1. FD Financial Diplomats Risk Analysis and Bank Financial Statements Hennie van Greuning World Bank Treasury FirstRand Board of Directors

2. Risk Analysis and Bank Financial Statements FD Financial Diplomats Outline – key messages 1.Discuss the common causes of financial crisis and failure. 2.Key lessons learned from the financial crisis 3.Proposed regulatory reforms and risk enhancements as a result of the financial crisis. 4.Basic risk analysis 2

3. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Credit Crises – Common Causes …all consequential events in human history have come from unexpected, rare occurrences Nassim Nicholas Taleb 3 Unusual Times

4. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial / Banking Sector Crises – Common Causes Business strategies flawed Poor governance oversight & risk management Balance sheets structurally weak Excessive gearing Excessive credit risk – Weak credit terms – Risky products Liquidity risk not well understood Risks taken at lower levels not understood by senior management 4 Recent bank failures – generic causes

5. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial Crises – Common Causes 5 Global imbalances have built up over years CA balances Financial

6. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial Crises – Common Causes 6 Debt can be viewed as sustainable as long as the debt to GDP ratio is non-increasing* 0% 50% 100% 150% 200% 250% 300% 350% 400% 1916192619361946195619661976198619962006 US Private Sector Debt to GDP Source: US Federal Reserve *Nouriel Roubini (2001) Debt Sustainability: How to Assess Whether a Country is Insolvent, Stern School of Business, NYU

7. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial Crises – Common Causes 7 US Housing Market Fundamentals Source: OFHEO and US Federal Reserve

8. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial Crises – Common Causes 8 Unrestrained asset (derivative) growth – CDS market growth Source: ISDA, The World Bank, US Bureau of Economic Analysis and US Treasury

9. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial Crises – Common Causes 9 South Africas macro economic imbalances monitor Current account balanceHousehold debt to disposable income House prices Inflation

10. Risk Analysis and Bank Financial Statements FD Financial Diplomats 1. Financial Crises – Common Causes 10 Consequences of macro economic imbalances Global financial sector crisis Global macroeconomic crisis Bank share prices Global growth

11. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Crises – Common Causes 11 Bank Failures Statistics Source: http://investingcontrarian.com/global/us-1800-bank-failures-tsunami-on-horizon/ 2010 began with a whimper for Bank Failures as the first week almost gave us the illusion that maybe and just maybe, the problem might just have solved itself as zero failures were reported. It was never going to be that easy, was it? As the graph, shows, a few weeks into 2010, the number of failures curve has already picked up steam and we see the red curve blasting away. May 20 Failures – 72 so far this year Problems - 775 institutions with aggregate assets of $431 billion 8,384 FDIC insured banks

12. Risk Analysis and Bank Financial Statements FD Financial Diplomats Key Lessons Learned I spent too much time out of the office with clients and trusted other people to manage the risk – I am sorry. Dick Fuld, ex-Lehman CEO.12 September 2009 We strive to have a balance in our team and I will use the analogy of the soccer team. A balanced team has good forwards, sweepers, backs and a goalie. If too many goals are let in, you must strengthen your defense. However to score goals you must have good strikers. You cant win matches with 11 goalies and nor can you win with 11 strikers. We have improved our defensive line but not at the expense of our forward line. SA banker - September 2009 Remember, models are only as effective as the assumptions on which theyre built and the inputs theyre provided Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so. Douglas Adams 12 What did management learn?

13. Risk Analysis and Bank Financial Statements FD Financial Diplomats Key Lessons Learned If things appear too good to be true, they probably are (If something cannot go on forever, it wont) – know where profits come from Back to basics – use common sense approach to risk management: Risk management is about quality of people, experience, judgment and coordination Pro-active, holistic and forward looking analysis, through e.g. robust stress testing and a combination of quantitative and qualitative risk information Align risk, capital, funding and strategy – and incorporate it in a dynamic risk appetite process Escalate clearly and early – to avoid surprises 13 The last time anybody made a list of the top hundred character attributes of New Yorkers, common sense snuck in at number 79. Douglas Adams Nothing travels faster than the speed of light with the possible exception of bad news, which obeys its own special laws. Douglas Adams, "The Hitchhiker's Guide to the Galaxy"

14. Risk Analysis and Bank Financial Statements FD Financial Diplomats 14 Themes Lehman Brothers Kidder, Peabody & Co Barings Bank Orange County Societe Generale Dick FuldJoseph JettNick LeesamBob Citron Jerome Kerviel Board failure Management failure Failure in Internal controls Weak risk management Accounting failure Corporate Governance failure Regulatory failure IT Compensation Financial Failure - Nothing New ?

15. Risk Analysis and Bank Financial Statements FD Financial Diplomats Disconnect between risk and controls: These are stories of what happens when the desire for excess returns overrides risk controls. The person in charge (in each case) showed excellent results in the beginning, and thus was allowed to transact without proper supervision and controls. Beware of star performer who is unconstrained by lack of supervision. If returns are too good to be true, there is likelihood of elevated risk Poor understanding of business and investment strategies by senior management and Board Fractured (and not always competent) oversight mechanisms: internal and external GREED 15 History: Analysis from Kidder Peabody to the present crisis

16. Risk Analysis and Bank Financial Statements FD Financial Diplomats 3. Regulatory reform 16

17. Risk Analysis and Bank Financial Statements FD Financial Diplomats 3. Regulatory Reform Some emerging market countries way ahead of the governance & regulatory curve – already implemented many items the world is still debating The crisis provides a unique opportunity to make significant internal improvements in organizations Good time to foster a culture of risk and transparency Flexibility: Those better able to adapt have an advantage in the market going forward Building-up infrastructure and capacity takes commitment and resources. 17 Not everything is bad news...

