Central Bank of Iran - conf.mbri.ac.ir

2009 Grant Thornton UK LLP. All rights reserved.

Central Bank of Iran Hossein Hamedani Partner Financial Services Advisory

June 2014

Paul Garbutt Partner Financial Services Regulation


1

Hossein Hamedani Partner: Chartered Accountant; BSC Econ (LSE) Financial Services Advisory T (direct) +44 (0) 20 7865 2213 E [email protected]

Hossein has investigated failed or failing banks banks and acted for regulators as an inspector/skilled person. Hossein has experience of auditing banks, funds and insurance entities and has acted as expert or advisor in international arbitrations including five major projects for the government of Iran. Following the financial crisis Hossein led investigation of a major European bank investigating governance and controls, large exposures, treasury and counterparty transactions with a view to recovery of funds. He also acted for the UK regulator on the question of why HBOS failed. Other banking investigations include: Barings, BCCI, Wallace Smith Trust Bank, IPB Post Bank in Czech Republic, and investigation of seven Indonesian banks following the Asian crisis. Hossein has acted as monitor on Iran and Libya sanctions.

Paul Garbutt Partner Financial Services Advisory T (direct) +44 (0)20 7865 2170 E [email protected]

Paul is the firm's lead for prudential regulation of banks and investment firms. He has over 20 years' industry experience as a manager within bank risk and finance teams and since 2006 has worked as an advisor to banks, investments firms and their regulator. Paul's clients include the UK regulators, a number of the largest global financial services institutions, and smaller banks and new organisations. Paul specialises in the practical application of financial services regulation and assisting clients to implement proportionate regimes for institutions of different size and in different industry sub-sectors. Examples of recent work Paul has undertaken include: contingency plans and stress testing; COREP and FINREP preparations; design of new regional risk function; preparations for FSA liquidity regime; Recovery and Resolution Planning; multiple ICAAP and ILAA reviews; new bank authorisations; s166 engagements on Past Business Reviews


Agenda

1. Why banks fail lessons from the past history repeats

2. Failures during the recent financial crisis

3. Lack of corporate governance

4. NPLs and the asset quality

5. Deleveraging of undercapitalised banks

6. Lack of working capital lending to the corporate sector


Why banks fail lessons from the past history repeats


Changing banking for good- Parliamentary Commission on Banking Standards June 2013


Credit crunch lessons from the past history repeats itself

1970's secondary banking crisis smaller banks fail

1990's

BCCI, Barings, B &C (Atlantic), Barlow Clowes, Polly Peck

Lloyd's insurance

South American financial crisis

Late nineties, noughties

Asian financial crisis

Eastern European Financial crisis

US global Hedge Fund collapses

Enron, Adelphia, Qwest, Tyco, Worldcom, Ahold, Parmalat, Nortel

Late noughties - the global financial crisis banks, investment banks, monoline insurers, hedge funds, Madoff - collapse of trust, loss of confidence in the boards, the rating and news agencies, the regulators and the auditors


The credit crunch lessons from the past - history repeats

Liquidity risk when the tide goes out "you learn who's been swimming naked" or "you see the slime on the stone"

History repeats itself:

Failure of governance and controls, foolish self belief

Fast growth + high returns = High risk

Poor lending and under provision for non-performing loans

Crony capitalism - Lending to individuals (alleged super rich) unholy alliances between management/top customers

High concentration of risk (e.g. property, sovereign debt, geography)

Related party transactions

Lack of liquidity- wholesale funding (interbank lending) dries up

Thin capital and high gearing

Hidden and toxic derivative off-balance-sheet losses

Lack of professional scepticism - trained to assume compliance


Causes of bad debt - history repeats across borders

Bad debts arise due to lack of :

Poor oversight by the board ( )

Management information

Internal controls ( )

Experienced loan officers (know your customer)

Due diligence before payment

Assessment of companies' ability to pay (

Concentration to sectors and groups and name lending

Economic reasons (mainly government policy)

