Plantilla Corporativa

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CRD IV Restoring order in the financial
system Hearing of the Economic and Monetary
Affairs Committee of the European Parliament
Barbara Frohn May 3 , 2010
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Basel III The individual proposals are
directionally correct
SANTANDER shares the goal of the BCBS and the EC
to strengthen the foundations of the financial
sector and supports the direction of the
individual BCBS and EC proposals. However,
additional focus could be directed towards the
following

• Intrusive supervision has proven to be more
  effective than (over-) regulation
• In the crisis, weak corporate governance and lack
  of internal control were key contributing
  factors, and in some cases even root causes
• The aim should not just be to penalize and avoid
  bad practices, but equally to give full
  recognition to, and thus reward, good practices
• Systemic risk cannot be measured by sheer size.

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But the Combined Impacts may lead to Unintended
Consequences

• Possible disruption of the interbank and equity
  markets
• i.e. Large Exposures rules, correlations,
  liquidity buffers, capital conservation
  standards will (bank) investor and issuer
  interests prove reconcilable?
• Concentration risk may prove unavoidable herd
  behaviour may lead to systemic risk
• i.e. Good Quality liquidity capital
  restrictions, stringent rules for securitisation
  CDS
• The CRD IV objective of level playing field
  cannot be served in a single market where full
  harmonization has not yet been achieved and where
  grandfathering may impact differently on banks.
• i.e. Deductions from Common Equity, Leverage
  ratio, Grandfathering provisions
• By whom will the growth of the real economy be
  serviced in future and will we then be better
  off?
• i.e. Maturity transformation and intermediation
  role, Leverage Ratio

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Forward Looking Provisioning What is the purpose?

• Economic activity is subject to periodic
  cycles
• where good years are followed by downturns or
• even strong recessions.
• Banks should, as the ant in the Aesop fable,
  store up
• provisions for the winter during the
  summer.
• (i.e. forward looking provisioning). But the
  current model
• (incurred loss approach, the grasshopper
  view)
• does not address this need.
• The Spanish model, which uses generic
  provisions
• for that purpose, has proved its usefulness to
• mitigate the impact of the recession on the
  PL.
• The EC and Santander proposals on this subject
  are
• forward looking provisioning based on the
  Spanish model
• but taking advantage of the risk data already
  available for
• Basel II, and using the concept of
  through-the-cycle
• expected loss.

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Provisioning Multiple Objectives, One Solution ?
FASB deliver right information on true
financial condition of the firm incentives to
investors improve incurred loss model by
earlier recognition of credit losses

IASB solution to too little, too late, but
only for closed portfolios
Forward Looking Provisioning
EC avoid underpricing excessive credit growth
BCBSCapital Stability Answer to
Procyclicality
G20 loan loss provisioning to incorporate a
broader range of credit information
FSB better reflection in accounts of underlying
economics of lending activities
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Prudential proposals - Strengths and Weaknesses
Bank Of Spain Dynamic Provisioning regime Combines high provision in good times with drawdown in bad times Transparent Simple Maintains the possibility to move over time to a system in which internal models may be used Not very risk sensitive only 6 loan groups Not exactly an Expected Loss model (statistical model based on historic data) Requires existence of rich historic data on each loan group
EC CRD IV Expected Loss provisioning relating Expected Loss amounts at the beginning of the year to Net Specific Provisions during the year Simple to implement, and also offers solution to small medium sized banks with less sophisticated systems Makes optimal use of internally externally validated Through-The-Cycle parameters already in use for regulatory capital calculations of IRB banks Serves shareholders depositors interests May not be fully compatible with expectations of accounting standard setters
SANTANDER Variation of the EC proposal with inclusion of a rho adjustment factor Has the same advantages as the EC CRD IV proposal and, in addition The rho factor adjusting the allowance presents a good compromise between the countercyclical smoothing of provisions in the PL and the need to preserve a minimum sensitivity of the PL and risk management to the changes in the cycle and risk environment
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Accounting proposals - Strengths and Weaknesses
IASB Expected Cashflow Model (ECF) Presents an improvement compared to the incurred loss model to the extent it recognizes real loan costs in the accounts Primary focus on shareholder interests Operationally complex and costly co-mingling of interest rate and credit risk management in one measure Present Value of changes in ECF must be recognised immediately and thus may add to procyclicality
FASB Modified Incurred Loss approach Clear and sole focus on shareholder interests It is questionable whether extending the provision event criteria may substantially remedy the shortcomings of the current model
EBF Expected Loss over the Life of the Portfolio model (ELLP) Adapts well to existing accounting principles responds to accounting requirement of not exceeding current maturities Remains as yet ambiguous on the calculation method to be used for the calculation of the expected losses over the life of the portfolio Unclear whether Point-in-Time or Through-The-Cycle parameters are to be used. To avoid divergent implementations, clear instructions should be formulated Estimating EL over a long horizon (lifetime) is complex, and may still need frequent re-adjustments and and thus end up being procyclical after all
This is a mixed model aiming to satisfy both
regulatory and accounting demands
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Main advantages of Expected Loss Provisioning

