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European Banks: Implications from Regulatory & Legislative changes

April 2011
Pieter Fyfer Managing Director, European Credit Sector Strategy +44 20 7883 4279, pieter.fyfer@credit-suisse.com Stphane Suchet Vice President, European Credit Sector Strategy +44 20 7883 4278, stephane.suchet@credit-suisse.com

PLEASE REFER TO THE DISCLAIMER SECTION FOR IMPORTANT DISCLAIMERS AND CONTACT YOUR CREDIT SUISSE REPRESENTATIVE FOR MORE INFORMATION.

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

European Banks: Implications from Regulatory & Legislative changes


Summary Key Regulatory changes Key Legislative changes (Resolution Regimes & beyond) Banking Model Evolution resulting from Regulatory & Legislative changes Investor Returns in Bank Capital Competitive Landscape & Implications for Non Banking Financial Institutions

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 2

European Banks
European Banks: Implications from Regulatory & Legislative changes

Summary

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Key Regulatory changes (Basel III & beyond)


Changes in Calibration Minimum Capital Requirements 4.5% minimum Common Equity Tier 1 (CET1) Additional Capital Conservation Buffer means 7% effective minimum CET1 from 2019 - Dividend/hybrid payments constrained if below 7% CET1 Implies intervention/resolution would be at c4.5% CET1 Addition of 0% to 2.5% in countercyclical buffer Basel will decide in H1 2011 regarding an additional capital requirement for systemically important banks; Likely that this aspect is left for local regulatory discretion SIFI surcharge will likely comprise of combination of Common Equity and CoCos (with relatively high capital ratio triggers) Unrealised losses on bond portfolios to be deducted from common equity More conservative treatment of minority interest More onerous treatment of insurance subsidiaries and stakes in other financial companies Minimum Tier 1 ratio of 8.5% and Total Capital Ratio of 10.5% (with CET1 ratio of 7% inc conservation buffer) Future Tier 2 will require permanent loss absorbency at the point of non viability (effectively a Low trigger Coco) Future Tier 1 hybrids will require permanent loss absorbency. Trigger level still to be defined at EU level or local regulatory but likely at a small buffer to minimum ET1 ratio (effectively a Medium trigger CoCo) Systemically important CoCos still to be defined (Likely to effectively be a Medium to high trigger CoCo) Increased requirements for Trading Book/ Market Risk Increased requirements for Derivative Counterparty Exposure Increased requirements for exposure to Financials Reduction in requirements for exposures to Central Clearing Counterparties (CCPs) Short term liquidity buffer ratio (LCR) requiring increased amount of high quality liquid assets Bank funding product (other than covered bonds) are not allowed to count for liquid assets Requiring banks to better align funding duration to asset duration and become less reliant on short term wholesale funding Nominal leverage requirement at Tier 1 level of 3%from 2018

Systemically important Financial Institution (SIFI) capital surcharge More conservative calculation of Common/Core Equity Changes in definitions of Non Common Equity Regulatory capital instruments

Changes in Calculation of Risk weighted assets

Liquidity Requirements

Funding Requirements Leverage Ratio

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 4

Key Legislation related changes (Resolution Regimes & beyond)


Resolution Regime Related Legislation Increased acknowledgement that governments need more options in resolving distressed banks in order to limit taxpayers exposure UK, Ireland, Germany & Denmark have already implement Resolution Regime legislation The Netherlands has produced draft Resolution Regime legislation EU will issue draft directive relating to Resolution Regime this summer Transfer powers by a Government or Resolution Authority (of a government) is a key Resolution Tool The Transfer [power resolution tool allows a Government or Resolution Authority (of a government) to move systemically important or priority creditors (like depositors) into a going concern or bridge bank while windingdown/liquidating the rest of the bank The ability of a Government or Resolution Authority (of a government) to impose losses on bondholders outside a liquidation, either through principal write-down or conversion into equity.

Transfer Powers

Haircut/Bail in tool

Preferred Treatment of Depositors Ring fencing of Retail activities/Subsidiarisat ion

EU likely to review the equal ranking of depositors relative to senior unsecured debt

Certain countries could require ring fencing of retail banking operations (in separate legal entity) from other banking operations

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 5

Business Model Implications from Key Regulatory changes


Changes in Calibration Minimum Capital Requirements Systematically important banks likely to require CET1 of c10% in our view Increased regulatory capital requirements (SIFIs and Non SIFIs) will require material delevering, with focus on both numerator (CET1) and denominator (RWA) of capital adequacy ratio Pricing of risk to reflect higherWACC, likely to drive significant widening of asset margins Higher levels of capitalisation should in the long term result in downward pressure on funding costs as perception of credit quality improves

More conservative calculation of Common/Core Equity

Increased incentive to dispose of Insurance operations Increased incentives to dispose of significant stakes in other financial companies Increased appetite for disposal of positions with unrealised losses (assuming all other factors support disposal) Reduction of excess capital in non wholly owned subsidiaries to ensure maximum utilization of minority interest in regulatory capital

Changes in definitions of Non Common Equity Regulatory capital instruments

Banks like to have between 3.5% and 10% in non CET1 capital in our view Non common equity capital will be in CoCos (in broad definition of the term) CoCos will consist of Low Trigger CoCo (Tier 2 instruments), Tier 1 hybrids (Medium trigger CoCos) and High Trigger Cocos (for systematically important banks) Cost of non CET1 capital will be materially higher than before given increased loss absorbency outside a liquidation, further increasing WACC compared to existing stock of Non CET1 regulatory capital Tax deductibility of Non CET 1 capital (in most countries) reduce the impact of increased spreads

Changes in Calculation of Risk weighted assets

Reducing of Proprietary Trading risk Increased to Central Clearing Counterparties (CCPs) Reduction of Counterparty exposure through structured solutions Disposal of capital intensive asset like ABS Residuals

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 6

Business Model Implications from Key Regulatory changes (continued)


Liquidity Requirements Reduced holdings of senior unsecured and subordinated bank bonds and ABS securities in Treasury/Liquid asset portfolios Increased holdings of covered bonds, high quality corporate credit and (quasi) government bonds in Liquid asset portfolios Resultant material investment return reduction on treasury/liquid asset pools Lengthening of duration of funding profile Stronger competition for deposits Increased issuance of covered bonds Reduction in low yielding/high quality risk/lending Incentive for banking industry to facilitate disintermediation of (high quality) corporate credit risk into capital market Increased focus on distribution of high quality risk rather than retaining risk

Funding Requirements

Leverage Ratio

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 7

Business Model Implications from Key Legislation related changes (Resolution Regimes & beyond)
Resolution Regime Related Legislation ( and introduction of Transfer Powers and Haircut/Bail in Tool) Increased funding costs on senior unsecured Reducing issuance of senior unsecured debt; increasing issuance of covered bonds and other forms of secured debt Increase in asset margins

Preferred Treatment of Depositors Ring fencing of Retail activities/Subsidiarisation

Marginally increased funding costs

Reduced taxation flexibility Improved ability to attract deposits and compete against other savings product providers Increased funding costs for groups with large IB units

Minimum CET1 4.5%

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 8

European Financials Capital Structure Preference


Valuation
Covered Bonds

Drivers
(1) Covered bond issuance is likely to increase as banks reduce reliance on short-term funding

Relative Value comment


Attractive

ASW + 97bps

Senior Debt

Benchmark + 191bps ASW + 123bps

(1) Issuance would be likely to increase as banks reduce reliance on short-term funding. (2) Banks would reduce holdings of other banks senior debt in Treasury portfolios under Basel III liquidity proposals

Fair to Attractive

Bench.+511 to call/+295 to mat.


Not more than T1 Max 50% of T1

Lower Tier 2 Capital

YTC 7.4% (median: 5.3%)/ YTM 5.7% (median: 5.4%)

(1) Shrinking asset class. ( 2) Less compelling than perpetuals as a result of relative valuation but also downward ratings risk Fair to Unattractive on potential removal of state support given implementation of resolution regimes Attractive

Upper Tier 2 Capital

Max 15% of T1

Bench.+1,030 to call/+402 to mat. (1) Category does not exist under Basel III proposals. YTC 12.6% (median: 6.2%)/ YTM 7.1% (2)Grandfathered to call date only. (3) Shrinking asset class with zero supply going forward (median: 6.2%) Bench.+854 to call/+421 to mat. (1) Non-compliant with new regulatory capital YTC 11.0% (median: 8.3%)/ YTM 8.0% proposals. (2)Grandfathered to call date (median: 7.3%) Bench.+588 to call /+435 to mat. YTC 8.4% (median: 8.3%)/ YTM 7.9% (median: 7.8%) (1) Non-compliant with new regulatory capital proposals; likely redemption sooner than implied in pricing. (2) Shrinking asset class; future supply largely hybrids that comply with Basel III proposals with loss absorbency in going concern

Innovative Hybrid Tier 1 Capital

Attractive

8% of RWA

Non-Innovative Hybrid Tier 1 Capital


Min 50% of Total Capital

Attractive

Min 50% of T1

Core Tier 1 Capital

FY10 P/E 11.5 FY10 Yield 8.7%

Benchmark (Global Equity Strategy)*

Regulatory changes should be positive developments from a risk-profile standpoint for bondholders as the quantum and quality of capital rise while the liquidity metrics of the banking sector are enhanced. However, this needs to be weighed against the negative of a resolution regime reform, which will expose bondholders to loss absorption outside a liquidation
Source: Credit Suisse, the BLOOMBERG PROFESSIONALTM service, pricing as at 4 April 2011. *See Global Equity Strategys 9 March report, European Banks: downgrading to benchmark at http://doc.research-and-analytics.csfb.com/doc?language=ENG&format=PDF&document_section=1&document_id=869623271