18. Risk Analysis and Bank Financial Statements FD Financial Diplomats 4. Key stakeholders - Accountability Key stakeholdersAccountability A. RegulatorsSet regulatory framework, including risk exposures limits and other risk management parameters, which will optimize risk management in the banking sector A. SupervisorsMonitor financial viability and effectiveness of risk management. Check compliance with regulations. B. ShareholdersAppoint fit and proper boards, management, and auditors C. Board of directorsSet risk management and other bank policies. Ultimate responsibility for the entity D. Executive managementCreate systems to implement board policies, including risk management, in day-to-day operations E. Risk Committee and ERMMonitoring of risk management practices F. Audit Committee and Internal AuditTest compliance with board policies and provide assurance regarding corporate governance, control systems, and risk management processes G. External AuditExpress opinion and evaluate risk management policies H. External stakeholders (depositors, customers, investment analysts, rating agencies, financial press, NGO's) Insist on transparency and full disclosure 18

19. Risk Analysis and Bank Financial Statements FD Financial Diplomats 4. Risk information not directly reflected in AFS Financial risksOperational risksBusiness risksEvent risks Balance sheet structure Internal fraudMacro policyPolitical Income statement structure External fraudFinancial infrastructure Contagion Capital adequacyEmployment practicesLegal infrastructureBanking crisis CreditClients, products and business Legal liabilityOther exogenous LiquidityDamage to physical assets Regulatory compliance MarketBusiness disruption and system failures Reputational and fiduciary Interest rateExecution, delivery and process Country risk CurrencyStrategic issues Summary of risk types

20. Risk Analysis and Bank Financial Statements FD Financial Diplomats 4. Risk information not directly reflected in AFS Risk in the context of a Bank Balance Sheet Assets Liabilities Credit risk +Interest Rate in the banking book +Liquidity Market risk + Banking book hedges Investment risk + Liquidity risk + Market risk Liquidity risk Liquidity & Funding risk + Interest rate in the banking book Market risk + Banking book hedges Market risk Capital risk Funding risk High level allocation to key risk types Note: figures are provisional

21. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Principles Questions to consider… What is the purpose of the analysis? What level of detail will be needed? What factors or relationships (context) will influence the analysis? What are the analytical limitations, and will these limitations have the potential to impair the analysis? What data is available? How will data be processed? What methodologies will be used to interpret the data? How will conclusions and recommendations be communicated?

22. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Principles What happened? Why did it happen? What is the Impact of event? Action plan going forward – Accountability – Target date What is Financial Analysis?

23. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Tools and techniques ToolsTechniques Questionnaires Group response to answers per risk category Data input tables (excel, etc)Manipulate the data to facilitate analysis Manipulated data Structure of the balance sheet Structure of the income statement Common-Size analysis Cross-Sectional / comparative analysis Ratios Graphs & charts Pie, Bar, Trend Analysis, etc Structural change in the business Annual growth (from year-to-year) Cumulative growth (base to current year) Ratios Ratio analysis Regression analysis

24. Balance Sheet Analysis FD Financial Diplomats Balance Sheet Overview 4. Regulatory Returns Analytical Value

25. Balance Sheet Analysis FD Financial Diplomats Composition of Assets : Structural Change & Growth 4. Regulatory Returns Analytical Value

26. Balance Sheet Analysis FD Financial Diplomats Asset Growth Over Time SARB -2008 Annual Bank Supervision Report 4. Regulatory Returns Analytical Value

27. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Tools and techniques Trend analysis – Asset Growth: cumulative from a base period Source: 2009 ABACUS

28. Risk Analysis and Bank Financial Statements FD Financial Diplomats 6. Financial Analysis – Tools and techniques Trend analysis: Total Assets, Gross Loans and Advances SARB – 2008 Annual Bank Supervision Report

29. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Tools and techniques Common Size Analysis - Vertical Analysis Period 1 (%) Period 2 (%) Revenue source: Service A3045 Revenue source: Service B2320 Revenue source: Service C30 Revenue source: Service D175 Total Revenue:100 Operating expenses (excluding depreciation) Salaries and employee benefits1525 Administrative expenses2220 Rent expense10 Earnings before interest, tax, depreciation (EBITDA)5345 Depreciation and amortization44 Earnings before interest and tax (EBIT)4941 Interest paid77 Earnings before tax (EBT)4234 Income tax provision158 Net Income2726

30. Risk Analysis and Bank Financial Statements FD Financial Diplomats Income Assets Assets Vs Income: Energy Applied Vs Income Earned Regulatory Returns Analytical Value

31. Financial Sector Failure Copyright © 2010 Dr. Hennie van Greuning Cost-to-Income Ratios of Individual banks Categorized by Asset Value of Each Bank SARB – 2008 Annual Bank Supervision Report 4. Regulatory Returns Analytical Value

32. Risk Analysis and Bank Financial Statements FD Financial Diplomats Composition of Income Statement - Multi Year Trend SARB – 2006 Annual Bank Supervision Report Regulatory Returns Analytical Value

33. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Tools and techniques Ratio Analysis: Liquidity statistics 0% 50% 100% 150% 200% 250% Period 1Period 2Period 3Period 4Current Period Customer loans as % of customer deposits Interbank loans as % of interbank deposits Readily marketable assets as % of total assets Volatile liabilities as % of total liabilities Volatility coverage (readily marketable assets as % of volatile liabilities) Bank run (readily marketable assets as % of all deposits type)

34. Risk Analysis and Bank Financial Statements FD Financial Diplomats Financial Analysis – Tools and techniques Correlation: Total Banking-Sector Assets to GDP SARB – 2008 Annual Bank Supervision Report