1. Creating Shareholder Value
Alan Jette – SVP Treasury & Balance Sheet Management
Presentation to the ICPM
3 June 2008

2. Emperor Exposed – What Went Wrong?
The last year has been a wrecking yard of bank earnings, writedowns, and shotgun mergers to avoid bankruptcies / insolvencies
ABCP
Fundamentally banks lost track of what creates shareholder value

3. Creating Shareholder Value
Bank’s create Shareholder Value Added (SVA) by adhering to a disciplined Risk Adjusted Performance Measurement (RAPM) process focusing on:
Risk adjusted earnings on Required Risk Based Capital
Generating stable, sustainable, growing earnings over time
Shareholder Value MV BV
ROE - Cost of Equity
Cost of Equity - Growth = 1 +
Positive Economic Profit
Stable Earnings
Sustainable Growth
TD’s Intrinsic Value Formula

4. RAPM – Key Components Components Keys to Success
Funds Transfer Pricing - assigns fully hedged cost of funds to all lending and deposit exposures
Expected Credit Loss Assessments for pricing and provisioning
Risk Based Capital Allocations
Differentiation between Productive and Non-Productive risk
Keys to Success
No exceptions or sacred cows
No internal arbitrage opportunities
No black boxes - full transparency of process, and results

5. Funds Transfer Pricing System
All loan and deposit positions transfer priced explicit cost of funds on a fully hedged, option adjusted funding basis
Liquidity premiums are assigned with an explicit term structure independent from market risk
Market and liquidity risk is transferred to treasury and managed centrally
FTP allocates true funding costs and creates transparency of results

6. Expected Credit Loss and Risk Based Capital
Product pricing and provisioning should reflect fair “through the cycle” credit costs and a risk adjusted capital allocation calibrated to absorb extreme “tail” events
Expected Credit Losses
Reflect through the cycle credit costs
Credit Risk Capital
Calibrate “tail” to absorb true 1 in 2000 event (AA default prob)
2 cycle average
10yr avg
Greater conservatism should be used for “untested” risks (Subprime)

7. Differentiate Between Productive and Unproductive Risks
Market Risk (non Trading)
Market risk is not a productive risk for a personal & commercial Bank
Exposures do not effectively leverage the retail franchise
US Banks: “we have to take interest rate risk to make money”
Theory: don’t need a retail bank infrastructure for investor to earn returns from market risk
Structural interest rate gap positions are an explicit position and view/bet on the market
Option Hedging
Locks in expected costs and eliminates potential for earnings variability
Does not create incremental costs
Reduces economic capital required

8. 3. Differentiate Between Productive and Unproductive Risks
Credit Risk
Organic credit risk is a productive risk for a Personal & Commercial Bank
Leverage the Bank’s franchise value to intermediate with individual customers
Creates excess spread relative to long run expected losses and capital costs
Wholesale credit exposures is more efficient and presents lower opportunities for risk adjusted returns
Securitization market
Purchased whole loan
Syndications

9. US Bank Strategies to Increase Nominal Returns
Interest Rate Gap Carry Trade
Credit Carry Trade
Structured Products with Embedded Optionality

10. Classic Gap Trade Trap Large Carry from Steep Yield Curve (2003-04)
Bank’s enticed to borrow short term and lend long
Earn substantial non-franchise earnings (some cases up to 40% of total)
Yield Curve Flattens and Carry Declines (2005)
Carry yield declines as short term roll-over borrowing costs rise
Doubles down carry volumes to main earnings contribution
Yield curve flat / inverted ( )
Negative contribution to earnings
Locked into positions/losses as MV assets now less than MV liabilities
Exiting will realize remaining losses

11. Disappearing Gap NII leads to Credit Carry Trade
Pressure to replace declining gap earnings leads to credit carry
Investors demand QoQ earnings growth
‘Non-Prime’ Mortgage products such as HELOC and 2nd Lien Mortgages offered large gross yields
Yields not properly risk adjusted for true credit risk and capital costs
2007/08 – Mortgage market implodes
Other firms replaced gap carry losses with structured interest rate risk yields
Nominally positive yield carry is negative value on risk / option adjusted basis

12. What Went Wrong
Competitive pressures and market forces reduced core earnings growth
Banks implemented strategies to generate non-core, non-controllable sources of earnings
Inflated market valuations based on reported, nominal earnings growth created the need to sustain earnings over time
Lack of transparency as to sources of earnings
Lack of understanding and required disclosures around quality of earnings, balance sheet capacity utilization and liquidity risk by
Senior management 3-4 levels removed from risk taking
Boards
Shareholders
Regulators
Rating Agencies
Did boards understand the “type” earnings firms were generating?
Did shareholders understand the type of earnings they were valuing?

13. Structural Incentives - Regulatory
Regulatory capital rules distort economic incentives
Tier 1 Leverage Test establishes a floor capital to asset ratio
Creates minimum capital requirement and earnings hurdle regardless of risk based capital requirements
Banks penalized for operating a low credit risk strategy and rewarded for increasing risk
No capital related to non-credit risks such as structural interest rate risk

14. Structural Incentives - Compensation
Compensation schemes did not create the proper incentives
Standard compensation schemes focused on
Year over year EPS growth
Top line revenue growth
Performance targets short term and not aligned with creating shareholder value
UBS Shareholder Report Quote
“ Structural incentives to implement carry trade: the UBS compensation and incentivisation structure did not effectively differentiate between the creation of alpha versus creation of return based on a low cost of funding”
“Bonuses were measured against gross revenue … with no formal account taken of the quality or sustainability of those earnings”

15. Paying the Price
After the decline in Gap Earnings and loss of NII growth – US Bank’s still didn’t show price declines
Consolidation premiums actually increased
But now – buyers can’t afford and sellers too risky

16. Culture not Process TD Experience
“It’s the culture of risk management which saves you” – CEO
Creating and maintaining franchise value is central to the kinds of risks you take and in what quantity
The retail bank franchise generates stable, predictable and sustainable core earnings that create economic profit and SVA
Its fundamental that if something generates an abnormal excess return it must have more risk than you are measuring – you are being transferred the risk
The culture must support the requirement for transparency and explainability of financial results

17. Culture not Process Danger Signs
Businesses earning high nominal income
Over reliance on equivalent exposure measures that don’t generate material need for capital on large notional positions
Securities that earn returns well in excess of stated risk profile
AAA CDO’s trading at L+100
Strategies that rely on increasing balance sheet capacity to remain “hedged”
Practical Constraints
Set “Dumb Limits” on exposure especially when tail risk is unknown
Don’t rely on outside evaluation of risk
Understand the drivers of excess (alpha) returns