Analysing The Operating

Environment
 Sovereign Risk
Sovereign Risk essentially looks at economic
and political risk of the country in which a bank:
Has its headquarters (its home country);
Has operations (its host countries).
Requires bank analysts to work closely with
country economists within their organisation.
Complex subject:
A Process, Not Only A Set Of Formulas
Dynamic process:
Volatility and Unpredictability
Use both Quantitative and Qualitative Analysis
Increasing Focus on Financial System
 Sources of Sovereign Risk

COUNTRY MARKET
FUNDAMENTALS EXPECTATIONS

Solvency Crisis Liquidity Crisis

 Political Risk
Assessing the Political Context
Identifying Key Political Actors and Institutions
Predicting Political Stability/Instability

Spectrum of Political Stability

Mild Moderate Severe Revolution

 Economic Risk
Evaluate Relevant Economic Data & Indicators
Assess Outlook for Prosperity & Welfare
Analyze Internal & External Financing Balances
Forecast Future Economic Trends
Use:
Historical comparisons;
Peer Group comparisons.
Red Flags:
Sharp Falls In Real GDP Growth;
Sharp Rises In Unemployment;
Widening Income Disparities;
Abrupt Drops In Savings & Investment Rates.
 Why Sovereign And Bank
Analysis Are Interlinked
To understand a bank you must understand the
country is which it is located.
Due to transfer risk it is usually considered that
banks cannot have better creditworthiness than
their sovereign.
The environment in which banks operate will
impact their risk profile.
Political impact on individual banks.
Economic impact on individual banks.
Conversely problems in the banking sector can
trigger broader economic concerns.
 Specific Economic Factors
Affecting Banks
Performance of the real economy (corporate
sector)
Interest rate environment
Exchange rate stability
Equity market performance
Corporate sector gearing ratios
Progress of the economic cycle domestically
Progress of the economic cycle internationally
Development of the capital markets
 Risks of volatile economic trends