Recession

Sanctions and Volatility (severe currency fluctuations)

Lack of payment by customer's suppliers (e.g. Government)

Imposed debt ( )

Imposed uneconomic interest rates


Credit crunch lessons from the past Some old techniques that are used to hide losses

Develop a fictitious market valuation technique

Swap allegedly good asset for bad and hide losses and help friends

pension fund investments for company investments

public company cash/debt/assets for guarantees or worthless collateral

Do not make a provision for bad debts

Show losses as assets/profits

record proprietary loss in customer name

raid client funds to show performance

record option premiums but not losses

Create income at high risk

buy out of the money options at huge premium

route back funds channelled offshore as income

repo assets and double count the cash as income

do a "great" deal with a counterparty

create a spiral and reduce reserves


Causes of failure European banks

Property Sovereign

debt Name

Lending Debt

Concentration Derivatives

Funding Gap

Fast growth

Corp Gov

UK

Nederland

Ireland Iceland

Spain

Portugal

Italy

Greece

Cyprus


Causes of failure Funding gap

HSBC RBS (1) Barclays Lloyds (2) N'wide N Rock HBOS B&B A&L

Customer loans 461.1 503.2 321.2 200.3 115.9 96.7 395.2 40.6 49.5

Customer Deposits 490.4 419.3 292.4 144.7 89.7 30.1 227.1 23.6 29.6

Funding gap -26.3 83.9 28.8 55.6 26.2 66.6 168.1 17.0 19.9

Self funding ratio 106% 83% 91% 72% 77% 31% 57% 58% 60%

Wholesale funding -6% 17% 9% 28% 23% 69% 43% 42% 40%

Ranking 1 2 3 4

Banks acquired ABN HBOS

Failed banks

Bank borrowing analysis - 30 June 2007


Causes of failure Fast Growth and Concentration of lending

Fast growth systems and controls lag behind critical business needs

Concentration of lending to property sector HBOS

2001 2008 2001 2008 Growth

GBP Billion IR Toman Billion 000

Corporate

Property 20,983 59,002 90,323 253,978 281%

Other 29,592 34,890 127,381 150,184 118%

Total corporate 50,575 93,892 217,703 404,162 186%

Retail

Property 127,636 238,696 549,417 1,027,481 187%

Other 21,574 113,329 92,867 487,831 525%

Total retail 149,210 352,025 642,283 1,515,312 236%

Total lending 199,785 445,917 859,986 1,919,474 223%

Corporate property % 41% 63% 41% 63%


Behaviour under pressure - The causes

Conflicts of interest and incentives fuel bad culture and lead to fatal flaws

Bad culture starts at the top

Management acting as gods, ignoring basic governance principles and controls - this cascades down to senior management and eventually the employees

Clubbiness develops between people with vested interest (major shareholders and customers, management and auditors), fuelled by big interests at stake

Problems never start big - small incremental steps lead to the big ones

At the very top there is an interdependence between big business (bankers, newspaper owners, analysts). If not addressed, this can lead to everything being swept under the carpet and result in grander, greedier and more systemic problems in the future.


Behaviour under pressure - the culture issue

" - Sherron Watkins, the Enron whistle-blower

Sir David Walker oral evidence to the PCBS, page 9 (Q15)

"Paul Volcker - Former chairman of US

Federal Reserve - FT 26 October 2011

Director's pay - the super class

Chief executives of FTSE 100 saw their median earnings soar 32 per cent last year to 3.5 million. This was 120 times that of the average employee, a multiple that has risen

from 45 times since 1998. FT 29 May 2011


Behaviour under pressure - the culture issue

"We have promoted an insider form of capitalism which exploits and indeed creates subsidies and tax loopholes on which the insiders prosper. The need to rescue banks was horrifying. The role of Money in Politics is disturbing.

Market capitalism creates inherent difficulties. The two most obvious are macroeconomic instability and extremes of inequality.

