Royal Bank of Canada

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Royal Bank of Canada

• BUS 419 Advanced Derivatives Securities
• Heng I (Miki) PunJeff ChanMacau ChanNathan Yau

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Agenda

• Industry Overview
• Regulations
• Overview of RBC
• Financial Statement Analysis
• Risk Management Structure
• Major Risks of RBC
• Risk Management Strategies

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Industry Overview
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Number of Banks Operating in Canada

• 29 domestic banks
• 24 foreign bank subsidiaries
• 27 full-service foreign bank branches
• 3 foreign bank lending branches 

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Major Players

• Toronto-Dominion (TD) Bank 21.9
• Royal Bank of Canada 20.6
• Canadian Imperial Bank of Commerce (CIBC)
  16.4
• Scotiabank 14.1
• Bank of Montreal 13.4

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Products and Services Segmentation
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Major Market Segmentation
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Key External Drivers

• Consumer Confidence Index - measures consumer
  optimism about the current macroeconomic
  environment and is strongly correlated with
  aggregate household debt levels.
• Overnight Rate - the interest rate at which major
  financial institutions can borrow and lend
  short-term funds to each other. It is strongly
  correlated with interest rates charged by
  industry operators on lending products.
• Corporate profit - Corporate clients are
  anticipated to account for 20.2 of total
  industry revenue in 2015. Changes in corporate
  profit tend to dictate demand for credit from
  this market segment.
• Regulations - improve the reputations of Canadian
  banks on a global scale, yet temper lending and
  increase compliance costs, to the detriment of
  industry profit.

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Regulations
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Bank Act

• Schedule I Banks are domestic banks and are
  allowed to accept deposits, which makes them
  eligible to receive, hold and enforce a special
  security interest
• Schedule II banks are also allowed to accept
  deposits and are subsidiaries of foreign banks,
  but they are excluded from the Back Act security
• Schedule III banks are permitted to operate in
  Canada, but are not incorporated under the Bank
  Act, which limits their range of banking
  activities

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The Basel Committee

• Established in 1930 in Basel, Switzerland
• Created by the central bank Governors of the
  Group Ten nations in 1974 and meets four times a
  year at the Bank for International Settlements
  (BIS) in Basel Switzerland
• A forum to promote discussion and policy analysis
  among central banks and within the international
  financial community
• Objective To enhance understanding of key
  supervisory issues and improve the quality of
  banking supervision worldwide

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Basel I The Basic Capital Accord

• Published in 1988
• Established a set of minimum capital requirements
  for banks with the goal of minimizing credit risk
• Banks that operate internationally were required
  to maintain a minimum capital ratio of capital to
  risk-weighted assets of 8 to be implemented by
  the end of 1992

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Basel II - The New Capital Framework

• Initially published in 2004 built on the work
  of Basel I, especially in the areas of risk and
  capital 
• Designed to improve the way regulatory capital
  requirements reflect underlying risks and to
  better address the financial innovation that had
  occurred in recent years
• Aimed at rewarding and encouraging continued
  improvements in risk measurement and control  
• Comprised three pillars
• Minimum capital requirements, which sought to
  develop and expand the standardised rules set out
  in Basel I
• Supervisory review of an institution's capital
  adequacy and internal assessment process and
• Effective use of disclosure as a lever to
  strengthen market discipline and encourage sound
  banking practices
• Provided 3 tiers of capital

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Basel III

• Originally published in December 2010 in response
  to the global financial crisis and is expected to
  be phased in between 2013 and 2019
• To strengthen the regulation, supervision and
  risk management of the banking sector
• Raises both the quality and quantity of required
  regulatory capital bases
• Improve the banking sector's ability to absorb
  shocks arising from financial and economic stress
• Enhances the risk coverage of the Basel II
  capital framework to capture on- and off-balance
  sheet risks
• Also strengthens the consistency and transparency
  of the capital base for commercial banks by
  defining and limiting the types of capital
  instruments they use

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Tier 1 Capital

• Under Basel III, need to be subordinated to
  depositors and general creditors, have fully
  discretionary non-cumulative dividends or coupons
  and have neither a maturity date nor an incentive
  to redeem
• Common shares and non-cumulative, perpetual
  preferred shares would be compliant with the new
  rules 
• The innovative instruments issued by the
  Canadian banks which currently qualify as Tier 1
  capital would not be compliant with Basel III 