THE ECONOMIC CYCLE IS ALWAYS PRESENT

Volatile economic trends adversely impact banks:
Lack of profitability in the corporate sector results in
problems servicing bank loans;
Asset quality deteriorates in a recession;
Banks operating in a tiger environment see only
economic growth for a long period (eg Asia) and do not
prepare themselves for the downturn;
Is this a risk in China at the moment?
 Particular Emerging Market
Economic Issues
Many emerging markets have still not moved away from
a reliance on primary products:
Trends in world commodity prices have a disproportionately
large effect;
Banks with significant agricultural exposure are susceptible to
bad loans and political interference;
In emerging markets approach all banks with Agriculture in their
name with care!
Manufacturing in emerging markets tends to be
assembly of products inspired by low labour costs:
Added value products increasingly being outsourced to emerging
markets as well.
Lifespan of an emerging market can be quite short:
Taiwan already losing its manufacturing business to mainland
China.
Economic Growth & Banking
Development I
Pressure on margins
Banks compete for corporate customers as they start
to demand more sophisticated products;
Competition for blue chip corporates reduces margins
on the best business;
Economic growth therefore results in weaker credit
culture as competition intensifies:
Collateral, covenants less strict in growth period
As inflation falls in a growth period, margins typically
become tighter.
 Economic Growth & Banking
Development II
Competition drives business into the SME sector
What is the status of small and medium sized
companies in the economy?
How big are the SMEs?
Relatively large with significant assets, such as the German
Mittelstand?
Very small, Mom & Pop companies with no assets?
Are new companies being created or is there a lack of
capital?
What can these business pledge as collateral?
Do they generate export revenues?
Are there adequate credit histories on these
companies?
 Economic Growth & Banking
Development III
After banks have moved into SME sector, next
phase of competition is in the personal banking
sector:
Credit Cards;
Consumer Finance;
Mortgage Lending.
Risk profile of lending likely to be much higher
once personal lending becomes the target of
competition, due to lack of credit histories.
 Geography I
How large is the country?
Land size
Population size
What is the climate?
Impact on agriculture
Impact on industry
Impact on tourism
What natural resources are important?
e.g. oil in the Middle East, Russia & Kazakhstan
 Geography II
Is the country landlocked, does it have a coast
or is it an island?
Which countries share a border
Are they friendly?
Or is there a cross border dispute?
Who are its allies?
How good is the countrys relationship with the US?
Can the country trade with its partners?
Is it on a trade transit route?
If so, from where to where?
 History
For how long has the country been independent?
What colonial influences were there present in the
past?
Have there been any recent wars and what was
their consequence?
Does the country have a history of peace or war
with its neighbours?
What racial groups settled in the country and
when?
Legal & Judicial System
 Legal infrastructure
Particular areas of legal weaknesses that
can impact banks:
Banking law
Law on the Central Bank
Bankruptcy law
Collateral Registration/Land Registry
Mortgage law
Labour Law
Exchange Controls Law
Continental vs. Anglo Saxon I
Continental Law
Most common in Europe & former European colonies;
Based on civil law;
Legislation is the primary source of law. Courts base their
judgments on the provisions of codes & statutes, from which
solutions in particular cases are derived.
Anglo Saxon Law
Most common in UK/US/Commonwealth;
Based on common law;
Statues may leave issues unaddressed because they are
already understood from the point of view of pre-existing case
law and custom.
Some argue that civil law countries tend to emphasize
social stability, while common law countries focus on the
rights of an individual.
Continental vs. Anglo Saxon II
Banks ideally like a clear cut legal system which
supports their claims as creditor.
Anglo Saxon law has usually been very strong in
supporting the resolution of legal claims in favour of
the creditor.
Many Anglo Saxon systems include mechanisms for
banks to take control of assets without a pro-longer
court process.
EU Law represents something of a hybrid.
Interesting to look at detailed implementation of
EU laws at national level, but appeal process
can be taken up to EU level.
 Letter of Law vs. Court System
Important to remember that regardless of
the wording of the law, the legal process is
in the hands of the court.
Consider whether the application of law by the
court system in a country is:
Reliable;
Consistent.
What motivates the court?
Social implications of repossession of property?
Political motivation of elected court officials.
Assessing The Regulator
 Objectives of Regulation
Financial Stability
Deposit Protection (banks).
Investor Protection (investment firms & life assurance firms).
Policy Protection (non life assurance).
Overall macro-economic benefits from a stable financial sector.
Guarantee of effective intermediation between real and financial
sectors.
Consumer protection
Particular focus of FSA in UK.
Potential for conflict with financial stability objective.
Political protection
Enables politicians to pass the buck in a crisis.
 Types of Regulator
Unified regulator or individual regulators
addressing each financial sector
Increased trend toward consolidation of
regulators into one national entity.
Single regulator usually located in special
agency outside Central Bank.
Where single banking regulator still exists,
usually still located in Central Bank.
Consider political motivation behind the
structure adopted.
 International Best Practice
Basel Committee On Banking Supervision
Club of leading industrial states.
Set international best practice.
Financial rules (capital, etc).
Framework for international co-operation.
Supervisory approach.
Core Principles of Effective Banking Supervision (1997)
EU Directives
Legal framework in Europe.
Covers some ground which is not explicit in Basel.
e.g. large exposures, more detail on consolidation, etc.
Minimum standards. Countries can be super-equivalent.
 Assessing the National
Regulator
Compare national rules with Basel/EU
requirements.
In which areas is regulator super-equivalent?
Are these sufficiently severe for local market
conditions?
Are there any areas in which local regulations
fail to meet international norms?
Has the regulator adopted all the core
principles?
 On/off site supervision
Are there adequate provisions for both on and
off site supervision?
On site supervision
Conducted by regulators own staff or auditors?
Frequency of review?
Off site review
Risk orientation of review.
How much data is available and how often is it
collected?
Danger of too much data collection in some countries which
are not sufficiently objective.
 Outsourcing
Does regulator permit outsourcing by banks?
Domestically.
Internationally.
What mechanisms does regulator have to conduct off
site reviews at the outsourcing location?
Information Technology
Critical that review can be carried out.
Call centres
Pure marketing centres are less likely to need on site review, but
any collection type activity must be reviewed.
UK FSA recently warned banks about risk of outsourcing
high risk activity to other countries.
Are outsourcing locations subject to same business
continuity rules as the home country offices?
 Staff Levels & Ability
Inevitably the regulator pays staff less than the
commercial bank sector.
Attrition of staff who leave to work in private sector.
Difficult to attract & keep best quality staff in regulator.
Flow of individuals with regulatory experience to banks helps
regulatory arbitrage.
Use annual report to get idea of staffing and staff
turnover.
Request meeting to discuss prudential regulations.
Dont ask questions about individual banks. Get to know them
first.

