CRD IV
Restoring order in the financial system
Hearing of the Economic and Monetary Affairs Committee of the
European Parliament
Barbara Frohn
May 3 , 2010
Basel III: The individual proposals are directionally correct …
SANTANDER shares the goal of the BCBS and the EC to strengthen the
foundations of the financial sector and supports the direction of the
individual BCBS and EC proposals. However, additional focus could be
directed towards the following:
 Intrusive supervision has proven to be more effective than (over-)
regulation;
 In the crisis, weak corporate governance and lack of internal control
were key contributing factors, and in some cases even root causes;
 The aim should not just be to penalize and avoid bad practices, but
equally to give full recognition to, and thus reward, good practices;
 Systemic risk cannot be measured by sheer size.
2
…But the Combined Impacts may lead to Unintended Consequences
 Possible disruption of the interbank and equity markets
i.e. Large Exposures rules, correlations, liquidity buffers, capital conservation standards: will
(bank) investor and issuer interests prove reconcilable?
 Concentration risk may prove unavoidable; herd behaviour may lead to systemic
risk
i.e. ´Good Quality´ liquidity & capital restrictions, stringent rules for securitisation & CDS
 The CRD IV objective of level playing field cannot be served in a single market
where full harmonization has not yet been achieved and where grandfathering
may impact differently on banks.
i.e. Deductions from Common Equity, Leverage ratio, Grandfathering provisions
 By whom will the growth of the real economy be serviced in future and will we
then be better off?
i.e. Maturity transformation and intermediation role, Leverage Ratio
3
Forward Looking Provisioning: What is the purpose?
4
• Economic activity is subject to periodic cycles:
where good years are followed by downturns or
even strong recessions.
• Banks should, as the ant in the Aesop fable, store up
provisions for the “winter” during the “summer”.
(i.e. forward looking provisioning). But the current model
(“incurred loss” approach, the grasshopper view)
does not address this need.
• The Spanish model, which uses generic provisions
for that purpose, has proved its usefulness to
mitigate the impact of the recession on the P&L.
• The EC and Santander proposals on this subject are
forward looking provisioning based on the Spanish model
but taking advantage of the risk data already available for
Basel II, and using the concept of through-the-cycle
expected loss.
Provisioning: Multiple Objectives, One Solution ?
IASB: ´solution to
¨too little, too late¨, but only
for closed portfolios´
5
FASB: ´deliver right information on
true financial condition of the firm &
incentives to investors´; ´improve
incurred loss model by earlier
recognition of credit losses´
Forward Looking
Provisioning
BCBS:´Capital Stability &
Answer to Procyclicality´
FSB: ´better reflection in
accounts of underlying
economics of lending activities´
EC: ´avoid underpricing &
excessive credit growth´
G20: ´loan loss provisioning to
incorporate a broader range of
credit information´
Prudential proposals - Strengths and Weaknesses
Bank Of Spain: Dynamic
Provisioning regime
+ Combines high provision in good times with drawdown in bad times
+ Transparent & Simple
+ Maintains the possibility to move over time to a system in which internal
models may be used
- Not very risk sensitive: only 6 loan groups
- Not exactly an Expected Loss model (statistical model based on historic data)
- Requires existence of rich historic data on each loan group
EC CRD IV : Expected Loss
provisioning relating Expected
Loss amounts at the beginning of
the year to Net Specific
Provisions during the year
+ Simple to implement, and also offers solution to small & medium sized banks
with less sophisticated systems
+ Makes optimal use of internally & externally validated Through-The-Cycle
parameters already in use for regulatory capital calculations of IRB banks
+ Serves shareholders & depositors interests
- May not be fully compatible with expectations of accounting standard setters
SANTANDER: Variation of the EC
proposal with inclusion of a
´rho´ adjustment factor
+ Has the same advantages as the EC CRD IV proposal and, in addition:
+ The ´rho´ factor adjusting the allowance presents a good compromise
between the countercyclical smoothing of provisions in the P&L and the need
to preserve a minimum sensitivity of the P&L and risk management to the
changes in the cycle and risk environment
6
Accounting proposals - Strengths and Weaknesses
IASB: Expected
Cashflow Model (ECF)
+ Presents an improvement compared to the incurred loss model to the extent it recognizes
real loan costs in the accounts
- Primary focus on shareholder interests
