www pwc de Basel IV beyond Challenges for

www. pwc. de Basel IV beyond Challenges for the Business Models of Tomorrow SCI's 3 rd Annual Risk Transfer & Synthetics Seminar 2019 March 12 Martin Neisen

Agenda 1 Introduction 2 Impact from „Basel IV“ on Risk Weighted Assets 3 Challenges and Solution Approaches 4 Conclusion SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C March 2019 2

Basel IV in a Nutshell Calculation of capital ratios under Basel III/CRR… Common Equity Tier 1 capital Additional Tier 1 capital Tier 2 capital Credit Risk Market Risk Op. Risk Other Market risk Operational Capital Credittopics risk floors • • Limitation oninternal theexisting use of the internal models-based Revised boundary of model the trading book stricter Replacement of approaches byand a floored new RWA (using standardised approaches) including revised byrisk a approach and the introduction of a standardised approval of internal models standardised approach percentage weights andofadditional RWA as determined due diligence using requirements the standardised approach for CVA Sensitivities-based analysis as new standardised • approaches Fundamental that operational riskexposures is related Constraints onassumption the use of internal models (for • • Global standard for large exposures with harmonised approach, which also serves aassets, floor for the internal to size of 72. 5% classes) and the total introduction risk weighted of as parameter calculated input floors using definition on exposures and groups of connected clients model approach the standardised approaches • Use of the ‘unadjusted business indicator’ as a measure of • • Standardised disclosure templates and new disclosure Internal model approach using expected based > 8% + operational risk exposure combined with a 1 collection and The output floor will be implemented as ofshortfall January requirement for all new RWA approaches on stressed calibration as data key metric considering capital analysis historical 2022 andofwill be fullyloss phased-in by 1 and January 2017. risks product-specific liquidity horizon New rules for securitisation RWA and STS securitisations buffers • Other • Pillar II and indirect Pillar I requirements on Step-in Risk • Business model • Phase-in of ‘old’ Basel III rules • Use of internal models Impact on individual banks depending on • Competitive position • Interest rate levels • Profitability Basel IV will not only be one of the biggest challenges for the financial industry going forward • Asset managers Contagion effect for other players in the financial markets • Pension funds • Hedge funds • Insurance companies Basel IV: recalibration of Basel III or the next generation of RWA? SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C March 2019 3

Credit risk – the new CR SA Institutions • Due diligence requirements are increasing the complexity of CR SA • Significant increase in RWA for exposures to unrated institutions Complexity Residential real estate • New subclasses, LTV determination increases complexity • Whole loan-approach and cash flowbased financings increase RWA Capital Corporates • Due diligence requirements are increasing the complexity as well as differentiation of specialized lending • No significant impact on RWA Complexity Capital Commercial real estate • Increase in complexity and, especially in the case of cash flow-based financing, a significant increase in RWA Capital Specialised lending • Special rules for transactions with SPV • Differentiation between project, object or commodity financing • Complex requirements for high-quality project financing Effects on RWA • The new CR SA will lead to a significant increase in risk-weighted assets • Only in exceptional cases can be expected that the RWA remains constant or to slightly decrease Complexity Capital Equity exposures • Significant increase in RWA • Additional subclasses make it necessary to identify the positions affected Capital Due Diligence requirement • The implementation of the new due diligence requirements for externally rated exposures represents the greatest procedural challenge of the new CR SA • Proportionality principle is to be expected in supervisory practice SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Complexity Capital Effects on exposure classes • Effects are expected in particular in the asset classes institutions (CR SA), equity exposures and income-producing real estate • The effects on corporates and retail business are moderate March 2018

Credit risk– Revision of the IRB approach PD Scope of application • Elimination of the advanced IRB approach for banks and large corporates (annual turnover at the group level > EUR 500 million) • Regulatory slotting approach for specialized lending to remain in place for the time being • Discontinuation of the IRB approach for equity exposures • Introduction of a capital floor on the basis of the CR SA • Elimination of the IRB exit threshold • (Still) no restriction of the scope of application for sovereign risk Complexity LGD • Increase in minimum PD from 3 bp to 5 bp and 10 bp respectively • F-IRB LGD for corporates drops to 40% • Extensive changes in the recognition of collateral and LGDs in the F-IRBA • Introduction of LGD Floors and Haircuts in A-IRBA Capital Complexity Capital CCF • CCF Floor for revolving retail receivables • CCF according to CR SA for all other requirements Complexity Capital Effects on the RWA • The revised foundation IRB generally results in a decline in risk-weighted assets, ceteris paribus. • This is due to the elimination of the scaling factor and the changed consideration of collateral. Floor Regulation • Only when the new capital floors are taken into account can a sometimes significant increase in RWA be expected, for example in the case of exposures secured by real estate • Optimisation of the CR SA is necessary SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Scope of application • Changes in the scope have a significant impact: • Elimination of the A-IRBA largely impacts exposures to banks and large corporates March 2018