Number of regulators per regulated bank (2000)

UK US Japan Germany
Ratio 0.89 1.13 1.32 0.28
 Sanctions/Penalties
What sanctions does regulator have to
punish banks who break rules?
Is resolution punitive or collaborative?
Does regulator fine offenders?
Or does it work with them to rectify problems?
Can individuals be removed from office
and prevented from working in finance?
 Cost of Regulation
Is the regulatory burden stifling business?
Local bankers association often publish data on
cost of regulation.
UK FSA currently commissioned Deloitte to
conduct a survey to find out real cost of
regulation.
Basel 2 will push up cost of regulation
significantly, but some of the cost of improved
risk management systems was needed anyway.
 Regulation/Competition
Co-Determinants of Banking System Risk
Consolidation of banks & Increased International rules appear to be
moving world toward Top Left corner.
BUT competition from non-banks in individual markets possibly
moving world to Top Right corner.

More
Prudential Regulation

Low Risk Medium Risk

Medium Risk in
High Risk in
Short Term
Short & Long Term
High Risk in Long Term
Less

Less More
Competition
Bancassurance/Financial
Conglomerates
 Bancassurance
Bancassurance (Allfinanz in Germany)
Combination of banking with insurance business in one financial
group.
Increasingly common in Europe.
Universal banking
Combination of banking with securities business in one financial
group.
Illegal in US from 1933 to 1999 (Glass Steagall Act)
Introduced in response to Wall Street Crash/Great Depression.
1929 Crash triggers banking failures.
FDIC established by Glass Steagall.
Commercial banks limited to earning 10% income from securities
business.
Revoked in 1999. Gramm-Leach-Bliley Act eliminated restrictions on
affiliations between commercial and investment banks.
Development of Bancassurance I
Development of Bancassurance II
Top 30 Bancassurance Groups in
the EU
Top 30 Bancassurance groups in the EU
(As of end 2001, total consolidated assets in billions)
1 Deutsche Bank Germany 917.7
2 Allianz Germany 911.9
3 BNP Paribas France 825.3
4 HSBC Holdings UK 778.6
5 ING Group Netherlands 705.1
6 ABN Amro Holding Netherlands 597.4
7 The Royal Bank of Scotland Group UK 590.0
8 Barclays UK 573.5
9 Crdit Agricole France 563.3
10 Socit Gnrale France 512.5
11 Fortis Belgium 475.4
12 AXA France 474.0
13 Santander Central Hispano Spain 355.9
14 Dexia Belgium 351.3
15 Banca Intesa Italy 313.2
16 Lloyds TSB Group UK 312.9
17 Banco Bilbao Vizcaya Argentaria Spain 305.5
18 Abbey National UK 303.3
19 Aviva UK 300.9
Source: Based on information from
20 Groupe Caisse dEpargne France 285.9 Bankscope and Isis. Assets are on a
21 Aegon Netherlands 264.1 consolidated basis if available. Formatted by
22 Almanij Belgium 259.3 European Central Bank
23 Prudential UK 255.8
24 Nordea Sweden 241.5
25 Generali Assicurazioni Italy 222.9
26 Credit Mutuel - CIC France 218.8
27 Danske Bank Denmark 209.0
28 UniCredito Italiano Italy 208.2
29 Munich Re Group Germany 190.1
30 San Paolo IMI Italy 169.3
European Bancassurance Deals I
Acquirer Sector Country Target Sector Country Year Value
Allianz Ins DE Dresdner Bank Bank DE 2001 22.3
Lloyds TSB Bank UK Scottish Widows Ins UK 2000 12.0
Group Fund & Life
Fortis Ins BE Gnrale de Bank BE 1998 10.5
Banque
Nationale Ins NL NMB Postbank Bank NL 1991 5.6
Nederlanden Groep
ING Groep Ins NL BBL Bank BE 1997 4.1
Abbey Bank UK Scottish Provident Ins UK 2001 2.9
National
Dexia Belgium Bank BE Financial Security Ins US 2000 2.7
Assurance
Irish Bank IE Irish Life Ins IE 1999 2.7
Permanent
ING Groep Ins NL BHF Bank Bank DE 1999 2.3
Lloyds TSB Bank UK Lloyds Abbey Life Ins UK 1996 2.1
Group
Wuestenrot Bank DE Wuerttembergische Ins DE 1999 2.1
Beteiligung Versicherung
SEB Bank SE Trygg-Hansa Ins SE 1997 2.0
European Bancassurance Deals II
Acquirer Sector Country Target Sector Country Year Value
Fortis NL Ins NL Banque Gnrale Bank LU 2000 1.8
du Luxembourg
Banco Bank ES Cia de Seguros Ins PT 2000 1.7
Santander Mundial
Central
Hispano
Halifax Group Bank UK Equitable Life Ins UK 2001 1.7
Sampo Ins FI Leonia Bank Bank FI 2000 1.7
Fortis Ins NL ASLK-CGER Bank BE 1999 1.5
RBS Bank UK Churchill Insurance Ins UK 2003 1.5
Caixa Geral Bank PT Cia de Seguros Ins PT 2000 1.4
de Depositos Mundial
Fortis Ins BE MeesPierson Bank NL 1997 1.3
ING Groep Ins NL BHF Bank Bank DE 1998 1.3
ING Groep Ins NL Crdit Commercial Bank FR 1999 1.2
de France
Unidanmark Bank DK Tryg-Baltica Ins DK 1999 1.2
Forsikring
Assicurazioni Ins IT Banca della Bank CH 1998 1.1