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 9

Competitive Landscape & Implications for Non Banking Financial Institutions


Regulatory & Legislative changes likely to result in a significant shift in business activities from Regulated Banking Industry to Non Banking Financial Institutions Central Clearing Counterparties (CCPs) to benefit from the increased incentive of banks to reduce non CCP counterparty exposure Disintermediation of credit risk into capital markets should benefit (credit focused) asset managers Bespoke structured risk transfer transactions (like securitisation of counterparty credit risk) could potentially create attractive opportunities for specialist investment managers Capital charges that are disproportional to risk could create attractive risk/reward profiles in resultant risk transfer solutions to NBFIGs Risk warehousing opportunities for Non Banking Financial Institutions Capital market investment opportunities for direct exposure to projects/infrastructure/commercial property developments Structured/Packaged lending solutions for smaller loan size transactions (like SMEs) Portfolio transfer opportunities (AFS fixed income portfolios, ex SIV/ABCP Conduit assets, NPL portfolios etc.) Focused equity investment opportunities (in specific subsidiaries based on business line or geographical focus) Spin-off of proprietary trading into (partially) listed investment managers/hedge funds Some market making activities potentially conducted outside the banking industry Improved prospects for Non-bank Finance companies with secured funding model Increased competition amongst banks will place upward pressure on deposit rates and can have an implication for saving product providers

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 10

European Banks Key Regulatory changes

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Key Regulatory changes (Basel III & beyond)


Changes in Calibration Minimum Capital Requirements 4.5% minimum Common Equity Tier 1 (CET1) Additional Capital Conservation Buffer means 7% effective minimum CET1 from 2019 - Dividend/hybrid payments constrained if below 7% CET1 Implies intervention/resolution would be at c4.5% CET1 Addition of 0% to 2.5% in countercyclical buffer Basel will decide in H1 2011 regarding an additional capital requirement for systemically important banks; It is possible that this aspect is left for local regulatory discretion SIFI surcharge will likely comprise of combination of Common Equity and CoCos (with relatively high capital ratio triggers) Unrealised losses on bond portfolios to be deducted from common equity More conservative treatment of minority interest More onerous treatment of insurance subsidiaries and stakes in other financial companies Minimum Tier 1 ratio of 8.5% and Total Capital Ratio of 10.5% (with CET1 ratio of 7% inc conservation buffer) Future Tier 2 will require permanent loss absorbency at the point of non viability (effectively a Low trigger Coco) Future Tier 1 hybrids will require permanent loss absorbency. Trigger level still to be defined at EU level or local regulatory but likely at a small buffer to minimum ET1 ratio (effectively a Medium trigger CoCo) Systemically important CoCos still to be defined (Likely to effectively be a Medium to high trigger CoCo) Increased requirements for Trading Book/ Market Risk Increased requirements for Derivative Counterparty Exposure Increased requirements for exposure to Financials Reduction in requirements for exposures to Central Clearing Counterparties (CCPs) Short term liquidity buffer ratio (LCR) requiring increased amount of high quality liquid assets Bank funding product (other than covered bonds) are not allowed to count for liquid assets Requiring banks to better align funding duration to asset duration and become less reliant on short term wholesale funding Nominal leverage requirement at Tier 1 level of 3%from 2018

Systemically important Financial Institution (SIFI) capital surcharge More conservative calculation of Common/Core Equity Changes in definitions of Non Common Equity Regulatory capital instruments

Changes in Calculation of Risk weighted assets

Liquidity Requirements

Funding Requirements Leverage Ratio

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 12

Calibration: New Rules vs. Old Rules


Basel II
Minimum Minimum

Basel III
Minimum + Conservation Buffer 7.0% 8.5% 10.5%

Core Tier 1 ratio Tier 1 ratio Total Capital


Source: BIS, Credit Suisse

2.0% 4.0% 8.0%

4.5% 6.0% 8.0%

An additional countercyclical buffer of 0 to 2.5% should be met with common equity or other fully loss-absorbing capital. However, there is no explicit limit on Tier 1 hybrids above the minimum requirements, and some banks could still issue a higher amount of hybrids than the implied c.18% at the minimum level (8.5%) to meet Pillar II requirements, for instance.

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 13

Basel III Minimum Capital Ratios


Basel II
Risk-based Capital Ratio 14%
?% TBTF Buffer X% 11.125% TBTF Buffer X% 11.75% Countercyclical Buffer 0-2.5%
9.25%

Transition Period
?% ?% TBTF Buffer X% 12.375% Countercyclical Buffer 0-2.5%
9.875%

Full Basel
?%

III
TBTF Buffer X% 13% Countercyclical Buffer 0-2.5% 10.5% Max T2 2.0%

12%

10%

Countercyclical Buffer 0-2.5%


8.625%

Max T2 2.0%
8.5% 7.875%

8%

8%

8%

8%

8%

Max T2 2.0% Max T2 2.0%


7.25% 6.625%

6%

Max T2 4.0%

Max T2 3.5

Max T2 2.5%
5.5%

Max T2 2.0%
6%

4.5%

4%

Max HT1 1.5%


4%

Max HT1 1.5%


4.5%

Max HT1 1.5%


5.125%

Max HT1 1.5%


5.75%

Max HT1 1.5%


6.375%

Max HT1 1.5%


7%

CCB 0.625%

CCB 1.25%

CCB 1.875%

CCB 2.5%

4%

Max HT1 1%
3.5%

Max HT1 2%

2%

2%

Minimum CET1 3.5%

Minimum CET1 4.0%

Minimum CET1 4.5%

Minimum CET1 4.5%

Minimum CET1 4.5%

Minimum CET1 4.5%

Minimum CET1 4.5%

Minimum CET1 2.0%

0% Before 2013 1.1.2013* 1.1.2014* 1.1.2015* 1.1.2016 1.1.2018 1.1.2017 * Assumes all buffers apply only from 1/2016 . 1.1.2019

Common Equity Tier 1

Hybrid Tier 1

CET1/HT1/Coco (TBD)

Tier 2

CET1/HT1/CoCo?

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Regulatory Minima: Basel 3, Swedish & Swiss Finish


Risk-based minimum capital ratios requirements for large Swiss banks Risk-based minimum capital ratios for major Risk-based minimum capital ratios under

Countercyclical Buffer 0-2.5%


19%

Swedish Banks
Countercyclical Buffer 0-2.5%
15-16%

Progressive Component

Basel III

Countercyclical Buffer 0-2.5%


Risk-based minimum capital ratios under

Tier 2 AT1
10-12%

Low Trigger CoCos 6%


13%

Too big to fail buffer ?% Tier 2 2%


8.5% 7% 10.5%

High Trigger CoCos for 3%


10%

Basel II
8%

CET1 3-5%
7% CCB CET1 2.5%

Buffer

AT1 1.5%
CCB CET1 2.5%

CET1 5.5%

4.0% Tier 2
4%

Minimum Capital

2% HT1
2%

Min CET1 4.5%

Min CET1 4.5%

Min CET1 4.5%

2% CET1

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 15

Capital Constituents and Ratios


Raising the quality, consistency and transparency of the capital base
CAPITAL ELEMENTS Tier 1 Capital will comprise only: Common Equity = paid-up voting or non-voting ordinary share capital for stock companies (and the legal/economic equivalent for non-stock companies) plus retained earnings and Other Comprehensive Income, but excluding minority interests and certain other filters Additional Going Concern Capital = issued instruments that are subordinated, have fully discretionary non-cumulative dividends/coupons (no stock settlement), no maturity date or incentive to redeem (no step-ups) and provide loss absorption on a going concern basis. Includes qualifying minority interests Tier 2 Capital remains essentially as todays Lower Tier 2 but with no step up (or similar) Innovative Hybrid Tier 1, Upper Tier 2 and Tier 3 categories will be abolished. Many existing hybrids will not have the features required to be Additional Going Concern Capital CAPITAL RATIOS Tier 1 Capital = Common Equity + Additional Going Concern Capital Common Equity must comprise the predominant form of Tier 1 Capital Total Capital = Tier 1 Capital + Tier 2 Capital All capital amounts and ratios are calculated/quoted net of capital adjustments (filters and deductions) Capital ratios will be calculated for the Going Concern and Gone Concern scenarios: Going Concern ratios: Common Equity / RWA (minimum 4.5%) Tier 1 Capital / RWA (minimum 6%) Gone Concern ratio: Total Capital / RWA (minimum 8%) Capital ratios will also be linked to additional capital buffers 2.5% Capital Conservation Buffer (means 7% effective minimum CET1 and 10.5% Total Capital from 2019) Up to 2.5% Countercyclical Capital Buffer Plus Too Big to Fail buffer for systemic banks amount yet to be determined COMPOSITION OF CAPITAL BUFFERS Capital Conservation buffer may only include Common Equity (2.5% after transition) Ratios falling within buffer ranges will trigger limitations on capital distributions - including payments on Tier 1 capital instruments and restrictions on discretionary bonuses Countercyclical capital buffer will be composed of Common Equity or other fully loss absorbing capital instruments expected to include going concern contingent capital and Hybrid Tier 1 (flexible size of 0 to 2.5% and timing for introduction will vary at national discretion). Too-Big To Fail buffer: for systemic banks only. Expected to be a mix of common equity, hybrid tier 1, going concern contingent capital and potentially bail-in bonds. Size and composition of this buffer will be specific to each institution and determined by regulator. Final outcome on TBTF buffer will be closely linked to the development of resolution regimes GRANDFATHERING Core Tier 1 No grandfathering for non compliant instruments - totally phased out from 1January 2013 For non joint stock companies, grandfathering with a capital amortisation schedule over 10 years (10% per year from 1 January 2013) Existing Public sector capital injection grandfathered until 1 January 2018 Hybrid Tier 1 & Tier 2 Tier 1 hybrids and Tier 2 capital instruments will also be phased out over a 10-year period (10% per year from 1 January 2013) Tier 1 and Tier 2 instruments with a step-up phased out from step up date (effective maturity date)