This is not merely inefficient it is unjust. Few begrudge Steve Jobs his fortune. The view on those who emerged rich from rescued businesses is very different. The era of bailouts must end."

Martin Wolf - FT 27 October 2011


HBOS -

27 January 2004 board minutes of HBOS plc record that in the view of the FSA:

Neither the FSA nor HBOS followed through on the implications of this characterisation. The accident happened.

The strategy set by the Board from the creation of the new Group sowed the seeds of its destruction. HBOS set a strategy for aggressive, asset-led growth across divisions over a sustained period. This involved accepting more risk across all divisions of the Group. Although many of the strengths of the two brands within HBOS largely persisted at branch level, the strategy created a new culture in the higher echelons of the bank. This culture was brash, underpinned by a belief that the growing market share was due to a special set of skills which HBOS possessed and which its competitors lacked. The effects of the culture were all the more corrosive when coupled with a lack of corporate self-

in some cases to this day, that HBOS was a conservative institution when in fact it was the very opposite.


Avoiding detection Who pays the price

Ultimately the society: having to pay for bailing out others' systemic failures, or through loss of pension funds, cheap interest for the rich (quantitative easing), government service cuts and higher taxes

Senior management and internal auditors

Directors, non executive directors and employees

Regulators

Auditors?


Failures during the recent financial crisis


Main causes of Bank Failures during the Crisis

United Kingdom

HBOS RBS

Northern Rock

United States

Lehman Brothers Bear Stearns Merrill Lynch

Washington Mutual

Europe

ABN AMRO Fortis Dexia

Spanish "cajas" Allied Irish Bank Bank of Ireland

Alpha Bank Bank of Cyprus

National Bank of Greece

Other

Landsbanki Kaupthing

Too much leverage

Inadequate financial

resources

"Too big to fail"

Poor resolution mechanisms

Product complexity

Poor governance Culture

failure

Unviable business models Failure of risk

management

Interconnect-edness


International Response to the Crisis

Reform capital rules and put in

place measure to mitigate pro-

cyclicality

Focus on better risk management

practices and governance

Strengthening accounting standards

Reforming compensation

OTC derivative markets reform and move to

central clearing

Measures to tackle "too big too fail" and

Systemically- important financial institutions

Hedge fund regulation

Regulatory of Credit rating agencies and reducing

regulatory reliance on them

Adherence to regulatory standards

Establish crisis management

groups

Measures to strengthen liquidity risk management and increase liquid asset

buffers


Key Areas of Reform

Financial Resources

Business Model Risk

Enterprise-wide risk

management

Governance & Culture

Market Conduct

Recovery and Resolution

Bank Authorisations

Market Infrastructure

Shadow Banking


Lack of corporate governance

Sir David Walker


Bank Governance & Culture failings

Regulators globally are making changes and increasing focus on corporate governance to prevent past events from causing a future crisis.

Risk Management

Silo-ed approach to risk management and reporting Basel models backward-looking and data driven High concentration of lending to individuals, sectors and groups Inexperienced loan officers who know the customers Lending before sufficient due diligence Inadequate MI Correlations not fully understood Lack of Stress Testing Lack of holistic and joined up enterprise-wide risk management frameworks

Governance & Culture

failings prior to the

Financial Crisis

Board and Senior Management

Did not challenge the executive or understand their business models Did not fully understand the business and the associated risks of certain activities and products (not enough bankers on the Board) Did not have sufficient management information to be able to carry out their oversight

Existing Governance frameworks proved to be a poorly effective check against bad decision-making

Business and strategy

Lack of consideration of risk appetite and return dynamics Unchallenged and weak assumptions Incentive structures flawed and encouraged risk taking behaviour

Case Studies from the UK

Weak lines of defence to identify and address problems before becoming fatal


The Three Lines of Defence Model

Governance and Oversight

Ensures that the business has an effective system of internal control and management of business risks, and is conducted in accordance with the PRA's principles for business

