1. The Asian Banker Summit 2011
Improving Sustainability in Banks Through Liquidity and Capital Management
The Asian Banker Summit 2011
6-8 April 2011
Dr. Colin Lawrence Director, Prudential Risk Division Financial Services Authority 1

2. Past Weaknesses – Liquidity Policy
No clear articulation of risk tolerance and supervisory objectives
Maintain going concern, or handle transition to gone concern?
Took no account of the business cycle
Underestimated potential stresses
Cross-border issues not addressed
Regulatory liquid assets not liquid

3. Past Weaknesses - Firms
Liquidity risk mismanaged
Governing Body not fully informed
Stress testing inadequate
Liquidity as a profit centre
Transfer pricing
New product approval

4. Implications for Firms
Enhanced liquidity risk management capabilities in firms
Greater use of stress testing
Testing and improvements to contingency funding plans
Less reliance on short-term wholesale funding, including from foreign counterparties
Greater incentive to attract a higher proportion of retail time deposits
A higher amount and quality of stocks of liquid assets, including a greater proportion of government debt
A check on unsustainable expansion of lending during favourable economic times

5. Systems and Controls Requirements
Governing body & Senior management oversight
Managing liquidity across legal entities, business lines & currencies
Comprehensive liquidity risk measurement
Policies to control liquidity risk
Pricing liquidity risk
Funding diversification
Intra-day liquidity risk management
Management of collateral

6. New UK Regime- will converge into Basel 3
Systems and Controls
Adequate Liquidity & Self Sufficiency
Stress Testing
Individual Liquidity Adequacy Standards
New Reporting

7. Sustainable Business Model is Key Starting Point
But Many Different Business Models Suffered in The Crisis
High Liquidity Ratios
Crisis Casualties Included:
Small Building Societies
Regional Banks
Large Universal Banks
Investment Banks
Global Players
Domestic Businesses
Businesses need to be well run, and the Business Model and Risk Appetite aligned

8. Illustrative Impact of Cyclical Downturn on Portfolios
User Cost of Credit
Payable to Treasury
CRM Spread
Gains
Losses
Cyclical

9. The Critical Link Between Risk and Stakeholder Value
Risk Transformation is What Banks Do…
Risk Adjusted
Revenue
Shareholder Value
Revenue
Fair Value Stock Price
EPS
RAPM
EVA
Risk Information
Diversification
Growth rate
Business cycle
Investor perception
Market sentiment
Operating
Margin
Market Risk
Pricing
- Spreads
- Fees
Product Cost
Overhead
Industry
Growth
Credit Risk
New Client
Market
Penetration
Product
expansion
Liquidity Risk
Client
Retention
Operational
Risk
Capital
Structure
Share of
Market
Client
awareness
Product
Innovation
Promotion
effectiveness
Diversification
/ Concentration
Benefits
Product Mng.
Sales forces
incentives
Selling skills
Portfolio div.
(inside risk
categories)
Strategic div.
(across risk
To understand risk adjusted profitability, a Board has to understand the risks being run 2 7 9

10. Historic Return on Equity for UK Banks
“…as long as the music is playing, you’ve got to get up and dance.
We’re still dancing” Chuck Prince 9 July 2007
Average ROE below 10% pa,
volatility low at c.2% pa
Average ROE over 20% pa, c.30%
pre-crisis and volatility much higher
Since the start of the 20th century,
Capital ratios have fallen by a factor of five in the US and UK.
Liquidity ratios have fallen by roughly the same amount in half the time.
As banks moved up the risk spectrum, the return required by shareholders has increased
Between , the return on UK banks’ equity averaged below 10% per annum, with low volatility of around 2% per year
This was roughly in line with risks and returns in the non-financial economy.
Since the 1970s returns on UK banks’ equity have averaged over 20%. Immediately prior to the crisis, returns were close to 30%.
Higher returns means higher risk. The volatility of UK banks’ returns trebled over the past forty years.
Higher returns even when driven by higher risk & leverage were rewarded by the market

11. No Business Model is Inherently “Better”… But Some are Riskier Than Others
Key issues to consider:
RAROC
Risk appetite
Risk strategy
Capital and Liquidity
Appropriate given 1.
Still appropriate under stress?
Risk Management & Control
First line of defence
Local level independent challenge essential
Principal agent problems
May show 1. does not work given 2. and 3.
Forces correct pricing
Can you create EVA under stress?
Complexity & Opacity
If you can’t measure and monitor risk - you should not do it
Regulators must be willing to shut down areas of business
Shadow Banking
Unintended consequence of more regulation?
How do we monitor and control?