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 16

Prudential Filters and Capital Deductions


Prudential filters and deductions from capital are to be harmonised internationally removing some favourable national treatments (of insurance shareholdings, for example)
CAPITAL DEDUCTIONS Assets Deducted from Common Equity Goodwill and other Intangibles: amount net of any associated deferred tax liability Deferred tax assets (DTA) which depend on future profitability: deduct the amount net of any associated deferred tax liability DTAs arising from timing differences: deduct any amount above 10% of own Common Equity (or above 15%, when taken together with the below) Mortgage Service Rights: deduct amounts above 10% of banks own Common Equity (or above 15%, when taken together with the above/below) Significant (>10%) holdings of common stock of another financial institution: the amount above 10% of the banks own Common Equity is deducted (or above 15%, when taken together with the above) Investment in own shares: holdings of own common shares plus any commitments to purchase Holdings of common stock of other financial institutions in excess of 10% of banks own Common Equity: the excess amount is deducted Shortfall of provisions for expected losses under IRB (if any) Defined benefit pension fund asset: the amount less any assets in the pension fund to which the bank has unfettered access Deductions from corresponding capital element Deduction from the corresponding component of capital (i.e. investment in common stock is deducted from Common Equity; other Tier 1 capital from Additional Going Concern Tier 1; subordinated debt from Tier 2 etc) for: Investments in certain non-consolidated banking, financial and insurance entities (no threshold)

PRUDENTIAL FILTERS Exclusions from Common Equity Non-Common stock surplus (share premium): share premium on common shares is included in Common Equity, but on other shares is not Minority interests (in the form of common equity): In non-bank subsidiaries: MI is not counted in consolidated Common Equity In bank subsidiaries: MI is not counted to the extent the bank is over-capitalised (multiplied by the parents proportional shareholding) Gains/losses on FV liabilities due to changes in own credit risk: filtered out of Common Equity. Extends to all FV liabilities, not just those arising by election of the FV option Cash flow hedge reserve: filtered out of Common Equity where it relates to hedging projected cashflows not recognised in the financial accounts No adjustment to financial accounts Unrealised gains and losses (e.g. AFS): these increase/decrease equity per financial accounts although treatment of unrealised gains remains under review Employee pension fund liability: reduces equity per financial accounts Included as RWA Deferred tax assets (DTA) which do not rely on future profitability: will be assigned the risk weighting of the relevant sovereign Other capital deductions (currently deducted 50% from Tier 1 and Tier 2): will be assigned a 1250% risk weighting i.e.
Certain

Holdings of capital as part of a reciprocal cross-holding agreement and investments in affiliated companies (no threshold) All other holdings of capital instruments (subject to threshold for financial institutions as above)

securitisation exposures (e.g. First loss) equity exposures under the PD/LGD approach Non-payment/delivery on non-DVP and non-PVP transactions Significant investments in commercial entities
Certain

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Risk Capture: Counterparty Risk


The BIS, noting lessons from the recent crisis, seeks to increase capital requirements against risks not adequately captured in the current Basel II regulations particularly counterparty risk arising in trading books and derivative positions BIS proposals in July 2009 (Basel 2.5) increased capital charges for market risk and securitisations and are expected to be implemented by 31/12/2011 (1) Basel III proposals primarily modify the treatment of exposures to financials and counterparty risk from derivative positions and are expected to be implemented by 1/1/2013 (i.e., no transition applies)
1. EXPOSURES TO FINANCIALS Increased RWAs for exposures to financial institutions (relative to non-financial exposures) to reflect higher asset correlations for this sector. Includes exposures to: Banks Broker Dealers Only firms with assets > $100bn Insurers Highly Leveraged Entities (e.g. Hedge Funds) Financial Guarantors Proposed 25% increase in correlation assumption with varying impact on RWs depending on rating:
-

2. COUNTERPARTY RISK EXPOSURE MEASURE More conservative exposure measures to be used for counterparty risk for both derivative and secured financing positions to address perceived risks: General wrong-way risk: Banks using Expected Positive Exposure (EPE) measures must estimate exposure used in calculating RWAs based on a data set that includes a period of stress (consistent with new stressed VaR for market risk) Specific wrong-way risk: Additional requirements to identify, monitor and control potential sources of higher general wrong-way risk Banking book-style capital charges for counterparty risk CDS purchased from a counterparty that is related to the referenced/guaranteed party Higher capital charges for single-stock equity derivatives where the counterparty is related to the reference company/stock Margining and Collateral: Increase in minimum holding period used to calculate counterparty exposure for large netting sets, where collateral is illiquid, where positions are difficult to replace or where margin call disputes have been experienced Apply regulatory haircuts to non-cash OTC collateral Higher haircuts for securitisation collateral and disallowing re-securitisations as eligible financial collateral Not permitted to reflect in exposure measure any benefit of collateral agreements that require collateral to be posted on counterparty rating downgrades
-

Source: Credit Suisse


40% 35% Banks & Insurers - Impact 30-35% RWA increase Hedge Funds & Other Impact 10-25% RWA increase

% In crease in R W

30% 25% 20% 15% 10% 5% 0% AAA AA A BBB

BB

CCC

Revised short-cut method for EPE estimation for margined transactions Additional operational and control requirements for collateral management including greater stress-testing and back-testing

Applies to all banking book and counterparty risk RWAs to financial institutions

Rating

. THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 18

Risk Capture: Counterparty Risk (contd)


3. CAPITAL FOR CVA RISK New counterparty risk capital add-on to better capture Credit Valuation Adjustment (CVA) MTM risk in addition to default and migration risk already captured in Basel II Capital requirement is equal to the market risk charge on a hypothetical bond (bond equivalent approach) with: notional equal to the EAD to counterparty maturity equal the effective maturity of the longest dated netting set measured over, effectively, a 10-day horizon Capital requirement is equal to the market risk charge including VaR and new Stressed VaR charge, but excluding the new incremental risk charge (IRC) Calculation is performed standalone on this portfolio no offset from other market positions Capital charge can reflect eligible hedges (BIS aims to incentivise hedging of CVA volatility) i.e.: single-name CDS & CCDS other equivalent hedging instruments directly referencing the counterparty [potential recognition of index hedges] Other hedges, for example market hedges (on underlying risk factors) or tranched credit protection, are not expected to be eligible in the first implementation Requirements for the calculation of CVA capital have not been fully defined and more advanced alternatives are under consideration and aim to address industry concerns on scope of eligible hedging, treatment of effective maturity and double counting with existing counterparty credit risk charge. Final regulation expected in Nov/Dec 2010. Banks will not be allowed to use own models to estimate CVA capital charges. 4. CENTRAL COUNTERPARTIES BIS is seeking to incentivise the use of Central Counterparties (CCPs) for OTC derivatives: collateral and MTM exposures to CCPs will carry [1-3%]RW
-

OTHER RWA CHANGES New RWA calculations for certain assets: Deferred tax assets (DTA) which do not rely on future profitability: will be assigned the risk weighting of the relevant sovereign Capital deductions currently deducted 50% from Tier 1 and Tier 2: will be assigned a 1250% risk weighting. This represents a material increase in effective Tier 1 requirement from 50% T1 requirement to 100% T1 requirement for a bank with 8% T1 ratio proposals as drafted do not cap at book value/notional (i.e. if > 8% T1 ratio) or allow alternative option to deduct 100% from Common Equity although this may be allowed given lobbying Certain securitisation exposures (e.g. First loss). Impact is expected to be especially material for securitisation positions Certain equity exposures under the PD/LGD approach Non-payment/delivery on non-DVP and non-PVP transactions Significant investments in commercial entities

Low RW (in the 1-3% range)

Continues existing treatment for clearing houses, but applies only to CCPs complying with new and stricter CPSS/IOSCO definition of CCPs. Non-zero RW will apply to exposures to other CCPs Serves to increase the RWA benefit (reduction) from purchasing CDS protection from CCPs on banking book assets, for example hedging loan books Equity investments in CCPs will continue to receive current Basel II equity treatment

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 19

Risk Capture: Market Risk Capital & Securitisations


Recap of July 2009 BIS Amendments to Basel II (Basel 2.5) The December 2009 proposals are in addition to the Basel Committee approving in July 2009 material amendments to guidelines for calculating capita l requirements for trading book assets, as well as more conservative requirements for securitisation and resecuritisation positions

