Group Strategy: 16 January 2009 The financial crisis: what is happening, why did it happen, and what are the implications for the banking industry? CONFIDENTIAL

Group Strategy: 16 January 2009

The financial crisis: what is happening, why did it happen, and what are the implications for the banking industry?

CONFIDENTIALCONFIDENTIAL

Jungkiu Choi / Brendon Hopkins

2Group Strategy: 16 January 2009Source: Financial Times

Market Turmoil

3Group Strategy: 16 January 2009

Agenda

What is happening?

Why has this happened?

Analysis of past financial crises

What are the implications for the banking industry?


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The crisis intensified in September 2008 with many large scale bank failures and collapse of Lehman Brothers LIBOR 3-Month Spread to T-Bills* (bps)

Jun MarAugJul Sep Nov Dec Jan FebOct Apr May JulJun Aug SepMarJan Feb Apr May

20082007

House prices begin to fall after loose credit and massive growth in MBS lead to record increases

H2 06

H1 08

H1 07

H2 07

H2 08

Oct

* Through 06-Oct-08; over U.S. 3 month T-billsSource: Datastream; Company reports; NY Times; Wall Street Journal; Group Strategy analysis

files for bankruptcy

US$3bn loan to rescue internal fund with subprime losses

freezes three funds

draws US$12bn on credit lines

run on the bank; BoE rescues

US$7bn trading loss

acquired by BoA

acquired by JPM with US$29bn Fed backing

Discount window opened to primary dealers

in FDIC receivership

in US conservatorship

acquired by Lloyds TSB

acquired by BoA

rescued by Fed

files for bankruptcy

sold to JPM

nationalised and acquired by BNP-P

nationalised and acquired by Santander

acquired by Wells Fargo

government bail out

US$700bn bailout passed by Senate

Several European governments guarantee deposits

government bail out

Icelandic banks collapse

UK and European governments construct bail out funds


A normal company - Nike

Assets Liabilities

Equity

Accounts Receivable

Other assets

Cash

Stock

Trade payables

Debt

Nike

Assets Liabilities

Deposits

Debt / Prefs

Equity

Wholesale funding

Loans tocustomers

Securities

Other assets

Cash

Loans to banks

A Traditional Bank


The Traditional Bank

Assets Liabilities

Deposits

Debt / Prefs

Equity

Wholesale funding

Loans tocustomers

Securities

Other assets

Cash

Loans to banks

Key Ratios

Loan / Deposits Ratio

[Total loans / total deposits]

Liquid Assets Ratio

[Cash+T.Bills+Net Interbank+Securities) / Total Assets]

Leverage ratio[Equity / Total Assets]

< 100%

Optimal levels

> 20%

< 20x

Capital Ratios (BoE guidance) - Core capital - Tier 1 - Total capital

4%8%

10%


Liquid Assets Ratio


Northern Rock

Assets Liabilities

Deposits

Debt / Prefs

Equity

Wholesale funding

Loans tocustomers

Securities

Cash

Loans to banks

Key Ratios

> 300%

Actual levels

< 10%

14x





Liquid Assets Ratio


Standard Chartered

Assets Liabilities

Deposits

Debt / Prefs

Equity

Wholesale funding

Loans tocustomers

Securities

Cash

Loans to banks

Key Ratios

85%

Actual levels

> 20%

14x




Other assets

Derivatives DerivativesCapital Ratios - Core capital - Tier 1 - Total capital

6.1%8.5%

14.9%


How banks suffer from a crisis

Assets Liabilities

Deposits

Debt / Prefs

Equity

Wholesale funding

Loans tocustomers

Securities

Other assets

Cash

Loans to banks

Loan losses

Ailment

securities Equity

Impact

Subprime write-off

Run on the bank

Loans Equity ratio falls

DepositsForce liquidation of assetsInability to fund = collapse

Basel 2 Pro-cyclicalRWAs as credit quality Capital ratios stressed

Interbank dries up Liquidity Price of fundingInability to fund = collapse


A global recessionary environment seems likely to ensue – the question is how bad will it be?