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Tier 2 Tier 3 Capital

• Will be simplified there will be only one set
  of Tier 2 capital (rather than Tier 2A and Tier
  2B under the current rules) 
• Will need to meet the minimum standard of being
  subordinated to depositors and general creditors
  and have an original maturity of at least five
  years 
• Subordinated debt issuances will not be compliant
  where they contain a step-up feature, other
  incentives to redeem, or provide for redemption
  in the first five years   
• Tier 3 capital will be eliminated

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Basel Ratios of RBC
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Overview of RBC
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Company Background

• Banking Industry contributes 51 billion for
  Canada (3.1 of the GDP)
• The second largest bank in Canada
• Currently based in Toronto and was founded in
  Halifax in 1864
• Operates in Canada, the US, and other 44
  countries
• 1,372 bank branches and 4,973 ATMs
• Has over 78,000 employees serving over 16
  million clients
• Bank of the Year for Canada in 2014

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Industry Leader

• Royal bank is leading the industry in terms of
  total assets, only ranking after TD bank.

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Market share
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Management Team

• Dave Mckay - CEO and President
• Joined RBC in 1988
• Education
• Bachelor of Mathematics from the University of
  Waterloo
• MBA from the Richard Ivey School of Business at
  University of Western Ontario 

• Doug McGregor - Chairman and CEO of RBC Capital
  Market
• Joined Marcil Trust in 1983, which was later
  acquired by RBC Capital Markets in 1990.
• Education
• Honours BA (Business) from the University of
  Western Ontario
• MBA from the University of Western Ontario

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Management Team

• Janice Fukakusa - Chief Financial Officer
• Joined RBC in 1985
• Education
• Bachelor of Arts from University of Toronto
• Master of Business Administration from Schulich
  School of Business.

• Mark Hughes - Chief Risk Officer
•  Joined RBC in 1981
• Education
• MBA (Finance) from Manchester Business School
• LL.B from Leeds University in England

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Corporate Governance Structure

• Risk Committees Responsibilities
• Oversee risk management
• Balance risk and rewards
• Make recommendation to the board

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SWOT Analysis
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Vision and Goals

• Vision Always earning the right to be our
  clients first choice.
• Three Strategic Goals
• In Canada, to be the undisputed leader in
  financial services
• Globally, to be a leading provider of capital
  markets, investor and wealth management
  solutions and
• In targeted markets, to be a leading provider of
  select financial services complementary to our
  core strengths.

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Major Products and Services

• There are 5 profit segment
• Personal Commercial Banking
• Wealth Management
• Insurance
• Investors and treasury services
• Capital markets

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Major Products and Services
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• 11 increase

Lucrative!!!
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Stock Trend

• TD - 52.20
• BMO - 73.60
• Scotia Bank 63.62

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Financial Analysis
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Balance Sheet
9.3 of Total Asset
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Balance Sheet Cont.
10 of Liabilities
94 is Liabilities
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Income Statement
Hedging Purpose
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Income Statement Cont.
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Comprehensive Income
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Cash Flows
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Cash Flows Cont.
1,673 Net Cash Flow
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Summary of Derivative Income
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Fair Value of Derivative Instrument
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Growth and Strength of the Last Three Years
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Comparison of ROE of RBC Global Peer
Second highest among Global Peer Group.
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Risk Management Structure
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Risk Philosophy

• Seeking to ensure that business activities and
  transactions provide an appropriate balance of
  return for the risks assumed and remain within
  our Risk Appetite through adherence to our
  Enterprise Risk Appetite Framework.

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Enterprise Risk Management Framework

• Provides an overview of our enterprise-wide
  programs for identifying, assessing, measuring,
  controlling, monitoring and reporting on the
  significant risks that face the organization.

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Risk Conduct

• A shared set of behavioral norms that sustain the
  core values, protect their clients, safeguard the
  shareholders value, and support market integrity
  and stability from undue risk.
• Four key components
• Tone at the top and middle management
• Accountability, which is shared across all
  businesses and employees
• Incentives
• Effective challenge

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Risk Appetite

• The amount and type of risk they are able and
  willing in the pursuit of our business objective.