In the EU proposals are being implemented via an amendment to the CRD (CRD3) and implementation is expected by 31/12/2011
July 2009 proposal for capital charge for trading book assets is calculated as:

General Market Risk Charge


Current model, based on 99% 10-day VaR subject to a multiplier

Stressed VaR Charge

Specific Risk Charge

New model, based on 99% 10-day VaR calculated on a 1-year dataset from period of significant financial stress

New model capturing specific risks, e.g. default risk and migration risk on credit products

Stressed VaR Charge is calculated using historical data from a period of market stress (e.g. 2008). Charge is intended to be broadly constant overtime, to reduce procyclicality. The bank can reassess whether the stressed market period remains relevant Specific Risk Charge is dependent on the nature of the relevant asset, as follows:

Un-securitised Credit Products

Bank calculates an Incremental Risk Charge (IRC), i.e. 99% 1-year charge capturing default risk and migration risk Internal models must capture at least the following parameters: correlation, concentration/diversification, risk mitigation effects, optionality, liquidity IRC covers credit-risk related positions except securitisation positions and correlation trading assets (see below). Does not include equities, FX, commodities or general IR risk Bank calculates a specific risk charge applying banking book capital requirements to net securitisation positions in trading book (long or short). RW varies between 7% (for AAA-tranches) and a capital deduction (for positions rated B+ or worse) Applies to securitisations broadly i.e. all tranched credit positions unless covered by the correlation trading carve-out. Does not allow netting of non-securitisation hedges (e.g. tranche CDS) Resecuritisation exposures (2) (e.g. CDO-squared) are subject to higher capital charges, up to 3.5x higher than securitisations Bank calculates a specific risk charge based either (i) on standard rules, slightly less onerous than securitisation rules, or (ii) an internal model, subject to strict qualitative minimum requirements as well as regulatory stress-testing requirements Covers securitisations or nth-to-default derivatives whose reference entities are liquid single-name products. Excludes resecuritisations

Securitisation Positions

Correlation Trading Portfolio

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 20

Leverage Ratio
BIS is proposing to introduce a leverage ratio as a supplemental measure to the risk-based ratio with the following ostensible objectives: to monitor and constrain the build-up of simple leverage in the banking sector, and to reinforce the risk-based requirements with a simple, non-risk-based backstop measure based on gross exposure Although initially a backstop metric, the leverage ratio will be enshrined in Pillar 1 regulation (in 2018) after a period of assessment and calibration Tables below show the baseline BIS proposal including amendments published in July 2010 The revised proposal remains materially more conservative than leverage ratio measures currently in operation in the US, Switzerland and Canada It takes a more conservative view of exposure e.g. inclusion of some Off-Balance Sheet exposures; partial gross-up of derivative exposures; ignores collateral and netting (except for derivatives), and It also uses a more conservative Capital Measure new Basel III definition of Tier 1 (net of deductions)
Leverage Ratio = EXPOSURE MEASURE Generally follows total assets per accounting balance sheet with adjustments intended to bridge differences between IFRS and GAAP in particular with relation to netting of derivative positions Based on average exposure (and average capital) over quarter All assets, including cash and high quality liquid assets (1) Valuations are net of provisions and valuation adjustments Does NOT allow offset of collateral or on-balance sheet netting - except for derivs For derivatives (inc. credit derivatives) banks to apply Basel II netting plus a simple measure of potential future exposure based on CEM factors (2) converting derivatives to a loan-equivalent amount Includes repos & securities financing (disallowing netting) Includes certain off-balance sheet (OBS) items: 10% CCF may be used for unconditionally cancellable OBS 100% CCF for other commitments (lending cmtmts, guarantees, etc.) Securitisations follow accounting valuations Items deducted from capital are also deducted from this exposure measure Capital Measure Exposure Measure CAPITAL MEASURE Tier 1 Capital to be used as the Capital Measure for the leverage ratio Tier 1 Capital measured net of capital deductions and prudential filters Regulators and BIS will also track leverage based on Total Capital and Tangible Common Equity CALIBRATION AND IMPLEMENTATION TIMETABLE Original proposals from December 2009 were materially relaxed via amendments published in July 2010 Proposals nevertheless remain draft until BIS publishes more detailed guidelines Implementation includes transition provisions with the following milestones: 1/1/2011: Supervisory monitoring begins 1/1/2013 to 1/1/2017: Parallel run tracking by supervisors and potential adjustments to definition and calibration
-

3%

1/1/2015: Bank-level disclosure begins H1 2017: Final adjustments to leverage ratio 1/1/2018: Included in Pillar 1 minimum capital requirements

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 21

Liquidity Regulations
The BIS III proposals aim to introduce quantitative liquidity requirements to complement the qualitative principles already developed by Basel in September 2008

The BIS III proposals aim for an internationally uniform quantitative framework to measure and monitor liquidity risk The proposed standards and monitoring tools should be applied to all internationally active banks on a consolidated basis. It may also be used for other banks and on any subset of entities of internationally active banks to ensure greater consistency and a level playing field between domestic and cross-border bank entities BIS defined two measure of liquidity developed to achieve two separate but complimentary objectives:

GLOBAL LIQUIDITY STANDARD

Liquidity Coverage Ratio (LCR): to ensure a bank has sufficient high quality liquid resources such that it can survive an acute stress scenario lasting one month Net Stable Funding Ratio (NSFR): to promote longer term stability by incentivising banks to access longer term stable funding sources and limit reliance on wholesale funding. NSFR aims at capturing funding instabilities over a minimum 1-year period in securities trading inventories, off-balance sheet exposures and securitisation transactions Proposed implementation timeline:

(per December 2009 proposals plus releases in July and September 2010)

LCR: Implementation 1 Jan 2015. Observation period prior to 2015 NSFR: Implementation 1 Jan 2018. Observation period prior to 2018, resulting in possible refinements to NSFR definitions In addition, BIS identifies four monitoring metrics to further aid supervisors in assessing the liquidity risk of a bank: Contractual Maturity Mismatch: banks are required to group assets and liabilities in buckets depending on contractual maturities to identify material mismatches. Suggested buckets are O/N, 1W, 2W, 1M, 2M, 3M, 6M, 1Y, 3Y, 5Y and over 5Y Concentration of Funding: banks are required to examine each significant counterparty and funding instrument as a percentage of total bank balance sheet, to identify funding exposures greater than 1% of total funding needs Available Unencumbered Assets: banks must identify the amount of assets that are marketable as collateral in secondary markets and/or eligible for central banks standing facilities Market-related Monitoring Tools: national supervisors may rely on real-time market metrics which can be used as early warning indicators in monitoring potential liquidity difficulties at banks

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 22

Liquidity Coverage Ratio (LCR)


CF: HIGH QUALITY LIQUID ASSETS Observation Phase until Jan 2015 BIS will observe the proposed liquidity requirements across business models and funding structures before finalising the LCR LCR Implementation on Jan 2015 Cash Sovereign & Public Sector Securities Qualifying Central Bank Receivables Sovereign Debt in domestic currency (1) 100% 100% 100% 100% CF: CASH OUTFLOWS Retail Deposits 5% to 10% Unsecured Wholesale Funding: - Small Business 5% to 10% - Non-Financial Corp, 25% Sovereign and Public Sector (with operational relationship) 25% - Operational activities with FI counterparties 75% - Non-Financial Corp Sovereign and Public Sector (no operational 100% relationship) - Other Secured Funding (illiquid assets) 100%

Stock of High Quality Liquid Assets LCR = 100% Net Cash Outflow over a 30-day period
Stock of High Quality Liquid Assets: assets satisfying the highest liquidity requirements, i.e. high credit standing, low duration, easy to value, low correlation with risky assets (i.e. financial institutions) and listed on a developed exchange e.g. Cash, central bank reserves, government bonds, at full book value Corporate and covered bonds subject to certain criteria and 20-40% haircut to book value Up to 40% of the liquidity requirements can comprise Sovereign and Public Sector Securities qualifying for the 20% risk weightings under Basel 2 (Level 2 assets) Net Cash Outflow: net cumulative liquidity mismatch position arising in the specific stress scenario over a 30-day period

LIQUIDITY COVERAG E RATIO (LCR)

- Lower Retail and SME - Retail clients - Non-Fin Corp,


CF: LEVEL 2 ASSETS Sovereign & Public Sector Securities qualifying for the 20% risk weightings under Basel II Corporate and Covered Bonds rated AA- or higher (2) 85%

Undrawn Commitments:

Sovereign, Public Sector, credit facilities - Non-Fin Corp, Sovereign, Public Sector, liquidity facilities - Other

5% 10% 10% 100% 100%

85% (AA or higher)

Additional requirements for derivatives collateral; Additional requirements for liabilities from maturing ABCP, SIVs and conduits.

