ELA EQUIPMENT MANAGEMENT CONFERENCE

ELAEQUIPMENT MANAGEMENT CONFERENCETucson, Arizona

February 14, 2005

BASEL / RAROCOwen Killian, Executive Vice President, VFA Risk

ELA EQUIPMENT MANAGEMENT CONFERENCE

Basel/RAROC or RAROC/Basel?

• RAROC Came First– RAROC (Risk Adjusted Return On Capital) is a measure of

profitability and performance– The development of RAROC began in the late 1970’s at

Bankers Trust Company as a way to measure the full risk in the bank’s portfolio

– By the early 1990’s many international banks were using RAROC to measure profitability and the amount of capital necessitated by the inherent risk in their portfolios

– In banking circles, expected loss (EL) is generally thought of as being covered by reserves and unexpected loss (UL) by capital

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Basel

• Basel Accord- The 1988 Accord was an attempt to standardize minimum

capital requirements to ensure the safety and soundness of the global banking system

- The original Accord was flawed because it was not very sensitive to risk; it was easily arbitraged; and it fell behind the technology best-practice banks were already using in measuring economic capital

- In January 2001, a committee of banking supervisors from the G-10 countries proposed a New Basel Accord (Basel II) to replace the original Basel Accord of 1988 (named for the city in Switzerland where this committee meets)

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Basel – cont’d.

• The Basel II Accord- In a nutshell, the Basel II Accords are a three pillar approach

to ensuring adequate capital among the world’s banks:- Pillar One: Regulatory capital- Pillar Two: Banking supervision- Pillar Three: Public disclosure of risks

- DLL, as a subsidiary of a large, internationally-active bank, is required by the Dutch National Bank to follow the Advanced Internal Ratings-Based (AIRB) approach to pillar one

- This required significant revamping of the risk measurement practices at DLL

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Basic Basel Equation:

PD % Probability of Default

LGD % Loss given Default

EAD $ Exposure at Default

EL $ Expected Loss

X

X

=

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Expected Loss?

• Why?- Leasing, like other credit business, involves taking some risk

that the payments for equipment leased are not made- This risk can be estimated and losses resulting can be

measured and accounted for in pricing and portfolio management

- The measured and predicted loss is called Expected Loss and covered by loss reserves

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Risk Measurement

• If we can measure risk, why is there unexpected loss?- The measurement of default (PD) and recovery (LGD) are

statistical concepts that involve measurement error- We can say we estimate EL with some degree of confidence

(we will not exceed this loss more than 50% of the time)- Unexpected loss is an estimate of losses that happen in the

remaining period of time- Businesses (including DLL) hold capital to insure business

sustainability for such losses

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From Basel To ECAP• Transition

- RaboBank determined that if compliance with the most advanced form of Basel II was required, then measuring ECAP and using a RAROC risk/return measurement system made sense

- (Other large banks already using ECAP and RAROC find Basel II AIRB approach easier to implement)

- Basel II uses the components of expected loss (EL), namely PD, LGD, and EAD to determine the unexpected loss (UL) and hence, capital, to ensure sustainability under adverse circumstances

- Estimating EL is only an intermediate step in determining the UL and ultimately, the capital required

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But First, What is ECAP?

ECAP = Economic Capital• Economic capital is the amount of capital

required on the basis of a full analysis of all forms of risk.– Credit Risk– Operational Risk– Market Risk– Country Risk

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From Basel To ECAP To RAROC

• Transition – cont’d.- ECAP takes these components plus a measure of default

correlation (necessary to determine the portfolio diversification effect) to estimate capital at a level usually higher than mere sustainability

- Default correlation is a statistical concept that measures the likelihood of an obligor defaulting on its debt if another obligor has defaulted on its debts

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Default Correlations - Example-1 0 0.1 0.25 1

Absolutely certain obligor 1will not default if obligor 2 defaults

Any default by obligor 1 andobligor 2 completely random

Absolutely certain obligor 1 willdefault if obligor 2 defaults

May not be directly observablebut similar to the likelihood of the US government defaults because a school district defaults

Similar to the likelihood that alaw firm in Boston defaults at the same time as a plumber in Tucson

May not be directly observablebut similar to the likelihood of a sub-contractor of a major auto manufacturer who deals only with that manufacturer defaulting when the auto manufacturer defaults

Most large corporate credit portfolios fall into this rangeMost retail credit portfolios fall into this range

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Basel II Accord Requirements, ECAP, RAROC

• Status- After 3 years of work

- DLL is nearly fully compliant with the Basel II Accords. We will be fully compliant by the January 1, 2005 deadline for the mandatory 2 year test period

- DLL VFA is fully aligned with the Basel II Accords, Division Europe, Corporate Center, RaboBank and all it’s subsidiaries on the Basel II Accords requirements, the calculation of the ECAP and RAROC

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The RAROC Equation

Risk Adjusted ReturnRAROC

Risk Adjusted Capital

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Components of the RAROC Equation

• Risk Adjusted Return– Revenues – Expenses – Expected Losses + Revenue on

ECAP +/- Transfer Values/Prices

• Risk Adjusted Capital– Capital to cover worst-case loss (minus expected losses) to a

required confidence threshold (RaboBank’s AAA rating) for credit, market, and operational risks

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The Goal is to Optimize RAROC• RAROC is a ratio that needs to be optimized (the

bigger the better), and the way to make a ratio larger it to either make the numerator bigger or the denominator smaller– With RAROC there are more variables to play with and the

interactions are more complex• Most experienced business managers understand

the numerator of the RAROC ratio and know how to make it bigger

• Economic capital, ECAP, is more of a mystery• Increases in risk adjusted returns (the numerator)

may increase the amount of capital (denominator) offsetting the increase in the returns – actually lowering the RAROC

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Next Steps• Optimizing RAROC means not only adding assets (leases) and/or

lowering expenses to an SBU portfolio• It means finding ways to add assets and/or lower expenses in ways

that keep the level of capital attracted by those actions level or, even better, lower

• This is usually done through portfolio diversification• A portfolio of risky assets (leases) is said to be more diverse when the

default correlation is low• A diversified portfolio is a major key to raising RAROC• Ready to being thinking about Stakeholder Value Management (SVM)

using RAROC as the tool to measure incremental value under SVM initiatives

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