The Impact of Basel IV on RWA is highly dependent on the portfolio composition and business model 0% Total RWA -10% Revised CR SA F-IRBA new pre Floor A-IRBA new pre Floor FRTB (Standardised approach) -10% Floor = 50% Floor = 72, 5% 10% 30% 20% 10% 50% High impact on real estate and specialised lending, as well as on equity instruments F-IRBA partially profits from Basel IV, No partial use as an opportunity for CSA banks -10% -5% 5% -5% Strong influence of capital floor on IRB -banks, impact from the new CR SA 40% 30% SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Impact especially from LGDdetermination from collateralised exposures, No partial use as an opportunity for CSA banks Increase especially for complex 100% products, calculation of credit risk (junk bonds) March 2019 6

Risk based pricing is an instrument to control profitability, resulting in better strategic allocation of capital Components of risk based pricing Description Interest rate (R) • Cost of operations (OPEX) are calculated on a product level by finance department using cost allocating methodologies Cost of capital • Cost of funding is the fund transfer price provided by the treasury department • Cost of risk (EL, expected losses) is directly influenced by risk parameters PD, LGD and EAD derived from internal models EL OPEX FTP Risk adjusted costs EL • Cost of capital is derived by multiplying the risk weighted exposure amount (RWA) by the target CET 1 ratio and target return on capital • Risk adjusted costs are compared with the interest rate prior to loan disbursement using metrics such as the Risk adjusted return on capital (RAROC) and Economic value added (EVA): RAROC Rating AA borrower Profitable transaction EVA> 0 and RAROC > target return on capital Cost of capital Rating B borrower Not profitable transaction Insufficient interest rate to cover risk adjusted costs Cost of risk Cost of operations SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Expected Profit Economic Capital EVA Exp. Profit – Cost of Capital where Expected Profit is (R– FTP – OPEX – EL)*(1 – tax rate) • ! Note that the components of risk based pricing could change over time, and therefore risk adjusted costs must be calculated over the entire lifetime of the loan in order to determine if it is profitable Cost of funding March 2019 7

Risk weights change over life of the loan and dependent on the approach used for estimation – an illustrative example Standardised risk weights over the life of a loan Comments Total NPV RAROC EVA 5% 13% 16% 22% 22% 12% -0. 34 0. 08 0. 10 0. 06 0. 01 0. 07 80% 120 70% 100 80 50% 40% 60 30% 40 EAD (EUR) RW, % 60% 20 10% 0% 0 0 5 10 15 20 24 Years RW Split old RW LTV EAD A loan with exposure amount of 100 EUR fully covered by collateral with maturity of 25 years and interest rate of 1. 5% SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C • Risk weights decrease in time due to loan amortization and changes in LTV • However, a significant impact is also observed due to the approach used to estimate risk weights: − at beginning of the period highest observed RWs were estimated using the new standardised approach based on LTV values − for the years 2 -4 highest RWs were obtained based on the new standardised approach using exposure splitting method − starting from the year 6, the highest RWs are observed from the former standardised approach using exposure splitting method March 2019 8

Allocation and pricing of capital costs under Basel IV individual positions vs. portfolio Capital costs play an important role in banks' pricing models. In addition to the potentially enormous impact of the capital floor on some banks using internal models, there also significant effects on their pricing and the underlying price models. Initial portfolio Assumption : Target CET 1 ratio 10% and regulatory return on capital of 5% Portfolio at time t RWA IRB RWA STD RWA 72, 5% STD Final RWA incl. Capital Floor 300 500 363 Induced cost of capital 1, 50 2, 50 1, 81 363 1, 81 Loan i How are the capital costs calculated under Basel IV? RWA IRB RWA STD RWA 72, 5% STD Portfolio in t + loan i RWA IRB RWA STD RWA 72, 5% STD Final RWA incl. Capital Floor Marginal costs of the loan i Before Capital Floor After Capital Floor RWA 50 70 50, 75 Induced cost of capital 0, 25 0, 35 0, 25375 350 570 413 Induced cost of capital 1, 75 2, 85 2, 07 413 2, 07 RWA Capital Floor determines the RWA in SA and IRBA lead to incorrect capital costs - Capital Floor increases total RWA and capital costs for IRBA banks ! Individual position valuation of loan i leads to incorrect results even taking into account the capital floor! Calculation of the marginal cost of loan i leads to correct cost of capital 0, 2500 0, 2538 If a capital floor represents a restriction, pricing must take into account the entire portfolio. SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C March 2019 9