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 23

Net Stable Funding Ratio (NSFR)


CF: AVAILABLE STABLE FUNDING Observation Phase until Jan 2018 BIS will observe the proposed liquidity requirements across business models and funding structures before finalising the NSFR NFSR Implementation on Jan 2018 T1 & T2 capital Other Prefs and capital instruments in excess of T2 limit with maturity > 1 yr Other liabilities with effective maturity > 1 yr 100% CF: REQUIRED STABLE FUNDING Cash, money market instruments Securities with maturity <1yr Loans to financials < 1 yr 100% Off-balance sheet commitments Marketable securities from sovereign / public sector rated AA or higher with maturity > 1yr Liquid corp bonds rated AA or better with maturity > 1yr 0% 0% 0% 5%

100%

NSFR =

Available amount of stable funding Required amount of stable funding

100%

Stable retail and small business client deposits with maturity <1yr Less Stable retail and small business client deposits with maturity <1yr Wholesale funding (non-financial corp or maturity <1yr) Other liabilities

90%

5%

NET STABLE FUNDING RATIO (NSFR)

Available Stable Funding: each liability of the bank multiplied by a conversion factor (0% to 100%, imposed by regulator) and summed. 100% CF for equity and borrowings > 1 year; lower factors for less stable funding (e.g. retail deposits, nonmaturing wholesale deposits, standby facilities) Required Stable Funding: each asset that supervisors consider should be supported with stable funding, multiplied by a factor and summed. Includes off balance sheet commitments (OBS) such as credit and liquidity facilities, guarantees, trade finance and other non-contractual obligations (subject to regulatory discretion)

80%

20%

50%

- Gold - Liquid equities - Liquid corp bonds rated AA- to A- with mat > 1yr Loans to non-financials < 1yr

50%

0%

Residential mortgages and other loans qualifying for the 35% or better risk weight under Basel IIs standardised approach Retail loans with maturity < 1yr Other

65%

85% 100%

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 24

Transition Periods
As of 1 January 2019

2011

2012

2013

2014

2015

2016

2017

2018 Migration to Pillar 1

Leverage Ratio Minimum Common Equity Capital Ratio Capital Conservation Buffer Minimum common equity plus capital conservation buffer Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials) Minimum Tier 1 Capital Minimum Total Capital Minimum Total Capital plus conservation buffer Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 Capital

Supervisory monitoring 3.5% 3.5%

Parallel run 1 Jan 2013 - 1 Jan 2017 Disclosure starts 1 Jan 2015 4.0% 4.5% 4.0% 20% 4.5% 40% 6.0% 8.0% 8.0%

4.5% 0.625% 5.125% 60% 6.0% 8.0% 8.625%

4.5% 1.25% 5.75% 80% 6.0% 8.0% 9.125%

4.5% 1.875% 6.375% 100% 6.0% 8.0% 9.875%

4.5% 2.50% 7.0% 100% 6.0% 8.0% 10.5%

4.5% 8.0% 8.0%

5.5% 8.0% 8.0%

Phased out over 10 year horizon beginning 2013 Observation period begins Observation period begins Introduce minimum standard Introduce minimum standard

Liquidity coverage ratio

Net stable funding ratio


Source: BIS, Credit Suisse

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Future for Non Common Bank Capital

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Contingent Convertible Capital Instruments (CoCos)


The Concept/Product:
The banking crisis revealed the lack of loss absorbency characteristics in the prevailing forms of nondilutive capital (Tier 1 hybrids, Upper Tier 2 and Lower Tier 2 debt)

Debt security that converts into equity at the occurrence of a defined trigger event Equity conversion can be achieved through principal write-down or exchange into ordinary shares

Future Tier 1 Hybrids and Tier 2 Instruments are effectively CoCos as well
All Tier 1 hybrids will require loss absorbency at the principal level outside a liquidation under Basel III All Tier 2 instruments of internationally active banks will require loss absorbency at the point of nonviability under Basel III

Almost all types of non common equity of banks will be a form of Coco in the wider interpretation of the
term given the requirement for permanent loss absorbency requirement outside a liquidation in both future Tier 1 and Tier 2 (of systemically important banks) capital instruments under the current Basel III proposals

The role of CoCos for Systemically Important Banks


Another category of Coco is likely be introduced to meet an additional capital requirement placed on
systemically important banks under Basel III. The Basel Committee will complete by mid-2011 a study of the magnitude of additional loss absorbency that global systemically important banks should have

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 27

Capital Requirements Swiss Finish


Risk-based minimum capital ratios requirements for large Swiss banks
Banks will need to satisfy additional requirements such as the countercyclical buffer, TBTF buffer and any surplus capital required by the local regulator +200%

19% Progressive Component

Large Swiss banks will face substantially higher capital requirements The requirements comprise the minimum capital requirements under Basel III, a buffer to absorb losses without falling below the minimum, and a progressive component to improve the solvency of systemically important banks.
Component
III. Progressive Component

Description
Additional solvency for systemically important banks Creates incentives for banks to restrict their systemic importance Banks exceeding the minimum organisational requirements to improve resolvability will receive a capital rebate Enables banks to absorb losses without falling below minimum Takes into account risk profile and the loss potential of the bank

Proposed Calibration
6% Low Trigger CoCos (trigger at 5% CET1) Size of progressive component dependant on market share and

Low Trigger CoCos (trigger at 5% CET1) 6% of RWA

total assets1

Risk-based minimum capital ratios under Basel III


10.5%
Max T2 2.0% 8.5% Max HT1 1.5% +100%

13%
High Trigger CoCos (trigger at 7% CET1) Up to 3% of RWA

10% Buffer
Additional CET1 Buffer > 5.5% of RWA

II. Buffer

Total 8.5%, comprising: At least 5.5% CET1 Up to 3% high trigger CoCos (trigger at 7% CET1)

7%
Capital Conservation Buffer CET1 2.5%

+120%

7%

High Trigger Coco threshold Low Trigger Coco threshold

4.5%

5%

I. Minimum Capital

Essential to maintaining normal operations Corresponds to Pillar 1 requirements under Basel III

4.5% common equity (CET1) from January 2015 BIS minimum requirements concerning total capital (8%) and Tier 1 (6%) must also be met All ratios are net of B3 capital adjustments (filters and deductions)

Minimum Capital

Minimum CET1 4.5%

+/-0%

Minimum Requirements CET1 4.5% of RWA

In addition to the capital requirements, the big Swiss banks also have to satisfy the requirements in respect of liquidity, risk diversification and organisation Source: Credit Suisse

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 28

Basel III: Capital Structure of Banks Going Forward


Migration of the capital base

Although BIS recommendations do not have the force of law, BIS Committee members are expected to implement them. Europe will
likely adopt the BIS recommendations where they are more restrictive than the proposed European approach, subject to limitations imposed by national laws
Proposed Basel Capital Elements
2% of RWA (net of deductions)

Current Typical Capital Elements


Tier 3 Capital (Market Risk only)
Max 50% of T1 10.5% of RWA

Tier 2 Capital

Min 5-year subordinated debt; with loss absorbency language Instruments that are subordinated have fully discretionary noncumulative dividends, no maturity or incentives to redeem and loss absorption on a goingconcern basis Common Equity common shares or the equivalent for non-joint stock companies plus retained earnings and comprehensive income net of deductions)

Not more than T1

Lower Tier 2 Capital

1.5% of RWA (net of deductions)

Additional Going Concern Tier 1 Capital Or Tier 1 Hybrids

Upper Tier 2 Capital


Max 15% of T1

8.5% of RWA 8% of RWA

Innovative Hybrid Tier 1 Capital

7% of RWA (net of deductions). Must be predominant amount of Tier 1 Capital

Min 50% of Total Capital

Other Hybrid Tier 1 Capital

Core Tier 1 Capital

Min 50% of T1

Core Tier 1 Capital

Contingent Capital Source: Credit Suisse

Role still to be finalised by H1 2011

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 29

Basel III: Loss Absorbency of Regulatory Capital Instruments


Going-concern trigger Gone-concern trigger

Viable

Non-viable

Insolvent

Monitoring

Early supervisory intervention

Resolution

Liquidation

Tier 1 Perpetual, no step up Optional coupon cancellation (no pusher but ord div stopper is allowed) Non-cumulative Deeply subordinated Loss absorption through conversion into equity or principal write-down upon breach of a predefined capital ratio Trigger: Local Regulator discretion

Tier 2 Dated with minimum maturity of 5 years Capital amortised over the last 5 years No coupon deferral Subordinated None (unless if used as a host for going concern contingent capital)

Key Features

Going Concern

Gone Concern

Loss absorbing through conversion to equity or principal write down when an institution is judged by its regulator to have reached the point of nonviability, or the public sector provides capital or equivalent support to restore a failing bank, without which the bank would not be viable Requirement to have this additional loss absorption feature maybe fulfilled by adding a contractual provision in the terms of the instrument, or as a result of an equivalent mechanism provided by the laws on resolution regime in effect in the issuers jurisdiction

Source: Credit Suisse

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 30

Key Legislative changes (Resolution Regimes)

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Key Legislation related changes (Resolution Regimes & beyond)


Resolution Regime Related Legislation Increased acknowledgement that governments need more options in resolving distressed banks in order to limit taxpayers exposure UK, Ireland, Germany & Denmark have already implement Resolution Regime legislation The Netherlands has produced draft Resolution Regime legislation EU will issue draft directive relating to Resolution Regime this summer Transfer powers by a Government or Resolution Authority (of a government) is a key Resolution Tool The Transfer [power resolution tool allows a Government or Resolution Authority (of a government) to move systemically important or priority creditors (like depositors) into a going concern or bridge bank while windingdown/liquidating the rest of the bank The ability of a Government or Resolution Authority (of a government) to impose losses on bondholders outside a liquidation, either through principal write-down or conversion into equity.