Moderate global Moderate global recessionrecession

Credit losses at lower end of the range – up to US$1.5trn US & UK economic slowdowns / recessions are short and mild; Asia remains insulated Credit markets largely recover in 09; low prices attract sophisticated buyers; liquidity and confidence

returns Limited additional credit losses in Q1 2009 and beyond Securitization volumes pick up in 2009; full recovery by 2010 Investment bank earnings bounce back in 2009 / 10

Long chillLong chill Credit losses in middle of the range – US$1.5trn-US$2trn US & UK experience recessions lasting 3-4 quarters; Asia slow but avoids recession Credit markets remain depressed throughout recover later in 2009 Securitization recovers later in 2009, but largely “vanilla” structures Further capital raising by banks to repair balance sheets More banks require rescue /bail-out

Prolonged deep globalrecession

Most likely range Credit losses in top end of range - US$2tn and possibly beyond

US and UK recession of 6 or more quarters; Europe and Asia slow significantly and more countries dip into recession

Unemployment increases over pre-2006 levels, peaking at 7%-8% in several quarters Sustained stock market decline has strong negative effect on the wealthy Banks consistently unable to meet capital raising targets; large corporate credit losses; several

sizable bank failures; large further government interventions required Strong social backlash to free market system and globalisation

Source: McKinsey analysis


Regulatory change is also accelerating with many unprecedented steps Long-term

impact

Coordinated European Interventions

EU members coordinate on Fortis and Dexia bailouts EU governments (e.g., Germany, Ireland, UK, Greece, Austria)

guarantee deposits

Treasury replaces management, gives FHFA control, explicitly guarantees GSE obligations, takes equity stake

Fannie Mae, Freddie Mac Conservatorship

NY State Insurance Dept Interventions

NY state allows AIG to borrow from its subsidiaries, before US$85bn Federal Reserve loan; announces regulation of CDS

Money Market Funds guaranteed

Treasury insures eligible mutual funds (TBD) to US$50bn total limit; no limit on amount per account-holder

UK and US Short-Sale Restrictions

FSA bans short selling on 32 financial stocks until January SEC bans short selling on financial stocks through October 2008

GS, MS Become Bank Holding Companies

Fed approves GS and MS to become BHCs; higher capital requirements reduce leverage by 50%

Regulatory changes since September 7, 2008

TARP (Paulson Plan) Legislation proposed – debated, modified, and passed –authorizing

Treasury to buy US$700bn in “troubled assets” to stabilize markets

Fed to Purchase Commercial Paper

Fed plans to purchase 3-month unsecured and asset-backed commercial paper from issuers


Asian regulators are taking steps to address key issues and maintain stabilityRegulatory changes since Sept-Oct 2008

Singapore central bank moving to zero-appreciation stance for trade-weighted Singapore dollar Singapore government guarantees bank deposits Asset maintenance ratio closely monitored (i.e. the money raised in SIN, is not deployed to toxic assets)

ASEAN

Government guarantees bank deposits for 2 years buys $8bn in non-bank mortgage securities Official interest rate cut by 100 bps Short-selling suspended

Australia

Taiwan government guarantees all deposits until December 2009; suspends short-selling until year end China government cut 1-year interest rates by c. 81 bps and Cash Reserve Ratio (CRR) by c. 50 bps Reduced major banks’ required reserve ratio Increased credit to encourage SME loans

China

RBI reduces CRR by 150 bps SEBI lifts ban on FII investment through the participatory note route Foreign investment limit in domestic debt market increased Government infusing capital in system to raise the state owned banks capital adequacy to 12%; dissuading banks from

withdrawing investments in equity markets

India

Emergency funding mechanism to help smaller lenders’ balance sheets through direct injections of public funds BOJ injects US$120bn into domestic money market to maintain liquidity and Yen stability Launch tentative measures to stabilise stock prices-: ban on short selling, suspension of sale of public sector-owned stocks,

relax restrictions on corporations' purchase of own stocks, resume purchase of stock held by banks, suspension of mark-to-market accounting rules, allow banks’s stock holdings to exceed its core capital

Japan

G20 5 point plan

FX stabilisation fund for banks and exporters who need US$. Fund value ~$5b Low-income mortgagees given an extended repayment period (extra 5 years) Government guarantees on SME bank loans

Korea

1. 2. 3. 4. 5.

All countries to systemically support important institutionsUndertake measures to get credit flowingAssist banks in raising capitalReassure saversRestart market for mortgage-backed securities


Agenda

What is happening?