Countervailing effects for higher-risk and lower-risk exposures Portfolio in t RWA IRB RWA STD RWA 72, 5% STD Final RWA incl. Capital Floor Loan i RWA IRB RWA STD RWA 72, 5% STD Portfolio in t + loan i RWA IRB RWA STD RWA 72, 5% STD Final RWA incl. Capital Floor Marginal costs of the loan i Before Capital Floor After Capital Floor 300 500 363 Induced cost of capital 1, 50 2, 50 1, 81 363 1, 81 RWA 80 70 50, 75 Induced cost of capital 0, 4 0, 35 0, 25375 380 570 413 Induced cost of capital 1, 90 2, 85 2, 07 413 2, 07 RWA Initial portfolio Portfolio in t RWA IRB RWA STD RWA 72, 5% STD Final RWA incl. Capital Floor 1 Loan i Case 1: higher-risk exposures RWA IRB RWA STD RWA 72, 5% STD Portfolio in t + loan i RWA IRB RWA STD RWA 72, 5% STD Final RWA incl. Capital Floor Marginal costs of the loan i Before Capital Floor After Capital Floor 0, 4000 0, 2538 1 370 500 363 Induced cost of capital 1, 85 2, 50 1, 81 370 1, 85 RWA 10 70 50, 75 Induced cost of capital 0, 05 0, 35 0, 25375 380 570 413 Induced cost of capital 1, 90 2, 85 2, 07 413 2, 07 RWA Portfolio B 0, 0500 0, 2163 2 Possibly opposite effect due to compensating effect of capital floor when investing in riskier exposures High effect with low-risk exposures (e. g. government exposures) 2 Case 2: low-risk exposures

FPE – Floor Portfolio Effect The challenge of capital allocation and pricing Floor portfolio effect affects RWA of all exposures with RWA below the floor 1 Bank IRB SAPseudo Risk position RWA 3. 000 1. 420 3. 000 Risk position RWA IRB 1. 000 800 SA 1. 000 3 Risk exposure value 2: IRB retail business (secured by real estate) Risk position RWA IRB 1. 000 120 1. 000 SA 1. 000 350 RWApre floor 800 RWApre floor 120 Total RWApre floor 1. 420 Floor 1. 531, 1275 Floor 725 Floor 253, 75 Additional RWAfloor 111, 1275 Additional RWAfloor 0 Additional RWAfloor Total RWAFloor 1. 531, 1275 RWAfloor 800 Avg. RW 51, 04% Avg. RW Total RWAfloor 1. 531, 1275 2. 111, 9 2 Risk exposure value 1: Company Partial Use Portfolio Risk exposure value 3: IRB SME Risk position RWA IRB 1. 000 500 SA 1. 000 761, 9 RWApre floor 500 Floor 552, 3775 133, 75 Additional RWAfloor 52, 3775 RWAfloor 253, 75 RWAfloor 552, 3775 80% Avg. RW 25, 38% Avg. RW 55, 24% Floor contribution factor 0, 718593 Floor contribution factor 0, 281407 RWfloor 72, 5% RWfloor 25, 38% RWfloor 55, 24% 1 ≤ RWAfloor 800 2 + RWAfloor 253, 75 3 + RWAfloor 552, 3775 The sum of the RWA multiplied by the floor is always less than / equal to the sum of the individual RWA multiplied by the floor the delta is the Floor Portfolio Effect! SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C March 2019 11

Floor Compensation Component (FCC) Taking FCC into account in Pricing and Capital Allocation Floor Compensation Component For correct pricing and capital allocation, the FCC has to be redistributed to the original position FCC is not constant • FCC depends on portfolio structure • FCC varies with RWA modifications in the portfolio Capital costs vary over time and depend not only on the risk of a position but also on the risk of the remaining Assumptions are necessary for… portfolio PD LGD EAD New risk positions RWSA PD LGD EAD All remaining positions in the portfolio RWSA SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C March 2019 12