Transfer Powers

Haircut/Bail in tool

Preferred Treatment of Depositors Ring fencing of Retail activities/Subsidiarisat ion

EU likely to review the equal ranking of depositors relative to senior unsecured debt

Certain countries could require ring fencing of retail banking operations (in separate legal entity) from other banking operations

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 32

Resolution Regime vs. Regulatory Changes: Credit implications


Resolution Regime Regulatory Changes

Changes in insolvency law Increasing loss given distress Bondholder losses, including senior

+
Improved liquidity positions Reduction in probability of distress Higher quantum and quality of capital

Bank Credit

Resolution Regime is a negative development for bondholders, partly offsetting the positives from the proposed Basel III capital & funding requirements
Source: Credit Suisse

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 33

Potential Loss Profile Going Forward


Loss Profile for Bondholders Pre-Resolution Regime a
*

Currently, bank bondholders in most European countries can only absorb principal losses in a liquidation

Probability of Default in Liquidation

Loss Given Default in Liquidation

Loss Profile for Bondholders Post-Resolution Regime a


*

Should Resolution Regimes be implemented, bank bondholders will be exposed to principal losses outside liquidation c
*

b
Loss Given Default in Liquidation

Probability of Default in Liquidation

Probability of Restructuring outside a Liquidation

Loss Given Restructuring outside a Liquidation

Source: Credit Suisse

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 34

Resolution Regime: Implications for Bank Credit


This is likely a negative development for bondholders, as it exposes bondholders to losses outside of liquidation. Going forward banks are unlikely to benefit from the same extent of state support where bondholders face limited losses. In the future if banks run into difficulties, bondholders from senior to junior securities will face potential permanent write-downs or conversion into equity Lower Tier 2 securities are likely to be downgraded by rating agencies as the implied support currently factored in needs to be removed (e.g., Ireland and the announcement of a change of resolution regime which resulted in a downgrade of Lower Tier 2 securities). Tier 1 securities have already been downgraded by rating agencies, while rating agencies might take the view that the likelihood of losses on senior debt is limited. Future Senior bonds with such write-down risk outside a liquidation could potentially also be downgraded but we think such rating actions will be more limited and less profound than on Lower Tier 2 debt This also means that going forward securities might have more qualitative triggers in order for regulators to step in at an early stage of the potential difficulties of a bank. This would in turn make it more difficult for investors to price the optionality of these securities This also might force banks to use more actively the covered bond than in the past, as senior secured debt is not likely to be affected by write-downs, reducing potential recoveries for senior bondholders Rating agencies might need to review their stance on not rating contingent capital, as all types of debt going forward might have conversion into equity features

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 35

Resolution: Debt Write-Down


To tackle the challenge of resolving large, complex financial institutions, the Commission is considering supplementary mechanisms designed to enable the institution to continue as a going concern, so it can be re-organised or, where appropriate, certain activities wound down in an orderly manner that minimises contagion One such mechanism under consideration is to write down all equity and the conversion of the debt of a troubled institution into equity, to restore its capital position so as to allow it to continue (either temporarily or permanently) as a going concern. However, significant legal and policy questions exist. These include:
Whether the mechanism should be based on statutory power for authorities to write down or convert debt under specified
conditions, or on mandatory contractual terms for write-down or conversion which would be required to be included in a proportion of the debt issued by financial institutions covered by the crisis management framework ranking of debt (the Commission believes as a matter of principle any debt write-down should be applied in a way that respects the ranking in insolvency) of the balance sheet, and the possible need to change ranking of certain creditors

If the power is statutory, the classes of debt that should be covered and the impact that the scope of application would have on the

The impact on the cost of financing, the risk of driving funding to short term or secured debt, the need to regulate the liabilities side The complexities of applying this tool to a cross-border group and the need to ensure recognition of any write-down or conversion by
foreign courts where the debt is booked in or governed by the law of a non-EU jurisdiction

The Commission notes the range of initiatives with similar objectives, including the Basel Committee consultation paper of 19 August 2010. The Committee will consult further on its implementation of any rules on contingent convertible capital that may be adopted, and will ensure that the development of any proposal on debt write-down as a resolution tool is coordinated with this

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 36

Resolution
The general rule should be that failing credit institutions should be liquidated under ordinary insolvency proceedings. However, it will not always be feasible to liquidate a bank under ordinary insolvency proceedings. In some cases, an orderly winding down through resolution will be necessary in the public interest for reasons of financial stability Measures aimed at maintaining the entity as a going concern, such as the power to write down debt or convert it to equity should be a last resort and only used in duly justified cases

Source: European Commission, Credit Suisse

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 37

Resolution Regime: Several Countries have introduced Legislation in this regard already

Germany (Restructuring & Orderly Liquidation of Credit Institutions Act) Ireland Credit Institutions (Stabilisation) Act 2010 UK (Banking Act 2009) Denmark Draft EU directive is planned for Summer 2011 More countries will likely implement legislation in this regard, becoming compulsory for EU member countries post the planned EU directive in this regard

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 38

Banking Model Evolution resulting from Regulatory & Legislative changes

PLEASE REFER TO THE DISCLAIMER SECTION FOR IMPORTANT DISCLAIMERS AND CONTACT YOUR CREDIT SUISSE REPRESENTATIVE FOR MORE INFORMATION.

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Business Model Implications from Key Regulatory changes


Changes in Calibration Minimum Capital Requirements Systematically important banks likely to require CET 1 of c10% in our view Increased regulatory capital requirements (SIFIs and Non SIFIs) will require material delevering, with focus on both numerator (CET1) and denominator (RWA) of capital adequacy ratio Pricing of risk to reflect higherWACC, likely to drive significant widening of asset margins Higher levels of capitalisation should in the long term result in downward pressure on funding costs as perception of credit quality improves

More conservative calculation of Common/Core Equity

Increased incentive to dispose of Insurance operations Increased incentives to dispose of significant stakes in financial companies Increased appetite for disposal of positions with unrealised losses (assuming all other factors support disposal) Reduction of excess capital in non wholly owned subsidiaries to ensure maximum utilization of minority interest in regulatory capital

Changes in definitions of Non Common Equity Regulatory capital instruments

Banks like to have between 3.5% and 10% in non CET1 capital in our view Non common equity capital will be in CoCos (in broad definition of the term) CoCos will consist of Low Trigger CoCo (Tier 2 instruments), Tier 1 hybrids (Medium trigger CoCos) and High Trigger Cocos (for systematically important banks) Cost of non CET1 capital will be materially higher than before given increased loss absorbency outside a liquidation, further increasing WACC compared to existing stock of Non CET1 regulatory capital Tax deductibility of Non CET 1 capital (in most countries) reduce the impact of increased spreads

Changes in Calculation of Risk weighted assets

Reducing of Proprietary Trading risk Increased to central clearing counterparties (CCPs) Reduction of Counterparty exposure through structured solutions Disposal of capital intensive asset like ABS residuals

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 40

Business Model Implications from Key Regulatory changes


Liquidity Requirements Reduced holdings of liquid bank senior unsecured and subordinated bonds and ABS securities in Treasury/Liquid asset portfolios Increased holdings of covered bonds, high quality corporate credit and (quasi) government bonds in Liquid asset portfolios Resultant return reduction on treasury/liquid asset pools Lengthening of duration of funding profile Stronger competition for deposits Increased issuance of covered bonds Reduction in low yielding/high quality risk Incentive for banking industry to facilitate disintermediation of (high quality) corporate credit risk Increased focus on distribution of high quality risk rather than retaining such risk
Max T2 2.0%

Funding Requirements

Leverage Ratio

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 41

Business Model Implications from Key Legislation related changes (Resolution Regimes & beyond)
Resolution Regime Related Legislation ( and introduction of Transfer Powers and Haircut/Bail in Tool) Increased funding costs on senior unsecured Reducing issuance of senior unsecured debt; increasing issuance of covered bonds and other forms of secured debt Increase in asset margins

Preferred Treatment of Depositors Ring fencing of Retail activities/Subsidiarisation

Marginally increased funding costs

Reduced taxation flexibility Improved ability to attract deposits and compete against other savings product providers Increased funding costs for groups with large IB units

Minimum CET1 4.5%

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 42

Business Model: Second order implications from Regulatory, Legislative and Political changes
Asset margin widening/Repricing of bank product to compensate for increased funding costs and capital requirements Consolidation of banking industry

Scale Structural (Germany, Denmark) Regulatory driven (Spanish Cajas) Leveraging strengths (Santander, BNP) Funding focused (DB/Deutsche Postbank)

Demutualisation Disposal of Non Core businesses & Portfolios Shifts in business mix/portfolio composition Cost base reductions/Focus on scale & technology Central Banks Access (Scope for fundamental review of charging of funded and unfunded access to differentiate between banks based on credit quality) Risk transfer solutions to Non-Bank Industry (Warehousing, equity & Mezzanine tranches in Synthetic securitisation of Counterparty risk) Expansion in growth markets Unlevel playing field based on potential differential in minimum capitalisation levels by country could drive transferring of operations across borders Focused equity investments/ partial dilution

Third party capital injections into business units Third party interest in specific subsidiary focusing on specific geography Third party interest in good bank post separation from bad bank

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 43

Investor Returns in Bank Capital

PLEASE REFER TO THE DISCLAIMER SECTION FOR IMPORTANT DISCLAIMERS AND CONTACT YOUR CREDIT SUISSE REPRESENTATIVE FOR MORE INFORMATION.