The Enterprise Risk Appetite Framework
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Risk Management Principles

• The following principles guide our
  enterprise-wide management of risk

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Risk Governance
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First Line of Defense (Risk owners)

• Provided by employees across business and support
  functions embedded in the businesses
• Alignment of business and operational strategies
  with Risk Conduct and Risk Appetite

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Second Line of Defense (Risk Oversight)

• Provided by areas with independent oversight
  accountabilities residing in functions.

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Third Line of Defense (Independent Assurance)

• Provided by internal audit
• Provides independent assurance to senior
  management and the Board of Directors.

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Risk Measurement

• Expected losses Losses that are statistically
  expected to occur in the normal course of
  business in a given period of time. (Earning at
  risk)
• Unexpected losses Losses that are statically
  estimated of the amount by which actual
  lossescan exceed expected losses. (Capital at
  risk)
• Unexpected Actual - Expected

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Risk Measurement

• Stress testing Examines potential impacts
  arising from adverse events.
• Ongoing enterprise-wide stress tests
• Risk specific stress testing programs
• Ad-hoc stress tests
• Reverse stress tests

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Risk Measurement

• Back-testing Ensure the credit risk parameters
  remain appropriate for use in capital
  calculations.
• Preformed by comparing the realized value to
  beginning estimates
• Validation of measurement models
• Ensure the model incorporate current market
  developments and industry trends.
• Ensure that all material underlying model risk
  are identified and mitigated

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Risk Control

• Enable the optimization of risk and return on
  both a portfolio and a transactional risk

Level 1
Level 2
Level 3
Level 4
General
Level 5
Specific
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Risk Pyramid

• Identify and categorize the principal risks in
  new and existing businesses, products or
  initiatives, acquisitions and alliances

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Major Risks of RBC

• Credit Risks
• Market Risks
• Liquidity Funding Risks
• Insurance Risks
• Regulatory Compliance Risk

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Credit Risks

• Credit risk is the risk of loss that an obligors
  inability or reluctant to follow the contractual
  obligations.

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Credit Risk Measurement

• Both individual obligor and port folio level
  risks are quantified
• Expected credit loss and minimize unexpected
  losses management
• Limit earning volatility
• Two approaches
• Internal Ratings Based Approach (IRB)
• Standard Approach
• Key parameters
• Probability of default
• Exposure at default
• Loss given default

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Credit Risk Measurement Wholesale Risk

• Wholesale portfolio comprises of
• Business
• Sovereigns
• Public sector entities
• Banks and other financial institutions
• Certain individuals and small businesses

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Credit Risk Measurement Wholesale Risk (Cont)

• Wholesale credit risk rating system
• Borrower Risk Rating (BBR) and PD

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Credit Risk Retail Risk

• The retail portfolio is comprised of
• Residential mortgages
• Personal loans
• Credit Card loans
• Small business loans

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Credit Risk Retail Risk

• Primary Risk Rating System Credit Scoring
• For acquisition of new clients
• Management of existing clients
• Pool Exposures for risk quantification
• Based on credit risk parameters

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Credit Risk Control

• Minimum requirements for management of credit
  risk
• Credit risk assessment
• Credit risk concentration
• Credit risk mitigation
• Structuring of transactions
• Collateral
• Credit derivatives

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Gross Credit Risk Exposure by Portfolio and Sector
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Provision for (recovery of) Credit Losses
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Gross Impaired Loans (GIL)
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Market Risk

• The impact of market prices upon the financial
  condition of the firm
• Including
• Potential gains or loss due to changes in market
  determined variables
• Credit spreads, equity prices, commodity prices,
  foreign exchange rates and implied volatilities.