Generali Svizzera Italiana
 Regulatory Issues
There is a regulatory challenge arising
from bancassurance.
Banks typically calculate capital adequacy
based on risk of assets;
Insurers typically calculate capital requirement
based on risk of liabilities;
Inconsistency of approach.
Risk of:
Double gearing on capital;
Regulatory arbitrage.
 Joint Forum
Tripartite Forum composed of:
Basel Committee of Banking Supervisors;
IOSCO (International Organization of Securities Commissions);
IAIS (International Association of Insurance Supervisors).
Last set of proposals for regulatory capital issued by
Joint Forum in 1999.
EU has implemented the Financial Conglomerate
Directive.
Requires full consolidated supervision of financial
conglomerates.
Prompted the US to introduce the Consolidated Supervised
Entity for broker/dealers.
 Solvency 2
EU has not yet standardised insurance company
capital regulation with that of banks and
securities firms.
Solvency 2 is a draft set of proposals:
Will introduce a three pillar approach to insurance
capital adequacy.
Parallels drawn with Basel 2.
Pillar 1 (capital requirement) will still be set
specifically for insurance companies.
Aims to enhance insurance risk management in same
way as Basel 2 has done for banks.
 Bancassurance
Perceived Benefits
Cross Selling.
Insurance firms can use branch network of banks to sell
products.
Bank can use data mining techniques to target remote
advertising at its clients.
Brand Leverage.
Banks often have more customer loyalty than insurance firms,
which can trigger increased sales for the insurance company.
Surprisingly not many mergers have resulted in the introduction
of a single name across the whole group.
Internal Regulatory Arbitrage.
Although regulators try to avoid outright double gearing, it is
possible to set up a booking matrix showing which products
should be booked in which company to achieve lowest capital
charge.
 Bancassurance
Potential Problems
Cultural Problems.
Bankers & Insurers tend to have quite different outlooks on
business.
Insurance often less customer focused.
Capital is more transient in insurance.
Easier to close an insurance business
Run off insurance firms are commonly found.
Technology platform quite different.
Insurance premiums can dominate business.
Bankers often view insurance premiums earned as equivalent to
fees in banking.
Recent BBC investigations accusing LloydsTSB of selling
inappropriate & expensive income protection plans in association
with personal loans.
Normal lending controls may sometimes have been subverted in
quest for insurance income.
 Bancassurance
Cross Selling
Recent experience suggests that cross
selling income estimated in many
bancassurance mergers is over-estimated.
Key example is Allianz take over of Dresdner.
General view is that Allianz significantly over-
estimated potential to sell insurance through
Dresdner branches.
BUT Dresdner not primarily a retail bank. More
success might have been had selling via
Sparkassen branches.
Will A Bank Bail Out An Insurer?
Insurance firms are more likely to close their
business in times of difficulty than a bank would
be.
Life assurance in UK has faced significant problems
as equity/bond yields have fallen.
Several large life assurance firms (Britannic, Pearl,
etc) have put their main life or endowment funds into
run off now operate as closed funds.
In comparison, Abbey National recapitalised its
insurance funds, worsening financial problems at
group level and precipitating take-over by Spains
BSCH.
Ageing Population & Pension
Reform
 Ageing Population
The Problem
Most of the developed world is experiencing an
ageing population.
Increased life expectancy.
Falling birth rate.
Replacement rates below 1 in many countries.
Immigration provides a route to negate underlying
demographic changes.
US helped in part by open attitude to immigration.
US population is not ageing as fast as that in Western
Europe.
 Current & projected old age
dependency ratio
1995 2000 2010 2020 2050
EU15 23.0 24.1 27.0 31.7 47.2
Belgium 23.8 25.4 26.9 32.6 43.5
Denmark 22.7 22.1 24.3 30.1 37.7
Germany 22.5 23.3 29.2 31.9 46.8
Greece 22.8 25.5 29.3 32.3 48.0
Spain 22.2 24.4 26.5 29.8 56.5
France 22.9 24.3 25.5 32.6 46.4
Ireland 18.0 17.4 18.5 24.5 43.6
Italy 24.0 26.5 31.0 35.5 55.7
Luxembourg 20.6 21.5 23.5 27.9 37.8
Netherlands 19.3 20.1 22.5 29.8 40.7
Austria 22.4 22.6 25.6 28.5 44.3
Portugal 21.4 22.5 24.3 27.3 44.0
Finland 21.1 21.9 24.7 35.0 42.1
Sweden 27.4 26.8 27.9 33.4 37.9
UK 24.3 24.0 24.7 29.8 42.8