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

European Financials Capital Structure Preference


Valuation
Covered Bonds

Drivers
(1) Covered bond issuance is likely to increase as banks reduce reliance on short-term funding

Relative Value comment


Attractive

ASW + 97bps

Senior Debt

Benchmark + 191bps ASW + 123bps

(1) Issuance would be likely to increase as banks reduce reliance on short-term funding. (2) Banks would reduce holdings of other banks senior debt in Treasury portfolios under Basel III liquidity proposals

Fair to Attractive

Bench.+511 to call/+295 to mat.


Not more than T1 Max 50% of T1

Lower Tier 2 Capital

YTC 7.4% (median: 5.3%)/ YTM 5.7% (median: 5.4%)

(1) Shrinking asset class. ( 2) Less compelling than perpetuals as a result of relative valuation but also downward ratings risk Fair to Unattractive on potential removal of state support given implementation of resolution regimes Attractive

Upper Tier 2 Capital

Max 15% of T1

Bench.+1,030 to call/+402 to mat. (1) Category does not exist under Basel III proposals. YTC 12.6% (median: 6.2%)/ YTM 7.1% (2)Grandfathered to call date only. (3) Shrinking asset class with zero supply going forward (median: 6.2%) Bench.+854 to call/+421 to mat. (1) Non-compliant with new regulatory capital YTC 11.0% (median: 8.3%)/ YTM 8.0% proposals. (2)Grandfathered to call date (median: 7.3%) Bench.+588 to call /+435 to mat. YTC 8.4% (median: 8.3%)/ YTM 7.9% (median: 7.8%) (1) Non-compliant with new regulatory capital proposals; likely redemption sooner than implied in pricing. (2) Shrinking asset class; future supply largely hybrids that comply with Basel III proposals with loss absorbency in going concern

Innovative Hybrid Tier 1 Capital

Attractive

8% of RWA

Non-Innovative Hybrid Tier 1 Capital


Min 50% of Total Capital

Attractive

Min 50% of T1

Core Tier 1 Capital

FY10 P/E 11.5 FY10 Yield 8.7%

Benchmark (Global Equity Strategy)*

Regulatory changes should be positive developments from a risk-profile standpoint for bondholders as the quantum and quality of capital rise while the liquidity metrics of the banking sector are enhanced. However, this needs to be weighed against the negative of a resolution regime reform, which will expose bondholders to loss absorption outside a liquidation
Source: Credit Suisse, the BLOOMBERG PROFESSIONALTM service, pricing as at 4 April 2011. *See Global Equity Strategys 9 March report, European Banks: downgrading to benchmark at http://doc.research-and-analytics.csfb.com/doc?language=ENG&format=PDF&document_section=1&document_id=869623271

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 45

Competitive Landscape (Implications for Non Banking Financials Institutions)

PLEASE REFER TO THE DISCLAIMER SECTION FOR IMPORTANT DISCLAIMERS AND CONTACT YOUR CREDIT SUISSE REPRESENTATIVE FOR MORE INFORMATION.

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Competitive Landscape & Implications for Non Banking Financials Institutions


Regulatory & Legislative changes likely to result in a a significant shift in business activities from Regulated Banking Industry to Non Banking Financial Institutions Central Clearing Counterparties (CCPs) to benefit from the increased incentive of banks to reduce non CCP counterparty exposure Disintermediation of credit risk into capital markets should benefit (credit focused) asset managers Bespoke structured risk transfer transactions (like securitisation of counterparty credit risk) could potentially create attractive opportunities for specialist investment managers Capital charges that are disproportional to risk could create attractive risk/reward profiles in resultant risk transfer solutions to NBFIGs Risk warehousing opportunities for Non Banking Financials Institutions Capital market investment opportunities for direct exposure to projects/infrastructure/commercial property developments Structured/Packaged lending solutions for smaller loan size transactions (like SMEs) Portfolio transfer opportunities (AFS fixed income portfolios, ex SIV/ABCP Conduit assets, NPL portfolios etc.) Focused equity investment opportunities (in specific subsidiaries based on business line or geographical focus) Increased competition amongst banks will likely place upward pressure on deposit rates and can have an implication for saving product providers Spin-off of proprietary trading into (partially) listed investment managers/hedge funds Some market making activities potentially to be conducted outside the banking industry Improved prospects for Non-bank Finance companies with secured funding model

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY 47

European Insurers

PLEASE REFER TO THE DISCLAIMER SECTION FOR IMPORTANT DISCLAIMERS AND CONTACT YOUR CREDIT SUISSE REPRESENTATIVE FOR MORE INFORMATION.

THIS REPORT IS NOT RESEARCH AND IS INTENDED FOR QUALIFIED INSTITUTIONAL BUYERS ONLY

Solvency II The Basics


On 22 April 2009, the Solvency II Framework Directive Proposal was agreed by the European Commission The framework will, following current plans, be implemented by 31 December 2012 The most important feature of Solvency II is its risk-based character, i.e., capital requirements are related to the risks assumed by insurers A second feature of the Solvency II framework is greater focus on insurance groups as well as separate solo legal entities A third feature is the market consistent valuation for both assets and liabilities Finally, Solvency II explicitly allows for the use of internal modelling for the calculation of capital requirements Provisions have been made for transitional arrangements between Solvency I and Solvency II; thus a big bang introduction of Solvency II is not being considered A transitional period of up to 10 years has been granted in relation to the standard formula for the calculation of the Solvency Capital Requirement (SCR) and the determination and classification of own funds Draft implementing measures due in June 2011 will likely contain greater detail of the transitional arrangements
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Solvency Capital Requirement: The Standard Formula


Solvency I Capital Requirement: Calculation only focused on reserves and premiums Life: 4% of Life Net Technical Reserves, 1% of linked reserves Non Life: 16% of Non-Life premium written (premium test mostly applicable) Solvency II Capital Requirement (SCR): Calculation encompasses market, counterparty default, life underwriting, non-life underwriting, health underwriting and intangible asset risk
Assets covering technical provisions, the MCR and SCR

(SCR) Constrained to lie between 25-45% of SCR

Total capital requirement (TCR) is given by:


Source: EIOPA, Credit Suisse

2 2 2 2 Where all risks are perfectly correlated: TCR = SCRequity + SCRcredit + SCRproperty + SCRint erest, completely uncorrelated risks: TCR = SCRequity + SCRcredit + SCRproperty + SCRinterest

rxc

CorrFacrxc SCRr SCRc

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Solvency II: EIOPA Advice on Capital Charges


Interest Rate Risk
The interest rate capital charge will be based on two pre-defined factors, an upwards and downwards shock in the term structure of interest rates combined with specific alterations in the interest rate implied volatility, resulting in four possible scenarios: MktintUpivolUp, MktintUpivolDn, MktintDnivolDn, MktintDnivolUp The capital charge Mktint will be determined as the maximum change in the Net Asset Value (of the four scenarios) due to revaluation of all interest rate sensitive assets and liabilities based on specified alterations to the interest rate term structures combined with specified alterations to interest rate volatility, subject to a minimum of zero CEIOPS has agreed to revise the volatility shock from a multiplicative formulation of 95% upwards and 20% downwards to an additive formulation of 12% upwards and 3% downwards, though the stresses are only relevant where insurers asset portfolios or insurance obligations are sensitive to changes in interest rate volatility, e.g., where liabilities contain embedded options and guarantees

Equities
Stress of 45% (QIS 5: 39%) for global equities (equities listed in EEA and OECD countries) as per EIOPA, which is supported by the majority of EIOPAs members
Source: EIOPA, Credit Suisse

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Solvency II: QIS5 Advice on Capital Charges


Corporate Credit Risk QIS 5: Capital Charges on Corporate Credit Risk*
Average Maturity 1.5 years 4 years 6 years 8 years 10 years Modified Duration 1.4 years 3.6 years 5.1 years 6.5 years 7.8 years Covered Bond AAA 0.8% 2.2% 3.1% 3.9% 4.7% AAA 1.3% 3.2% 4.6% 5.9% 7.0% AA 1.5% 4.0% 5.6% 7.2% 8.6% A 2.0% 5.0% 7.1% 9.1% 10.9% BBB 3.5% 9.0% 12.8% 16.3% 19.5% BB 6.3% 16.2% 23.0% 29.3% 35.1% B or lower 10.5% 27.0% 38.3% 48.8% 60.0%

*We have constructed the table using the QIS5 calibrations, published on 5th July 2010. The modified duration calculations are based on a 5% coupon bond trading at par. Under current proposals government bonds issued by OECD countries are not going to incur a capital charge. Source: EIOPA, Credit Suisse

Credit: QIS5 calibration


Rating Class AAA AA A BBB BB B or Lower Unrated Rating Class 0.9% 1.1% 1.4% 2.5% 4.5% 7.5% 3.0% Duration Floor 1 1 1 1 1 1 1 Duration Cap 36 29 23 13 10 8 12

Credit Capital Charge based on QIS 5: Mktspbonds = Modified Duration * F (Ratingi) Example: For a 10m holding in A bond with a 5-year modified duration, the capital charge would be 5 x 1.4% = 7.0% (or 7.0% x 10m = 0.70m)

