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

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

Economic & Market Analysis

Industry Structure n Competition n Market Dynamics

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

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

Products Produced n Products n Technology n Substitutes

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

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

Substitutes n credit unions n foreign banks n small virtual competitors n small region-specific/culturally specific institutions

Cost and Revenue Structure n Revenue Sources n Cost Structure

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

Cost Structure n Operations n Human Resources

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

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

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

Risk Management Environment

Risks Major Risks: n Market Risk n Credit Risk n Liquidity Risk Measurement: n Statistics n Economic Capital

Techniques & Products Techniques: n Hedging Products: n Swaps n Futures (Currency) n Options

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

RBC

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

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

Net Income by Segment

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

Risks to be Managed n Credit n Market n Liquidity n Insurance n Operational

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

Economic Capital

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

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

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

Worldwide Revenues

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

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

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

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

Insurance Risk n Product design and pricing risk n Claims administration risk n Underwriting risk n Liability risk

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

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

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

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

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

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

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

BMO

Enterprise-wide Risk Management Comprehensive risk governance Effective process & modelsQualified risk professional

Integrated Risk Management n Management of risk is integrated with the management of capital and strategy  Capital at Risk (CaR)

Total Capital Risk by Risk Type n Strategic 11% n Operational 24% n Credit 38% n Market 27%

Direct Risk Management n Credit Risk n Market risk n Liquidity and Funding Risk n Operational Risk

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

Credit risk n Provision for credit losses was $820 M (0.56% of average net loans and acceptance) n Gross impaired loans totaled $2,337M n Net loans exposure to cable and telecom companies was approximately $2.0 billion

Credit risk n Risk measurement –Gross impaired loans and acceptance n Measure the financial condition of the portfolio –Provision for credit losses n A measure of credit quality experience

Market Risk n Is the risk of a negative impact on the balance sheet and income statement resulting from adverse changes in the value of financial instruments as a result of changes in certain market variables.

Market Risk n The market variables include:  Interest rates  Foreign exchange rates  Equity or commodity prices  Credit spreads  Credit migration and default

Market Risk n Risk measurement –Market Value Exposure (MVE) –12-month Earnings Volatility Value at Risk (VaR), an MVE measure, calculate the magnitude of BMO’s market risk. Value at Risk (VaR), an MVE measure, calculate the magnitude of BMO’s market risk. Earnings Volatility (EV), a measure of the adverse impact of potential changes in market variables on 12-months after tax income Earnings Volatility (EV), a measure of the adverse impact of potential changes in market variables on 12-months after tax income

Liquidity and Funding Risk n Is the risk of being unable to meet financial commitments in a timely manner at reasonable prices as the fall due. Financial commitments include liabilities to depositors and suppliers, and lending and investment commitments.

Liquidity and Funding Risk n Risk measurement 1)Cash and securities-to-total assets ratio Cash and securities totaled $63.0 billionCash and securities totaled $63.0 billion Total assets $252.9 billionTotal assets $252.9 billion 2)Core deposits-to-total deposits ratio Core deposits totaled $96.5 billionCore deposits totaled $96.5 billion Total deposits totaled $161.8 billionTotal deposits totaled $161.8 billion

Liquidity and Funding Risk

n Off-balance sheet special purpose entities (SPEs ) –To securitize BMO assets in support of capital or funding management n Customer credit commitments –Integral part of BMO credit-granting practices and create liquidity and funding exposure.

Operational Risk n Is the risk of loss resulting form inadequate or failed internal processes, system or human error, or external events –Never be eliminated

Operational Risk n Composed of –Operational risks, which include physical and logical security, transaction processing, operations control technology and outsourcing risks –Business and event risks, which include strategic, image and reputation, taxation, accounting and financial management, legal, regulatory requirement and HR risks.