Because of the floor, strategic decisions at overall portfolio level could impact the profitability of new loans (1/2) Profitability of new loans before sale of a significant SA portfolio: base case EVA is positive Example Portfolio structure Profitability over the life of the mortgage loan Total NPV RAROC 10% 15% 16% 22% 25% 26% 16% EVA 0. 00 0. 07 0. 04 0. 01 0. 45 440 80% 320 319 70% 800 60% SA RWA Final RWA Non-strategic portfolio (SA) Strategic mortgage portfolio (IRB) Output Floor (72. 5%) RW, % EAD 120% During the life of the loan the exposure amount decreases, resulting in decrease in 100% LTV ratio and reduction of RW 40% 60% 30% 40% 20% 10% 0% 0% 0 • RW of IRB portfolio – 15% (SA RW of the same portfolio – 30%) 5 10 15 20 24 Years RW SA (LTV approach) • RW of SA corporate portfolios – 100% • Output floor is not a limiting factor for new loans 80% 50% LTV, % 1. 000 RW IRB RW Final (after floor) LTV A loan with exposure amount of 100 EUR fully covered by collateral with maturity of 25 years and interest rate of 1. 5% SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C March 2019 13

Because of the floor, strategic decisions at overall portfolio level could impact the profitability of new loans (2/2) Profitability of new loans after sale of a significant SA portfolio: risk weights increase, EVA turns negative Example Portfolio structure Bank sells of corporate portfolio, increases size of bank portfolio Total NPV RAROC EVA 232 190 SA RWA 15% 20% 21% 8% -0. 28 0. 04 0. 06 0. 07 0. 04 0. 01 -0. 13 Final RWA Non-strategic portfolio (SA) Strategic mortgage portfolio (IRB) Output Floor (72. 5%) During the life of the loan the exposure amount decreases, resulting in decrease in LTV ratio and reduction of RW 70% 60% RW, % EAD 12% 80% 310 800 4% • RW of SA bank portfolio – 35% 100% 80% 50% 40% 60% 30% 40% 20% 10% 0% 0% 0 • RW of IRB portfolio – 15% (SA RW of the same portfolio – 30%) 120% LTV, % 1. 000 Profitability over the life of the mortgage loan 5 10 15 20 24 Years RW SA (LTV approach) RW IRB RW Final (after floor) LTV A loan with exposure amount of 100 EUR fully covered by collateral with maturity of • Output floor is now a limiting 25 years and interest rate of 1. 5% factor for new loans SCI's 3 rd Annual Risk Transfer & Synthetics Seminar March 2019 14 Pw. C

IRB reborn – an example of IRB implementation impact for a German bank using SA approach in the context of Basel IV Results of Basel IV impact study for a mid-sized German bank Basel IV impact for SA portfolios (mln EUR) Overall impact 464 147 2. 210 7. 892 • 2 Additional risks arise because for some portfolios the exact increase is unknown until additional information is collected (e. g. whether or not real estate is income producing or not) • 3 New “Partial Use Requirements” allow the bank to implement the IRB approach only for selected portfolios. 1. 244 +23% 633 1. 839 1. 347 Corporate 1. 020 Retail 1. 368 -9% 0% 1. 383 2. 263 Real Estate +46% Current RWA Minimum impact Other credit Impact range If all portfolios remain on the standardised approach, Basel IV can result in an increase in RWA of 21 -28% for the bank +156% -10% Total RWA • 1 Impact at the level of portfolios +28% 6. 539 Key observations Market & CVA Operational Effect of IRB implementation (mln EUR) If IRB is implemented for retail and real estate exposures, the total RWA of the bank might actually decrease from current levels by 7% and stay above the output floor Decomposition of the portfolio 72. 5% floor 6. 539 4. 527 2. 264 8. 356 6. 093 3. 829 • 4 Current RWA (SA) Basel IV SA portfolios RWA (SA) Portfolio with IRB potential SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C RWA reduction Final RWA optimisation might further improve results, e. g. it might help reduce the RWA for the standardised approach March 2019 15

Detailed regulatory requirements towards IRB models make the implementation process easier and less costly From uncertainty Cost of IRB implementation programme (%) To defined rules IRB 1. 0 IRB 2. 0 • Uncertain requirements and no tested methodologies • Tested market practices and clear interpretation of regulatory requirements and supervisory expectations • Poor quality IT systems • Internal and off-the shelf IT systems for internal models • Lack of risk data • Risk data at least partially available (e. g. for IFRS 9) • Few IRB/data specialists • Many specialists in banks and/or in the market 100 44 Regulatory documents CRR 2. 0/ CRD V EBA/ECB guidelines Basel II/Basel III Basel IV CRR/CRD IV Final Guidelines on PD estimation, LGD estimation and the treatment of defaulted exposures Draft RTS on the specification of the nature, severity and duration of an economic downturn Final RTS on the specification of the IRB assessment methodology for competent authorities Modelling and Validation Final RTS on the materiality threshold for credit obligations past due Internal Processes Final Guidelines on application of default definition SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C 6 IRB 1. 0 (2008) IRB 2. 0 (2018) Model Governance Data Quality Framework IT Architecture March 2019 16