• In times of economic growth a cumulative
  provision buffer is being created
• prevents overheating of the economy
• excessive credit growth is avoided
• real loan costs are being recognized from
  inception
• In periods of recession the accumulated provision
  is being used
• less chance of major capital constraints on banks
  
• no sudden lending freeze
• As a consequence,
• depositors that have entrusted their money with a
  bank can be sufficiently at ease about the
  solvency situation of the bank in question
• financial stability will be preserved
• the negative growth of the real economy is not
  further aggravated by bank behaviour.

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Minimum Requisites for Forward Looking
Provisioning
Repeating the successful implementation of the
Spanish system, uniformity, simplicity and
transparency are key

• Uniformity Aiming at reducing discretionality in
  the calculation of provisions applicability to
  all firms
• Simplicity Using existing, externally and
  internally validated, parameters which were duly
  tested during the crisis keeping the horizon
  oversee-able which reduces the risk of multiple
  re-adjustments
• Transparency Shareholders and depositors
  interests will not be served by implementing a
  dual system their investment analysis will
  furthermore be accommodated by Pillar 3
  disclosures a.o. on risk parameters and other
  factors supporting the EL estimations.

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Implications of a dual system
BASEL
IFRS
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and therefore Convergence is the best way forward

• Ideally, one unique forward looking provisioning
  regime should be in place responding to both
  accounting and prudential concerns
• On a similar note, a European only solution
  must be discouraged
• Decisions on a EL provisioning regime should not
  be made in isolation, but considering other
  procyclicality measures and capital buffers
• Increasing the provision pool in good years
  must also imply being able to consume it in bad
  years provisions must go directly through PL
• Contradictory incentives it is evident that EL
  provisions leading to DTAs should not be deducted
  from capital
• If ultimately regulatory demands still exceed
  accounting solutions, the excess should be
  introduced as an economic cycle provision outside
  the perimeter of regulatory capital

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So can EL Provisions deal with procyclicality?

• Accounting standard setters insist that they
• Cannot accept provisions beyond existing
  portfolios and maturities and therefore do not
  promote Through-The-Cycle provisions
• Aim to provide a true reflection of the firms
  current situation to investors and therefore
  dislike adjusting the value of a loan for its EL
  creating a day one loss
• Therefore, only if
• Accounting standard setters are willing to
  compromise and to implement a system which does
  not lead to continuous fair value re-adjustments
  flowing through PL
• Regulators accept that the average lifetime of
  the portfolio is not too far off the objective of
  a full cycle
• However, given the dynamic nature of lending
  practices and product development procyclicality
  can never be eliminated in full.

• A joint regime may be created resulting in a less
  marked procyclicality effect, even though the
  capital regime may still have to be reinforced by
  mandatory Through-The-Cycle rating parameters
  to become less procyclical

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Conclusions and Message
If a constructive public-private sector dialogue
on the new Basel proposals ensues, (cumulative)
impacts are measured extensively and rules are
tested before implementation, Then a new
homogeneous regulatory framework could emerge
that satisfies the expectations of politicians,
governments, supervisors and accounting bodies,
prevents (most) crises from happening whilst
still allowing banks to remain private ventures
in a level playing field context that allows the
market to properly differentiate between good and
bad practices. But for this to happen a siloed
approach to regulation and standards must be
avoided. Only then the financial sector stability
can be restored and preserved.
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Annex A new model for provisioning (I)

• No in advance recognition of credit losses in
  good years (mispricing)
• Strong fluctuation of provisions
• Volatility of results and possible loss of
  market confidence in the institution
• Procyclicality possible excessive credit growth
  in good years and credit
• squeeze in bad years

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A new model for provisioning (II)

• Recognition in advance of credit losses in good
  years
• Use of generic fund in bad years
• Flat Provisions (for a stable portfolio)
• Stability of Results
• Mitigation of procyclicality

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A new model for provisioning (III)

• Recognition in advance of credit losses in good
  years
• Use of generic fund in bad years
• More stable provisions but not flat
• Results less volatile
• Mitigation of procyclicality

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