Operational Risk n Risk measurement: –Combines the likelihood of an operational risk event occurring with the probable loss if it does occur –Expected and unexpected loss can be determined by the loss distribution

Operational Risk n BMO’s goal: –To make this risk transparent throughout the enterprise

Derivative portfolio n Interest rate contracts –Swap, Futures, Option n Foreign Exchanges Contracts –Cross-Currency swaps, Futures, Forward FX n Commodity Contracts –Swap, Futures, Forward, Option n Equity Contracts n Credit Contracts

CIBC

CIBC Business Lines n CIBC Retail: 49.4% of total assets –Financial Services and lending, credit cards, mortgages, deposits, insurance and investment products to retail and small business –CIBC branches, ABM network, telephone and internet banking

CIBC Business Lines n Wealth Management: 9.3% –Relationship based advisory sales, services and products through a sales force of investment professionals. –Full service brokerage in Canada and US, discount brokerage, global private banking and trust services, and asset management

CIBC Business Lines n CIBC World Markets: 39.5% –Provides integrated and corporate banking solutions –North America, UK, and Asia primarily –Specializations: Mergers/Acquisitions, research, sales/trading of securities/derivatives, merchant banking and commercial banking

CIBC Business Lines n Amicus: 1.8% –Co-branded electronic retail banking services. –Operates through pavilions in retail locations; offers variety of deposit and credit products

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

Risks to be Managed n Credit n Market n Liquidity n Operational

Risk Management Structure: n Manages risk within tolerance levels established by is management committees, BOD, and BOD committees with the objective of optimizing shareholder wealth

Credit Risk: n Essentially Default Risk

Credit Risk Management: n Reviewed by Capital & Risk Committee (CRC) n Reduce Concentrations n Majority of risk from loan and acceptance portfolio n Credit risk also from off-balance sheet activities n Two key policies

Loans n Consumer Loans: –67% of CIBC portfolio: Inherently diversified n Business and Government Loans: –33% of portfolio, 87% of which is in North America (the rest in UK, Western Europe), Asian exposure managed down

*Country Risk: n Risk that assets may become frozen in a foreign country n Manage risk through limits on exposure n Argentina ordeal

Derivative Use: n Active in credit derivative markets n CLO’s n Credit derivatives are used to mitigate sector concentrations n Largest Sectors Hedged: telecom ($724 million), utilities ($354 million), and financial institutions ($346 million) n Notional amount outstanding to credit protection: $4 billion (Oct. 31, 2002)

Counterparty Credit Exposure: n Arises from its interest rate, foreign exchange, equity, commodity and credit derivatives market making and portfolio management activities. n Investment grade: 91% of CIBC’s derivative credit exposure

Management of Market Risk: n The risk of financial loss arising from changes in the values of financial instruments and includes interest rate credit spread, foreign exchange equity, commodity and liquidity risks

Measures of Market Risk: n VaR: Values-at-Risk  RMU n Stress testing and scenario analysis, n Backtesting,

VaR and RMU: n Statistically defined n Market risk measure of the potential loss from adverse movements that can occur under normal market conditions n An RMU is defined as the overnight loss with less than a 1% probability of occurring in normal markets.

Traded Activities: n Holds positions in both liquid and less liquid trade’s financial instruments as a fundamental component of providing integrated financial solutions to meet clients needs.

n Foreign Exchange Risk

Non-trading Activities and Risks: n Interest Rate n Non-Trading Equity Exposure n FX-Risk n Non-Exchange Traded Commodity Derivatives

Management of Liquidity Risk: n Dynamic infrastructure, policies and standards, measurement, monitoring and control. n Liquid assets n $103.8 billion of wholesale term debt n Moodys and S&P rating downgrades

SPE’s n Securitized various financial assets, including credit card receivables, residential and commercial mortgages, and business loans through SPE’s n *Securitization: entity transfers assets to an SPE in exchange for cash

Management of Operational Risk: n Failures in internal controls, which include people, processes and systems n Insurance

Recommendation about Risk Management: n Banks are in the business of risk management n Continual improvement methodology for risk management

References Canadian banks 2002: Perspectives on the Canadian banking industry. Pricewaterhousecoopers Survey Report. Accessed October 14, 2003 from Canadian banks 2002: Perspectives on the Canadian banking industry. Pricewaterhousecoopers Survey Report. Accessed October 14, 2003 from Canadian securities course: Volume 1. (2001). Canadian Securities Institute. Canada’s Banks Department of Finance. Accessed October 14 from Canada’s Banks Department of Finance. Accessed October 14 from