- Operationally complex and costly: co-mingling of interest rate and credit risk management
in one measure
- Present Value of changes in ECF must be recognised immediately and thus may add to
procyclicality
FASB: Modified Incurred
Loss approach
EBF: ´Expected Loss
over the Life of the
Portfolio´ model (ELLP) *
+ Clear and sole focus on shareholder interests
- It is questionable whether extending the provision event criteria may substantially remedy
the shortcomings of the current model
+ Adapts well to existing accounting principles; responds to accounting requirement of not
exceeding current maturities
- Remains as yet ambiguous on the calculation method to be used for the calculation of the
expected losses over the life of the portfolio; Unclear whether Point-in-Time or ThroughThe-Cycle parameters are to be used. To avoid divergent implementations, clear
instructions should be formulated
- Estimating EL over a long horizon (lifetime) is complex, and may still need frequent readjustments and and thus end up being procyclical after all
* This is a mixed model aiming to satisfy both regulatory and accounting demands
7
Main advantages of Expected Loss Provisioning
 In times of economic growth a cumulative provision buffer is being
created:
 prevents overheating of the economy
 excessive credit growth is avoided
 ´real´ loan costs are being recognized from inception
 In periods of recession the accumulated provision is being used:
 less chance of major capital constraints on banks
 no sudden lending freeze
 As a consequence,
 depositors that have entrusted their money with a bank can be sufficiently at ease
about the solvency situation of the bank in question
 financial stability will be preserved
 the negative growth of the real economy is not further aggravated by bank behaviour.
8
Minimum Requisites for Forward Looking Provisioning
Repeating the successful implementation of the Spanish system,
uniformity, simplicity and transparency are key
 Uniformity: Aiming at reducing discretionality in the calculation of
provisions; applicability to all firms;
 Simplicity: Using existing, externally and internally validated, parameters
which were duly tested during the crisis; keeping the horizon oversee-able
which reduces the risk of multiple re-adjustments;
 Transparency: Shareholders´ and depositors´ interests will not be served
by implementing a dual system; their investment analysis will furthermore
be accommodated by Pillar 3 disclosures a.o. on risk parameters and
other factors supporting the EL estimations.
9
10
Implications of a dual system
BASEL
Assets
IFRS
Liabilities
1000
100
1,25
2,5
896,25
1000
Assets
Capital
Retained earnings
Provisions
Others liabilities
1000
Liabilities
1000
896,25 Others liabilities
1000
P&L
+
-
75
70
2,5
1000
P&L
revenues
costs
provisions
+
-
2,5
Dividends
1,25
100 Capital
3,75 Retained earnings
75
70
revenues
costs
5
Retained earnings
1,25
Dividends
1,25
Retained earnings
3,75
…and therefore Convergence is the best way forward
 Ideally, one unique forward looking provisioning regime should be in place
responding to both accounting and prudential concerns;
 On a similar note, a ´European only´ solution must be discouraged;
 Decisions on a EL provisioning regime should not be made in isolation, but
considering other procyclicality measures and capital buffers;
 Increasing the provision pool in ´good´ years must also imply being able to
consume it in ´bad´ years; provisions must go directly through P&L;
 Contradictory incentives: it is evident that EL provisions leading to DTAs should
not be deducted from capital;
 If ultimately regulatory demands still exceed accounting solutions, the excess
should be introduced as an economic cycle provision outside the perimeter of
regulatory capital
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So can EL Provisions deal with procyclicality?
 Accounting standard setters insist that they
I.
Cannot accept provisions beyond existing portfolios and maturities and therefore do not
promote ´Through-The-Cycle´ provisions
II. Aim to provide a true reflection of the firm´s current situation to investors and therefore
dislike adjusting the value of a loan for its EL creating a ´day one´ loss
 Therefore, only if:
 Accounting standard setters are willing to compromise and to implement a system which
does not lead to continuous fair value re-adjustments flowing through P&L
 Regulators accept that the average lifetime of the portfolio is not too far off the objective of
a full cycle
A joint regime may be created resulting in a less marked procyclicality
effect, even though the capital regime may still have to be reinforced by mandatory
´Through-The-Cycle´ rating parameters to become less procyclical
 However, given the dynamic nature of lending practices and product
development procyclicality can never be eliminated in full.