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Market Risk Measurement

• Positions whose revaluation gains and losses are
  reported in Revenue
• Changes in the fair value of instruments
  classified or designated as at fair value through
  profit and loss
• Impairment on available-for-sale (AFS) securities
• Hedge ineffectiveness
• CET1 capital
• Changes in the fair value of AFS securities
• Changes in the Canadian dollar value of
  investments in foreign subsidiaries
• Re-measurements of employee benefit plans
• CET1 Ratio
• Changes in risk-weighted assets (RWA) resulting
  from changes in traded market risk factors
• Changes in the Canadian dollar value of RWA due
  to foreign exchange translation
• Economic value of the bank
• Changes in the value of other non-trading
  positions whose value is a function of market
  risk factors

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Market Risk Control

• Value-at-Risk (VaR)
• A statistical measure of potentia loss of a
  financial portfolio computed at the 99th
  percentile confident level over one day holding
  period
• Stressed Value-at-Risk (SVaR)
• Same as VaR but it is computed using a fixed
  historical one year period of extreme volatility
  and its inverse rather than the most recent two
  year

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VaR and SVaR
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Trading Revenue and VaR
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Liquidity and Funding Risk

• Risk that RBC may be unable to generate or obtain
  sufficient cash or its equivalent in a timely and
  cost-effective manner to meet the commitment as
  they come due

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Liquidity and Funding Risk Measurement

• Structural (Long term) Liquidity Risk
• Cash capital and other structural metric
• Tactical (Shorter-term) Liquidity Risk
• Apply net cash flow limits in CAD and other
  currencies for key short-term time horizons
• Assign a risk-adjusted limit to pledging exposure
  
• Contingency Liquidity Risk
• Liquidity Contingency Plan
• Liquidity Contingency Team

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Liquidity and Funding Risk Control

• Policies
• Define risk tolerance parameters.
• Authorities and limits
• Funding Strategy

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Insurance Risk

• Potential financial loss that may arise where the
  amount, timing and/or frequency of benefit
  payments under insurance and reinsurance
  contracts are different than expected.
• Measurement
• Insurance Risk Framework
• Insurance risk policies and procedures

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Regulatory Compliance Risk

• Risk of potential non-conformance with laws,
  rules, regulations, prescribed practices,
  contracts or ethical standards in any
  jurisdiction in which we operate.
• Develop Regulatory Compliance Management
  Framework for Risk Measurement
• Five Elements
• Use regulatory compliance programs in business
  activities and operations.
• Ensure regulatory compliance risks are identified
  and assessed appropriately
• Design and implementation of specific controls.
• Monitoring and oversight of the effectiveness of
  the controls

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Other Risks of RBC

• Optional Risk
• Strategic Risk
• Reputation Risk
• Legal and regulatory environment risk
• Competitive risk
• Systemic risk

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Risk Management Strategies
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Derivatives Instrument

• Financial Derivatives Financial contracts whose
  value is derived from an underlying interest
  rate, foreign exchange rate, credit risk, and
  equity.

• Non-financial Derivatives Contracts whose value
  is derived from precious metal and commodity
  derivative contracts in both OTC and exchange
  markets.

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Derivatives issued for trading purpose

• Sales Activities Structuring and marketing of
  derivative products to clients to enable them to
  transfer, modify or reduce current or expected
  risks.
• Trading Activities

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Trading Activities

• Market-making - involves quoting bid and offer
  prices to other market participants with the
  intention of generating revenue based on spread
  and volume
• Positioning - involves managing market risk
  positions with the expectation of profiting from
  favourable movements in prices, rates or indices
• Arbitrage activities - involve identifying and
  profiting from price differentials between
  markets and products

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Hedging Strategies
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Derivative-related credit risk

• Generated by the potential for the counterparty
  to default on its contractual obligations when
  transactions have a positive market value to the
  Bank.
• Represented by the positive fair value of the
  instrument.
• Normally a small fraction of the contracts
  notional amount.

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Risk Control Techniques

• Evaluate the creditworthiness of counterparties.
• Manage the size, diversification and maturity
  structure of the portfolio.
• Compare the credit utilization for all products
  with established limits on a continual basis.
• Use of master netting agreement - provides for a
  single net settlement of all financial
  instruments covered by the agreement in the event
  of default.
• Use of collateral includes the mark-to-market
  provisions in agreements, which then provide the
  right to request the counterparty pay down or
  collateralize the current market value of its
  derivatives positions when the value passes a
  specified threshold amount.

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