Analysis of past financial crises



Source: Economy.com

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650

Office of Federal Housing Enterprise Oversight HPI (all transactions)

The genesis of the crisis lay in the largest US real estate bubble in the past forty years

Late seventies “housing bubble”

Late eighties “housing bubble”

Recent “bubble”

1975 0677 81 8479 83 88 9286 90 94 9896 00 02 04 08

44% increase in HPI from 2002-2007

40% overvaluation relative to long-term trend

US$14.4 trillion of residential / commercial mortgages outstanding


In a globalised world where cross-border investments have increased, linking financial marketsLines show total value of cross-border investments between regions*, 2007 Figures in bubbles show size of total domestic financial assets, US$bn

*Includes total value of cross-border investments in equity and debt securities, lending and deposits, and foreign direct investment

Australia,New Zealand, Canada 8,530

Russia, Eastern Europe5,070

Latin America5,939

US 61,194

Japan20,089

WesternEurope 52,435

UK11,055

Middle East, rest of world 5,524

Hong Kong,Singapore, Taiwan4,379

EmergingAsia21,782

Source: Brookings Institution, McKinsey, Laura Tyson

0.5%-1% of world GDP

1%-5% of world GDP

5%-10% of world GDP

10%+ of world GDP

World GDP(2007) = US$55trn


Other bubbles that drove the crisis are also consequently bursting due to deleveraging….

Sub prime and other lending

Corporate earnings

Stock market

Commodity

Consumer spending

Asia exports

?

Real estate


Banks have played their part with key failures in leadership, infrastructure, governance and risk management….

1TransparencyWeaknesses in basic risk infrastructure (e.g., data quality)

Limited understanding of liquidity, capital, and accounting implications (e.g., liquidity and capital position undermanaged)

Underestimation of structural risks and serial “bubbles”(e.g., no consideration of “bubble” indicators)

Risks not sufficiently considered in strategies (e.g., hidden tail risks, growth ambitions not matched by institutional capabilities)

Risk appetite/risk taking capacity overestimated2Ownership

Overreliance on models with significant limitations (e.g., risk factors not fully captured, lack of proper stress testing)

In time of crisis, inadequate decision speed and quality (e.g., CRO/CFO debates on numbers, no contingency plans)

3Processes

4GovernanceAccountability for risk evaporated (overreliance on CRO, committees

improperly used to socialize accountability)Dramatic skill deficiencies incl. ExCo and Board

5CultureMisaligned, short term, top-line oriented incentives

(e.g., self interest of decision makers outweighing well-being of institutions)

Risk concerns pushed aside


Agenda

• What is happening?

• Why has this happened?

• Analysis of past financial crises

• What are the implications for the banking industry?


De v

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yst e

ms

Japan (1990s)Japan (1990s)

Argentina (1981, 1995)Brazil (1995, 1999)Mexico(1995)

Argentina (1981, 1995)Brazil (1995, 1999)Mexico(1995)

Korea (1997)Thailand (1997)Chile (1982)US Depression (1929)

Korea (1997)Thailand (1997)Chile (1982)US Depression (1929)

Indonesia (1997)Indonesia (1997) Russia (1997)Russia (1997)

Financial sector Financial sector and macro economy (trade deficit)

Financial sector and real economy (companies

ROIC < WACC)

Financial, real economy and politics

Financial, real economy, macro economy and

politics

H

M

L

Root causes and depth of crisis

UK (1973)Sweden (1991)Denmark (1990)

UK (1973)Sweden (1991)Denmark (1990)

Market resolutionMarket resolution Government intervention and external supportGovernment intervention and external support

Type 1Type 1

Type 4Type 4

Type 2Type 2 Type 3Type 3

Type 6Type 6Type 5Type 5

US S&LUK (1991- averted)US S&LUK (1991- averted)

Types of financial crisis: more than 100 financial crises since 1980 can be classified into 6 types – with the largest being shown below. This crisis is more severe than them all…

Current crisis looks likely to be deep and long across many sophisticated financial markets with major impact in real economy

Current crisis looks likely to be deep and long across many sophisticated financial markets with major impact in real economy

Has impacted US election and is beginning to lead to political changes e.g. resignation of government in Belgium over Fortis

Has impacted US election and is beginning to lead to political changes e.g. resignation of government in Belgium over Fortis


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85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

% US Ted Spread (3m LIBOR - 3m Tsy Bill Yield)

Most severe credit crisis since 1987

Sources : Bloomberg, SCB Global Research

Every financial crisis is unique, but the flight to quality repeats

87 Stock Market Crash

S&L Crisis

Russian Ruble Crisis

Bursting of Tech Bubble & 9/11


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10New home sales (000s, SAAR) (LHS)

Months supply of unsold new homes (3mma)

A U-shaped recession is not helping either

It is not just a financial crisis: A battered housing market will make the recovery process a slow and painful one for households