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Solvency II: QIS 5 Implications from the revised credit capital requirements
Given the multiple changes we have seen to the Solvency 2 proposals to date, it is highly likely that these rules can change again. However, assuming the rules remain largely unchanged and where internal modules are used, they do not result in capital charges materially different to the standard model, we would see the following potential implications on the back of the new credit related capital module: Insures preference for front end of credit curve : Given the progressive nature of the credit capital requirement as duration is added, insurers are incentivised to take credit risk at the front end under the credit risk model. For instance, on an A rated exposure with a mod dur of 1, the capital charge is 1.4% while for an A-rated security with a mod dur of 7, the capital charge is 9.8% (1.4% * 7 as per table on previous page). Credit curves are not nearly steep enough to compensate insurers for such incremental capital requirements on additional duration which could attract insurers to shorter credit products. (Interest rate risk can still be managed by swaps to ensure overall duration mismatch of assets to liabilities is reduced as such mismatch will attract a capital charge) Lower demand for credit by insurers than under previous version of the specifications due to the higher net capital requirement than under the previous version of the specifications. For instance, certain government exposures might be much more attractive to hold than credit. There will be no capital requirement for government risk of any EEA state which was also the case under the previous version. However, the relative difference in capital requirement compared to other credit has increased meaningfully under the latest specifications due to the loss of the discount rate benefit in the credit stress test. For instance, an exposure to a Greek government bond with a 10 mod duration will result in a zero percent capital charge while a 10 mod dur exposure to a AA rated corporate bond is 11%. (The latter would have been much lower on a portfolio basis for an average insurer under the previous module given the inclusion of the wider illiquidity premium in the credit stress discount rate) Increased incentive for insurers to hold covered bonds: Covered bonds rated AAA have received preferential treatment, with 0.6% spread widening factor compared to 0.9% widening factor for other AAA corporate bonds Long duration BB (and lower rated bonds) will remain of very low interest to insurers: Although this has not changed that materially compared to previous version based on the investment grade index used in calculating the widening of the discount rate in the credit stress scenario, it is still important to reiterate. In BIG credit, insurers might potentially exclusively only take short term risk based on current curves given the extent of additional capital required to add duration. (A BB corporate bond with mod dur of 1 will have a 4.5% capital charge while a BB corporate bond with mod dur of 5 will have a 22.5% capital requirement for instance)
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European Banks
Appendices

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Basel III: Base Requirements for Tier 1 Hybrids


Criteria for Classification as Additional Going Concern Capital for Regulatory Capital Purposes
1. It is issued and paid in 2. It is subordinated to depositors, general creditors and subordinated debt 3. It is neither secured nor covered by a guarantee of the issuer or related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim vis--vis the banks creditors 4. It is perpetual i.e., there is no maturity date and there are no incentives to redeem (e.g., step-ups, principal stock settlement) 5. It may be callable at the initiative of the bank after five years if supervisory approval is obtained, the bank has not done anything that creates an expectation that the call will be exercised; the bank has replaced the instrument with the same- or better-quality capital on conditions that are sustainable for the income capacity of the bank unless the supervisor is satisfied that the capital position would be well above the minimum capital requirements if the call is exercised 6. The repayment of principal (through redemption or repurchase) must be with prior supervisory approval, and banks should not assume or create market expectations that approval will be given 7. The bank must have full discretion at all times to cancel distributions/payments; cancellation of discretionary payments must not be an event of default; the bank must have full access to cancelled payments to meet obligations as they fall due; and cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders 8. Any dividends/coupons must be paid out of distributable items 9. It must not have a credit-sensitive dividend feature i.e., one that is reset periodically based in whole or in part on the banks current credit standing 10. It must not contribute to liabilities exceeding assets if such a balance sheet test forms part of national solvency law 11. Those instruments classified as liabilities must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism that allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects: (a) reduce the claim of the instrument in liquidation; (b) reduce the amount re-paid when a call is exercised; and (c) partially or fully reduce coupon/dividend payments on the instrument 12. Neither the bank nor a related party over which it exercises control or significant influence can have purchased the instrument nor can the bank directly or indirectly have funded the purchase of the instrument 13. It cannot have any features that hinder recapitalisation e.g., provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame 14. If issued out of a SPV, proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form that meets or exceeds all of the other criteria for inclusion in Tier 1 Additional Going Concern Capital
Source: BIS, Credit Suisse

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Basel III: Base Requirements for Tier 2 instruments


Criteria for classification as Tier 2 Capital for Regulatory Capital Purposes 1. It is issued and paid in 2. It is subordinated to depositors and general creditors 3. It is neither secured nor covered by a guarantee of the issuer or related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim vis--vis the banks creditors 4. Maturity: (a) minimum original maturity of at least five years (b) recognition in regulatory capital in the remaining five years before maturity will be amortised on a straight-line basis (c) no incentives to redeem e.g., no step-ups 5. It may be callable at the initiative of the bank only after a minimum of five years if supervisory approval obtained and the bank has not done anything that creates an expectation that the call will be exercised; the bank has replaced the instrument with the same or better quality capital on conditions that are sustainable for the income capacity of the bank unless the supervisor is satisfied the capital position would be well above the minimum capital requirements if the call is exercised 6. The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal) except in bankruptcy and liquidation i.e., upon a non-payment, holders may only sue for such non-payment but cannot declare an event of default 7. It must not have a credit-sensitive dividend feature i.e., one that is reset periodically based in whole or in part on the banks current credit standing 8. Neither the bank nor a related party cannot have knowingly purchased, or directly or indirectly have funded the purchase of, the instrument 9. If issued out of a SPV, proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form that meets or exceeds all of the other criteria for inclusion in Tier 2 Gone Concern Capital

Source: BIS, Credit Suisse

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Basel III: Additional Requirements for Internationally Active Banks


The additional requirements relate to loss absorbency features in both Tier 1 hybrids and Tier 2 instruments at the point of non-viability and should be in addition to the base requirements
1. The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event unless: 1) the governing jurisdiction of the bank has in place laws that (i) require such Tier 1 and Tier 2 instruments to be written off upon such event [emphasis added], or (ii) otherwise require such instruments to fully absorb losses before tax payers are exposed to loss; 2) a peer group review confirms that the jurisdiction conforms with clause (a); and 3)it is disclosed by the relevant regulator and by the issuing bank, in issuance documents going forward, that such instruments are subject to loss under clause (a) in this paragraph [emphasis added]. 2. Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies). 3. The issuing bank must maintain at all times all prior authorisation necessary to immediately issue the relevant number of shares specified in the instrument's terms and conditions should the trigger event occur. Trigger event 4. The trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (2) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority. 5. The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted. Group treatment 6. The relevant jurisdiction in determining the trigger event is the jurisdiction in which the capital is being given recognition for regulatory purposes. Therefore, where an issuing bank is part of a wider banking group and if the issuing bank wishes the instrument to be included in the consolidated group's capital in addition to its solo capital, the terms and conditions must specify an additional trigger event. This trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority in the home jurisdiction; and (2) the decision to make a public sector injection of capital, or equivalent support, in the jurisdiction of the consolidated supervisor, without which the firm receiving the support would have become non-viable, as determined by the relevant authority in that jurisdiction. 7. Any common stock paid as compensation to the holders of the instrument must be common stock of either the issuing bank or of the parent company of the consolidated group (including any successor in resolution).
Source: BIS, Credit Suisse

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Disclaimer
This information has been issued by Credit Suisse Securities (Europe) Ltd. ("CS"), which is authorised and regulated by the Financial Services Authority for the conduct of investment business in the United Kingdom. These materials have been prepared by a Credit Sector Strategist (Strategists). Strategists are employees of CSs Trading Desk and are supervised by Trading Desk managers. Their primary responsibility is to support the trading desk. To that end, Strategists prepare trade commentary, trade ideas, and other analysis (analysis) in support of CSs trading desks. The information in these materials has been obtained or derived from publicly available sources believed to be reliable, but CS makes no representations as to its accuracy or completeness. Strategists may receive additional or different information subsequent to your receipt of these materials. The analysis of Strategists is subject to change, and subsequent analysis may be inconsistent with information previously provided to you. CS does not undertake a duty to update these materials or to notify you when or whether the Strategists analysis has changed. These materials and other written and oral communications from Strategists are provided for information purposes only, do not constitute a recommendation and are not a sufficient basis for an investment decision. Strategists are not part of CSs Fixed Income Research Department, and the written analyses disseminated by Strategists are not research reports. The views of CSs Trading Desks, including Strategists, may differ materially from the views of the Research Department and other divisions at CS. CS has a number of policies in place designed to ensure the independence of CSs Fixed Income Research Department including policies relating to trading securities prior to distribution of research reports. These policies do not apply to the analysis provided by Strategists. CS may have accumulated, be in the process of accumulating, or accumulate long or short positions in the subject security or related securities on the basis of Strategists analysis. Trading desks may have, or take, positions inconsistent with analysis provided by Strategists.

58

European Sector Strategy: Financial Institutions


Europe Pieter Fyfer Managing Director, Financial Institutions European Sector Strategy +44 20 7883 4279 pieter.fyfer@credit-suisse.com Stphane Suchet Vice President, Financial Institutions European Sector Strategy +44 20 7883 4278 stephane.suchet@credit-suisse.com

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