12. Basel 3 – More Capital & Higher Quality Capital Reflects Key Regulatory Objective of Increasing Loss Absorbency
FSA Current Regime
Basel 3 proposal
Tier 1 Capital
Going concern capital
Core
(at least 50% of T1)
Tier 1 Capital
Core
50%
4.5%
Non-innovative 6%
50%
Innovative
(max 15% of T1)
15%
Non- core
Tier 2 capital
Upper Tier 2 8%
Gone concern capital
Lower Tier 2
(max 50% of T1)
100%
Tier 2 capital
Tier 2
50%
250% of Tier 1 capital
Tier 3
Upper Tier 3
Lower Tier 3
(not limited)
Global minimum liquidity regime also introduced for the first time

13. Different Types of Stress Tests Required Forward Looking, With a Focus on Extreme Tails & Points of Weakness
Sensitivity analyses
Large movement on single factor or parameter
Scenario analyses
Used to assess model risk, effectiveness of potential hedging strategies etc.
Full representations of possible future situations to which portfolio may be subjected
Involves simultaneous, extreme moves of a set of factors
Reflects individual effects and interactions between different risk factors, assuming a certain cause for the combined adverse movements
Used to assess particular scenarios (e.g worst-case)
Historical
Based on observed events from the past
Hypothetical
Plausible events that are yet to be realized
Requires expert judgment and analysis – sometimes difficult to link with underlying factors
Macroeconomic (eg changes in unemployment, cyclical downturn etc)
A shock to the entire economy
Occurs external to firm and develops over time
Market (eg stock market crash, change in interest rates, shock to credit spreads in a sector)
A shock to the financial and capital markets
May be historical or hypothetical
Event-driven
Based solely on a specific event independent of the portfolio characteristics
Identify risk sources/events that cause changes in market and effects of these changes on the risk parameters
Portfolio-driven
Directly linked to the portfolio
Identify risk parameters changes that result in a portfolio change and identify events that cause the parameters to change
Worst Case/Catastrophe (E.g. terrorist attack, change in regulations)
Event exogenous to market/economy, though impact arises through resulting changes
Often are tied to specific characteristics of portfolio or exposures

14. Expectation of Firm’s Stress Testing Framework Integrated with Risk Appetite & Business, Capital & Liquidity Planning
Business strategy
Risk appetite
Business Plan / Operating plan / Corporate Plan
Capital Planning
Stress testing (base & stress plan)
Mitigation plan
Stage 1
Stress testing governance framework – active Board and senior management ownership and engagement in all stages
Stage 2
A. Establishing
Stress testing programme
Stress testing infrastructure
Policies and procedures
B. Implementing
Second-order effects
Challenge process
Firm wide and granular
Forward looking
C. Taking action
Management actions
Regular monitoring
Amendments to business plan

15. STRESSED CORE TIER 1 CAPITAL VS. THRESHOLD
Macro to Micro – Vicious or Virtuous Cycle?
Threshold Conditions for Intervention & Management Actions Key
1: Agree the macro scenario
2: Macro to Micro
5: Management Actions
3: Stress the Firm
4: Aggregate outcome
MACRO ECONOMIC SCENARIO
GDP
UNEMPLOYMENT
HOUSE
PRICES
COMMERCIAL
PROPERTY
INFLATION
INTEREST RATES
ECONOMETRIC / QUALITATIVE ASSESSMENT
BANK 1
BANK 2
BANK 3
BANK 4
BANK 5
SYSTEMIC
& PEER
VIEW
CALIBRATION
PRE-PROV INCOME
(PPI)
BUSINESS UNIT 1
REVENUE
COST
STRESSED PPI YRS 1-5
STRESSED CORE TIER 1 CAPITAL VS. THRESHOLD
BUSINESS UNIT 2
BUSINESS UNIT 3
GROUP
IMPAIRMENTS
PORTFOLIO 1 PD
LGD EL
STRESSED IMPAIRMENTS YRS 1-5
PORTFOLIO 2 PD
LGD EL
STRESSED IMPAIRMENTS YRS 1-5
PORTFOLIO 3 PD
LGD EL
STRESSED IMPAIRMENTS YRS 1-5
GROUP
STRESSED IMPAIRMENTS YRS 1-5
TRADING BOOK
STRUCTURED FINANCE, CREDIT, MONOLINES, MARKET RISK
STRESSED VALUATIONS YRS 1-5
OTHER STRESS
PENSION, CONDUCT OF BUSINESS, ETC
STRESSED ADJUSTMENTS YRS 1-5
REVISED CORE TIER 1 YRS 1-5
STRESSED RWAS YRS 1-5
EAD, PD, CYCLICALITY FACTOR/ MARKET RISK RWAS
RWAS
MNGMT ACTION
CAPITAL RAISING, DISPOSALS, COST CUTTING ETC 15