Conclusion: What to do next? So much for theory. . . What do banks have to consider? In view of the currently increasing regulatory requirements and the increasing pressure on profitability, banks should already prepare themselves today for Basel IV and other regulatory changes: Impact Analysis of the Basel IV Amendments 01 The new standards will bring significant changes to internal processes and systems. This concerns data, models and systems from the front to the back office as well as control functions. • New requirements in parameter estimation, new input floors and the introduction of the aggregated capital output floor will bring a completely new complexity to the existing rules and standards. • Model validation approaches have to be revised. • Complete revision of the RWA calculation and reporting systems • The new disclosure requirements will evolve from obligation to one of the most important financial publication, as the flood of new information will strongly influence investors, supervisors and market participants. 02 Determination of the implementation process 03 Due to the very individual impact of the new rules depending on different business models, products and customers, there is no single answer to the challenges. An individual response first requires an individual and detailed impact analysis. Strategy optimisation SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Due to the large differences in the effects of the new requirements, it is not only necessary to develop one's own strategic reactions, but also to anticipate the reactions of other market participants. Strategic measures must be developed and implemented in a timely manner, since the measures are only implemented after a certain delay. March 2019 17

Pw. C’s Global Basel IV initiative – Ahead of the curve Basel IV Webpages Basel IV Youtube channel and monthly webinars SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Impact calculations using Pw. C tools for all standardised approachs Basel IV Book January 2019 18

Thought Leadership/Toolbox Conferences SCI's 3 rd Annual Risk Transfer & Synthetics Seminar Pw. C Roadshow Basel IV Poster January 2019 19

Martin Neisen Partner – Global Basel IV Leader Phone: +49 69 9585 3328 Mobile: +49 151 538 00865 E-Mail: martin. neisen@pwc. com © Juli 2018 Pricewaterhouse. Coopers Gmb. H Wirtschaftsprüfungsgesellschaft. Alle Rechte vorbehalten. “Pw. C” bezeichnet in diesem Dokument die Pricewaterhouse. Coopers Gmb. H Wirtschaftsprüfungsgesellschaft, die eine Mitgliedsgesellschaft der Pricewaterhouse. Coopers International Limited (Pw. CIL) ist. Jede der Mitgliedsgesellschaften der Pw. CIL ist eine rechtlich selbständige Gesellschaft. Pw. C

Thank You for Your Attention. © 2018 Pricewaterhouse. Coopers Gmb. H Wirtschaftsprüfungsgesellschaft. Alle Rechte vorbehalten. „Pw. C“ bezeichnet in diesem Dokument die Pricewaterhouse. Coopers Gmb. H Wirtschaftsprüfungsgesellschaft, die eine Mitgliedsgesellschaft der Pricewaterhouse. Coopers International Limited (Pw. CIL) ist. Jede der Mitgliedsgesellschaften der Pw. CIL ist eine rechtlich selbstständige Gesellschaft.

Martin Neisen Partner Experience Summary Martin is the Global Basel IV leader of Pw. C and coordinates Pw. Cs initiative for the implementation of Basel IV. This initiative covers all aspects regarding the impact and the implementation of Basel IV, including strategic implications, standardized approaches, internal models, business implications, IT and also knowledge management. Friedrich-Ebert-Anlage 35 - 37 60327 Frankfurt am Main phone: +49 69 9585 3328 mobile: +49 151 53800865 fax: +49 69 9585 947603 martin. neisen@de. pwc. com He leads the Regulatory Management department in Pw. C Europe and is our central expert in the area of Basel II / IV and projects regarding other regulatory topics. Short CV Martin Neisen is a Pw. C Partner located in Frankfurt. He is leading the Regulatory Management business in Pw. C Europe. Language: Deutsch, English, Netherlands Areas of Expertise • German regulatory banking law • Qualitative and quantitative risk management • • Credit Risk, Market Risk, Op. Risk Credit rating processes Canadian Bankers Assiciation Pw. C Previous Clients (excerpt) • • • Deutsche Bank Commerzbank HSH Nordbank AG Deka. Bank VW FS AG DZ BANK AG Martin has strong experience in both, IT and technical implementations. Furthermore he is a leading expert for projects that combine accounting, risk management and regulatory aspects. He has a background of over 16 years in the financial industry. He is a specialist in the wide area of international and european regulatory law as well as risk management. Martin is a very experienced international expert that worked with many Tier 1 and Tier 2 banks worldwide. Martin is also one of the Pw. C experts for questions regarding the ECB supervision (SSM). January 2019 22