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Conclusions and Message
If a constructive public-private sector dialogue on the new Basel proposals ensues,
(cumulative) impacts are measured extensively and rules are tested before
implementation,
Then a new homogeneous regulatory framework could emerge that satisfies the
expectations of politicians, governments, supervisors and accounting bodies, prevents
(most) crises from happening whilst still allowing banks to remain private ventures in a
level playing field context that allows the market to properly differentiate between good
and bad practices.
But for this to happen a silo´ed approach to regulation and standards must be avoided.
Only then the financial sector stability can be restored and preserved.
13
Annex A new model for provisioning (I)
CURRENT INCURRED LOSS MODEL
P&L
cycle
average
average-good
good
average-good
average
average-weak
weak
average-weak
average
specific
prov./assets
year
1,00%
0,50%
0,00%
0,50%
1,00%
1,50%
2,00%
1,50%
1,00%
1
2
3
4
5
6
7
8
9
assets
10.000
10.000
10.000
10.000
10.000
10.000
10.000
10.000
10.000
income
225
225
225
225
225
225
225
225
225
specific provisions
-100
-50
0
-50
-100
-150
-200
-150
-100
operating
costs
result
bef.tax
-90
-90
-90
-90
-90
-90
-90
-90
-90
35
85
135
85
35
-15
-65
-15
35
 No ´in advance´ recognition of credit losses in good years (mispricing)
 Strong fluctuation of provisions
 Volatility of results and possible loss of market confidence in the institution
 Procyclicality: possible excessive credit growth in good years and credit
squeeze in bad years
A new model for provisioning (II)
EXPECTED LOSS PROVISIONING MODEL
Generic Prov. = Specific Loss - Expected Loss
P&L
provisions
cycle
average
average-good
good
average-good
average
average-weak
weak
average-weak
average
income
specific
prov./assets
year
1,00%
0,50%
0,00%
0,50%
1,00%
1,50%
2,00%
1,50%
1,00%
1
2
3
4
5
6
7
8
9
assets
10.000
10.000
10.000
10.000
10.000
10.000
10.000
10.000
10.000
specific
225
225
225
225
225
225
225
225
225
-100
-50
0
-50
-100
-150
-200
-150
-100
generic
0
-50
-100
-50
0
50
100
50
0
total
-100
-100
-100
-100
-100
-100
-100
-100
-100
 Recognition in advance of credit losses in good years
 Use of generic fund in bad years
 Flat Provisions (for a stable portfolio)
 Stability of Results
 Mitigation of procyclicality
operat. result
costs bef.tax
-90
-90
-90
-90
-90
-90
-90
-90
-90
35
35
35
35
35
35
35
35
35
generic
fund (year
end)
0
50
150
200
200
150
50
0
0
A new model for provisioning (III)
ADJUSTED EXPECTED LOSS PROVISIONING MODEL
Generic Prov = (Specific - Exp. Loss ) * rho
RHO =
50%
cycle
average
average-good
good
average-good
average
average-weak
weak
average-weak
average
specific
prov./assets
year
1,00%
0,50%
0,00%
0,50%
1,00%
1,50%
2,00%
1,50%
1,00%
1
2
3
4
5
6
7
8
9
P&L
provisions
assets
income
10.000
10.000
10.000
10.000
10.000
10.000
10.000
10.000
10.000
225
225
225
225
225
225
225
225
225
specific
-100
-50
0
-50
-100
-150
-200
-150
-100
generic
0
-25
-50
-25
0
25
50
25
0
total
-100
-75
-50
-75
-100
-125
-150
-125
-100
 Recognition in advance of credit losses in good years
 Use of generic fund in bad years
 More stable provisions but not flat
 Results less volatile
 Mitigation of procyclicality
operat. result
costs bef.tax
-90
-90
-90
-90
-90
-90
-90
-90
-90
35
60
85
60
35
10
-15
10
35
generic
fund
0
25
75
100
100
75
25
0
0