                    Wholesale &
    (10.0)%                                                                              Transport
                                                                                          (public)                           1st Metal
                                                                                                                   Fishery (largecorp)
                  0                    5                       10                     15                    20                  25
                                                 Customer categories by exposure size (US$mm)

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Efficient frontier


            High SVA                                           Efficient frontier

                                                       Step 2 stand-alone: Investing in
                        Step 2: Investing in           alternative assets only
                        alternative assets
                                                     Current position
                                                     Bank X’s asset portfolio
                        Step 1: Hedging
                        negative SVA and
                        high concentration
                                                               Low SVA

    Improvement in SVA of asset portfolio by reducing capital at risk and increasing
                                  return of capital
                                        026550-001                                         I B A 30
Capital management
  Category                                  Objective                                                       JPMorgan solution
                          Issuing more efficient capital instruments to                       In achieving target ratios beyond core economic
                           optimise the capital mix                                             capital requirements, the bank should seek to
                          Introduced to capital alternatives which meet both                   maintain the cheapest forms of regulatory capital
                           the economic capital requirements and                                available
  Capital                  regulatory/competitive standards                                    Replace expensive capital by issuing Lower Tier II
                          Moving towards a more                                               Achieve target Tier I ratio by using non-dilutive HT
  management                                                                                    I capital
                                                                                               Time the issue ahead of major capital redemption
                                                                                                in 2005 by the bank and other issuers in the same
                                                                                                peer group

  Target capital position—December 2004
                                      Economic capital          Regulatory capital                      New regulatory capital
   11% CAR                                               Economic Capital       Regulatory capital

   11% CAR                                                                                                             100
                                                                        1,200                                                          3,700
   7% Tier 1                                                                                                                          3,700
   7% Tier 1                                       500

                                                  500                                                                                  4,900

       Economic capital Economic capital      Regulatory
  Economic capital Economic capital Regulatory
                            buffer          (hybrid) Tier 1
                                                                  Lower Tier 2 2
                                                                          Tier            Upper Tier 2 2
                                                                                                  Tier               Tier3 3
                          buffer         (hybrid) Tier 1                                                                           structure

                                                              026550-001                                                                       IBA
Asset liability management
  Category                             Objective                                               JPMorgan solution
                       Lower funding cost and increase fee income                   Implement liability management strategy to
                       On-balance sheet methods, such as holding longer              reduce funding costs
                         duration assets (i.e., Introduction of new mortgage         Introduce cost saving strategies such as equity-
                         loans in Korea) or shortening assumed duration for           linked deposits, Quanto swap and Swap in arrears
  Asset liability        deposits without maturity can prove be more
                         effective for managing this risk
  management                                                                         On-balance sheet methods, such as holding longer
                                                                                         duration assets (i.e., Introduction of new mortgage
                       Mitigate asset-liability mismatch (Liabilities longer            loans in the bank’s home country) or shortening
                         than the assets                                                 assumed duration for deposits without maturity
                                                                                         can prove be more effective for managing this risk

  Monthly assets and liabilities                                        Net funding need
  refixing risk (in billion)                                            (in billion)
   25,000    Assets and Liabilities                                     15,000
   15,000                                                               10,000
    5,000                                                                 5,000
  (30,000) M1 M2 M3 M4 M5 M6 M7        M8 M9 M10 M11 M12
                                                                                    M1   M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12

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The bank could enhance shareholder value by around
9% of current market cap. from optimizing the
balance sheet
  Quantifying the benefit for shareholders—market capitalization (billion)

                         459        5,174        5,103


    3,000                                                            2,618



            Peer 1    Bank after    Peer 2   Bank before    Peer 3   Peer 4   Peer 5   Peer 6
                     optimization            optimization

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JPMorgan credentials

                       026550-001   I B A 34
JPMorgan is the only investment bank to offer
comprehensive balance sheet advisory to FIG clients…

  Recognized leader in balance sheet advisory
  Excerpt of article

  Also on the institutional side, the bank has been putting more resources in asset and liability management (ALM), another strategic push for the bank
  this year. JP Morgan set up an ALM team in Asia at the beginning of this year to target banks and life insurance companies around the region, and the
  bank now has projects in several countries, says Bulchandani, who heads up the team in conjunction with his credit derivatives role. “We started this
  effort at the end of February, and my target is to have between eight and 10 companies signed up with some completed, in a 12-month period,” he

  Similar to the problems encountered by life insurance firms in Europe, Asia’s insurance companies face a mismatch in the yields they are able to achieve
  on their investments and the returns guaranteed on their policies. At the same time, with domestic fixed-income markets rarely stretching beyond
  15years, there is a mismatch in duration in the asset and liability portfolios.

  “The liability side is similar to what happened with insurance companies in Europe,” says Bulchandani. “They have guarantees and they have embedded
  option-ality in their policies. The difference is that, by and large, Asian life insurance companies have realised the problem. They realize the benefits of
  diversification, they realize that they have to be more in fixed-income and use equity as a way of generating alpha. They really want to take fixed-
  income, they really want to take international assets and diversity. However, they have to ensure that they operate within the scope of existing
  regulations. The key regulations to consider are related to the amount of overseas assets the company can hold, the types of assets it can invest in, and
  the types of derivatives hedges it can execute.”

  As part of its ALM approach, the banks first examines market and regulatory constraints and defines the objectives of the analysis, then sets the
  performance metrics, analyses, the overall asset and liability portfolios, and sets a tactical optimization benchmark for the insurance company to
  follow. “We are not telling the insurance companies to stop taking risk, but rather to take a mix of risks and to diversify,” continues Bulchandani. “If
  you look to 2005 and 2006, there are various significant factors that can affect the derivatives market- International Accounting Standard 39, Basel II,
  the tightening of credit spreads, and so on. And in the world, the bright spot is going to be ALM, which can give some positive momentum to the capital
  market growth.”

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… and has enjoyed significant success across the
region in delivering on our total balance sheet
  Key themes              Total balance sheet approach to advisory business

         Basel II                    Advising insurance company on optimal asset

                                     Advising leading bank on BIS II, economic capital
         IAS 39
                                      framework and diversification benefits
                                     Advised bank on economic capital framework and
                                      concentration risk
   Merger integration
                                     Advised a leading insurance company on embedded
                                      optionality of liabilities and concentration risk
      Enhance risk                   Advised leading bank on redeployment of liquidity to
    adjusted returns                  achieve increase diversification and risk adjusted
   Concentration risk                Advised leading bank on capital management, capital
                                      allocation and concentration risk
         Overall                     Advised leading bank on credit portfolio management
   financial efficiency               and hedging of balance sheet risk

                                      026550-001                                          I B A 36

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