16. Micro to Macro - Illustrative Portfolio Analysis
Early Signalling of Risk via Leading Indicators Key
PORTFOLIO C
Systemic Risk KPI
Firms to focus on 16

17. Early Intervention & Identification of Management Action Prevention, Intervention, Recovery, Resolution….
Year 1
Year 4
Year 2
Year 3
Year 5
CT1 % Under Stress 10 8 6 4 2
Management Actions/Intervention
Rights Issue
Sale of Business
Cut dividend
Reduce RWAs etc…

18. Liquidity Stress Testing Need to Ensure Time For Remedial Action
Wholesale funding risk
Retail funding risk
Intra-day liquidity risk
Funding diversification risk
Intra-group liquidity risk
Cross-currency liquidity risk
Off-balance sheet liquidity risk
Franchise-viability liquidity risk
Marketable asset risk
Non-marketable asset risk
Idiosyncratic Stress
Market Wide
Stress
Combination
Cash Flows
Liquidity Position
Profitability
Solvency
Short Term &
Protracted
Short Term &
Protracted
Basel 3 new focus on liquidity, UK regime already implemented

19. Includes stress to failure
Stress Testing
Wholesale funding risk
Retail funding risk
Intra-day liquidity risk
Funding diversification risk
Intra-group liquidity risk
Cross-currency liquidity risk
Off-balance sheet liquidity risk
Franchise-viability liquidity risk
Marketable asset risk
Non-marketable asset risk
Idiosyncratic Stress
Market Wide
Stress
Combination
Cash Flows
Liquidity Position
Profitability
Solvency
Short Term &
Protracted
Short Term &
Protracted
Includes stress to failure

20. Hypothetical Comparison of Liquidity Mismatch by Type

21. Decreasing Stress (A - C)
Hypothetical Comparison of Liquidity Mismatch by Type
Link to Liquidity Stress Tests and Funds Transfer Pricing is Key
Decreasing Stress (A - C) A B C 1 2 3
Increasing Stress (1 - 3) 21

22. Recovery and Resolution Plans “Living Wills” Regulator Actively Involved Through Supervision & Specialist Reviews
Going Concern
Bank Owns &
Executes
Operational & Legal Structure
CURRENT
Hold-Co vs. Branches
Segregation of accounts
Single customer view
Booking practices
Infrastructure issues
Local liquidity
Collateral (aggregation, hypothecation…)
Off-balance sheet items
Cross border complications
TIME
Resolution Plan
OPTIONS
Wind-downs and disposals
Early equity injection
Deposit transfer/ Bridge Bank
Liquidation/ Deposit pay off
Share transfer (Temporary Public Ownership)
Regulator Owns
& Executes
Gone Concern
Key elements of
Recovery Plan also
feature in Resolution Plan
CRISIS
DATA
Recovery Plan
Recovery
Capital Plan
Liquidity Plan
Reduce / stop activities
Plan to wind down/
liquidate trading book
Bank Owns
& Executes
Going Concern
RECOVERY
Plan to sell
Businesses/Subsidiaries
1. Key triggers
Breached
2. Key triggers
breached

23. Speed Matters Market May Allow Little Time Between Recovery and Resolution
2007
2008
Aug 07
Mar 16
Sep 07
Sep 14
Sep 15
Sep 17
Sep 23
Sep 25
Oct 12
Oct 13
Nothern Rock nationalization
Bear Stearns, acquired
by JP Morgan
Fannie Mae & Freddie Mac are rescued by the FED
Merril Lynch is sold to Bank of America
Lehman Brothers declares bankruptcy
Lloyds take-over HBOS
Goldman Sachs receives support of $5Bn from B. Hathaway Investment
JP Morgan buys Washington Mutual
Wachovia is acquired by Wells Fargo
The next crisis will be different – together we are building a global framework that is robust and forward looking
UK Government rescues RBS

24. Better Macro & Micro Prudential Supervision Data + Analytics + Judgement Key
WHAT- Ensure financial stability
Monitor, identify and prioritise systemic risk
Link micro-supervision and macro-economic risks
Consider unregulated parts of the market
Ensure it is somebody’s job to remove the “punchbowl”
HOW - By getting ahead of the curve
Create counter-cyclical buffers – capital/liquidity in the system should rise as risk rises
Identify leading indicators (data + analytics + judgement)
Clear thresholds for intervention
ACTIONS - Resolve if necessary
Early action when thresholds breached
Firm specific (Management actions)
Market wide levers (eg LTV ratios)
Contingency plans in place
Living Wills
Bail–out to Bail-in
Resolution
Monetary
Policy
Macro Prudential
Supervision
Micro Prudential