Source: Bloomberg, SCB Global Research


US housing to keep on falling

Case Shiller, 2000=100

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1-Dec-03 1-Dec-04 1-Dec-05 1-Dec-06 1-Dec-07

Source: Bloomberg

No recovery before 2010


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% expecting prices to rise minus % expecting prices to fall

UK: Another housing market in trouble

Institute of Chartered Surveyors Survey

Source: Bloomberg


Barclays’ recent share price

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£p

Mar 07ABN Bid announced

June 07ABN Bid sweetened with £2.4bn equity raised (330m shares at 720p each) to CDB & Temasek

Oct 07RBS wins ABN bid

July 08£3.7bn equity issued (1.3bn shares at c. 282p to Qatar / institutional investors)

Sept 08Lehman US acquired for £1.5bn (funded partly by £0.7bn of equity (226m shares at 320p)

Oct 08£7.3bn to be raised from Qatar and Sheikh Mansour (4.3bn shares at c. 170p)

July 08Completes acquisition of Expobank, Russia

July 08Announces sale of Barclays Life to Swiss Re

29Group Strategy: 16 January 2009(100) (80) (60) (40) (20) 0

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Experience on the systematic banking crises suggests that downturn conditions persist for a long time…

Peak to Trough GDP Decline (left, %) against Duration of Downturn (right, years)

Economists identify these systematic banking crises…

Spain (1977)

The first energy crisis 52% of Spanish banks in serious

financial problems

Finland (1991)

Soviet Union recession preceded by financial market liberalisation and the collapse of exports Finnish government spent over €10b

to support Finnish banks

Norway (1987)

Commodity-shock-driven recession loan losses and insolvency in banks three largest banks nationalised

Japan (1992)

Rating agencies lowering of Japanese banks evaluations due to non-disclosure and a lack of transparency 13 Japanese financial institutions

effectively went bankrupt during 1995

Sweden (1991)

Restructuring of the tax system caused financial bubble that formed during 1980s to burst Central bank unsuccessful in

defending the currency’s fixed exchange rate

Tracking of GDP and real house price trends before, during and after respective banking crises

Peak to Trough Real House Prices Decline (left, %) against Duration of Downturn (right, years)(scales not comparable, purple denotes current crisis)

Source: ‘Is the 2007 U S Subprime Financial Crisis So Different? An International Historical Comparison’, C. Reinhart & K. Rogoff; Feb-08

‘Big 5’ post WW2

Emerging market crises

Asian Crisis (1997)Hong Kong, Indonesia, Malaysia, Philippines, Thailand

Colombia (1998) and Argentina (2001)Interest rate actions in defence of currency regimes spread knock on effects to banking sector

Dataset also includes US 1929

(30) (25) (20) (15) (10) (5) 0

Philippines (1997)

Hong Kong (1997)

Korea (1907)

Malaysia (1997)

Average

Thailand (1997)

Indonesia (1997)

US (1929)

(9.3) 1.9

Japan (1992)

Hong Kong (1997)

UK (2007)

US (2007)

Spain (2008)

Average

Philippines (1997)

Japan (1992)

US (1929)

Malaysia (1997)

Indonesia (1997)

Korea (1997)

Thailand (1997)

(55.9) 3.4

0 2 4 6


Financial crisis evolves in a typical path but timeframes for each stage can vary significantly….

2 - 6 months

Liquidity Defaults, asset price crashFear, lost of confidence

Crisis Breakout

Crisis Breakout

Liquidity Crisis

6 - 18 months

Credit Crisis

Liquidity problem continuesFinancial institutions closedBig defaults

2 - 5 years

Restructuring

Industry consolidationRegulatory changesLT capital base growsIncreased M&A

5 - 15 years

Recovery GDP recovers

Oversupply and easy credit conditions

Asset prices rising fast

"As long as the music is playing, you've got to get up and dance”


Severity and duration of crisis is uncertain – but some lessons have been learned from past experience….