Ratio between the total number of elderly persons of an age when

they are generally economically inactive and the number of persons
of working age.

Source: Eurostat
 Macro-Economic Impact
Increased healthcare costs.
Could lead to public sector rationing.
Increased pension burden.
More pensions to be paid by fewer people of
working age.
Incentive to move more pension provision to
private sector.
Biggest problem for countries with largely
unfunded pension schemes.
 Impact on Financial Services
Industry
Financial Services Industry needs to re-align its
product range to new profile of customers.
In general older population spend less on large capital
items.
Less demand for unsecured lending.
Savings orientated products designed to give an
income in retirement more attractive.
Banks can expand internationally to diversify their
business across a broader population group.
Makes banks less susceptible to impact of ageing
population.
Emerging markets tend to have a younger, still
expanding population.
 New Products I
Private, Funded Pensions
Huge growth area as more countries develop private
pension provision.
Pressure from governments to keep fees low.
Need for high yield could tempt individuals into higher
risk investments.
Introduces risk of mis-selling accusations (particular
problem in UK).
Equity Release
Strong in US, UK & Australia.
Enable retired people to draw an income from the
equity accumulated in their houses.
 New Products II
Yield chasing investments.
Compare to Japan. When market rates are
close to zero, difficult to earn an income.
Growth of popularity of hedge funds is in part
a response to this.
Inheritance products & Products hiding
savings from government.
Will grow in popularity as governments
increasingly means test old age benefits.