Timing 0 - 6 months from triggering event

6 - 24 months from triggering event

2 - 15 years from triggering event (median of 5+/- years)

What is Usually Going On

Several big defaults FX volatility Interest rate surge Payment systems in challenge Lending freezes Asset price crashes Full of rumors and fears

Liquidity crisis settles down a bit

Economic slowdown becomes visible; continuous defaults are spreading

People start to accept negative views; optimists are disappearing

Political search on “who is responsible?” begins

Trade and investment begins Old business models die out and

new business models come in M&A activities, industry

consolidation

Typical Government

Reaction

Liquidity injection Equity injection to the banks

and/or financial institutions Reduction of interest rates (in

case of liquidity dry out) or increase of interest rates (in case of large capital outflows out and FX depreciation)

Credit guarantees Forced restructuring of big

institutions NPL management (e.g. AMC

set up by government) Discussions on regulatory

changes become serious

Changes in supervision related regulations

Changes in foreign investment related regulations

Changes in accounting and transparency

Lessons Learned

Multiply 3x to government estimation of the amount of action needed (government are typically over-optimistic)

Individuals typically under-estimate the impact of the crisis on real economy but stock markets usually over react

The tail of this process is much longer than typically anticipated

Unless shareholders, debtors and management take responsibility, moral hazard can be built in the system

The better you are prepared, the more you can direct action – either to streamline sensitively or to seize opportunity.

Typically industry ranking is significantly changed during this phase – new winners and losers emerge.

Liquidity Crisis Credit Crisis Restructuring/Recovery


Current macro environment – Multiple deleverage

Banks realise losses and provisions rise

Falling profits result in job cuts, capital raisings and asset sales

Economic activity falls and asset prices fall further

Triple deleverage

accelerates

Sustainable banking sector RoEs fall, leading to share price freefall

Rising losses inUS subprime market and contagion as prices fall in other asset classes

Banks lose confidence in each other –wholesale fundings dries up and funding costs rise

Lending slows to retail and wholesale customers




Triple deleverage

accelerates








Multiple deleverage

accelerates





Macro economic slow down

Multiple deleverage in a down-turn from:

- Falling profitability- Lower capital

regeneration- Higher bad debt charge

Basel II pro-cyclicality

Negative profitability gearing

Regulatory pressure

Slowing distribution

Basel 2IFRS accounting

Regulatorypressure

Liquidity / funding issues


Agenda

What is happening?


Analysis of past financial crisis?



Over the medium term, further regulatory overhaul is highly likely …

Basic reforms

Broaderregulatoryexpansion

Improvement of capabilities and effectiveness of risk management practices

3

Introduction of stricter liquidity management including liquidity buffers

2

Fixing flaws in supervisory structure, e.g., gaps in supervision of US investment banks, unregulated US mortgage originators

4

Increased scrutiny applied to business model – more intensive process for entering new business lines / products

7

Align incentives to incorporate risk elements, e.g., stronger long-term incentives, deduct capital and funding costs from bonus pools, keep slice of risk on balance sheet, deposit safety fund

8

Higher capital requirements in particular for securitization (as amendment of Basel II)

1

Mitigation of pro-cyclical elements in Basel II5

Mitigation of pro-cyclical elements in fair value accounting6


Significant industry consolidation is advancing fast in Western markets…

* By assets

**Analysis without savings and cooperative banks

*** Total banking assets of deposit taking institutions and investment banking assets of Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, State Street and GE Commercial Finance

Top 5 players* (%)

Germany** UK US

8875

2007 2008E

8474

2007 2008E

43

2007

55

2008E

To

p 5

Pla

yer

sM

&A

Source: Central banks, McKinsey analysis


The challenge on profitability could be severe over the next few years…

2000 05 10 2015

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Moderate

Long chill

Prolonged deep recession

Goldman Sachs estimates losses to peak in Q1 / Q2 2009

Global banking revenues (% GDP)

Additional Credit Losses

Shrinking Volumes

Pressure on Margins from Liquidity Costs

Increasing Equity Requirements

Deleveraging

Crisis impact

25% cost reduction required to compensate revenue loss


In the long term, a new banking model will almost certainly emerge…

Winning Business Models

Efficient universal banks with strong, effective risk management and strong performance culture

Highest Growth Regions

Emerging markets, but with some major bubbles and failures

Winning Products

Relationship banking Transactional banking Easy to understand investment products Reshaped mortgage and consumer finance Low-cost liability gathering products

Most Important CEO Issues

Risk management Re-regulation Consolidation

Biggest Opportunity

Reinventing residential mortgage markets Innovation in business models Cutting complexity and cost structures Acquire and turnaround underperforming players

Prospects

Very tough short term More attractive long term as crisis forces consolidation, better risk

management and efficiency

Group Strategy: 16 January 2009

Questions?

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Group Strategy: 16 January 2009 The financial crisis: what is happening, why did it happen, and what are the implications for the banking industry? CONFIDENTIAL