1st Line of Defence Divisional risk management and control Direct responsibility for the management and control of risk

2nd line Defence Group risk review and oversight (Board) Coordinates, facilitates and oversees the effectiveness of the risk management framework

3rd Line of Defence Risk assurance and challenge provides independent assurance and challenge on the integrity and effectiveness of the risk management framework

Internal audit Audit committee

Remuneration Committee

Nominations Committee

Board Board risk committee

Risk Management Compliance Risk committee Compliance committee

Executive committee Lines of business Operations


Bringing Governance and Culture together "Tone from the Top"

Governance

Responsibility of Board and senior management to steward the Firm prudently goes beyond 'letter of the law' compliance oversight and challenge

Board responsible for setting the overall strategy and policies

Embed a safety and soundness culture throughout the whole organisation

Culture

Culture should support prudent management: (i) proactively seek to understand circumstances that impact viability (ii) challenge accepted orthodoxies (iii) take action

Values should be set having regard to the interest of stakeholders and embedded from top to bottom

Controls should prevent excessive risk taking

Remuneration structures should reward prudent management

Approach to regulator should be open and cooperative

Competence

Board (including NEDs) need to have sufficient experience and time to perform their roles

The Board should have a mix of skills to understand the breadth of the business

Regulators will challenge the Board on the performance of senior management and will scrutinise appointments to significant functions.

Structures

Clear structures of accountability and delegation for individuals and committees

Appropriate structures in respect of unregulated entities in the Group, holding companies, and overseas subsidiaries and branches.


Factors that enable sustainable performance


NPLs and the asset quality


Causes of bad debt

Bad debts arise due to lack of :

Poor oversight by the board ( )

Management information

Internal controls ( )

Experienced loan officers (know your customer)

Due diligence before payment

Assessment of companies' ability to pay (

Concentration to sectors and groups and name lending

Economic reasons (mainly government policy)

Recession

Sanctions and Volatility (severe currency fluctuations)

Lack of payment by customer's suppliers (e.g. Government)

Imposed debt ( )

Imposed uneconomic interest rates


NPLs and the asset quality

Non-performing loans and poor quality assets can:

Increase leverage

Stifle lending activity

Use up capital

Create 'zombie banks' on the verge of solvency

The solutions introduced are:

Asset quality reviews and stress testing to assess values and provisions

Creation of Good Bank / Bad Bank

Recapitalisation or closure


Stress testing and asset quality exercises by different regulators

Name of Exercise Regulator Stress Bank role Regulator Role Output

Internal Capital Adequacy Assessment Process (ICAAP)

National Capital Conducts stress

Reviews the bank's assumptions, methodology and outputs

Output of the stress will be reflected in capital requirements.

Individual Liquidity Adequacy Assessment (ILAA)

UK Liquidity Conducts stress

Reviews the bank's assumptions, methodology and outputs

Output of the stress will be reflected in liquid asset buffer.

Supervisory Stress Testing - Firm Data Submission Framework (FDSF)

UK Capital Submits data

Performs the stress using own model

Used as a supervision tool. May require recapitalisation

EBA stress test EBA Capital Submits data


May require recapitalisation

Comprehensive Assessment (including AQR)

European Capital Submits data


May require recapitalisation and will impact level of supervision

Comprehensive Capital Analysis and Review (C-CAR)

US Capital Submits data

Performs the stress May require recapitalisation


The AQR Reviews

The AQR Methodology Data integrity validation

Selected portfolios sampled for review

Accounting and process adjustments as a result of AQR findings

Assessment of the adequacy of banks' asset valuation, classification of non-performing exposures, collateral and provisioning

Grant Thornton has been undertaking AQRs across Europe.


Enterprise-wide stress testing and financial stability

All Banks need to: define their risk tolerance and appetite stress capital plans and assumptions prepare for failure


Deleveraging of undercapitalised banks


Greater focus on risk-based capital measures Basel II

Minimum Capital

Requirements:

Formulaic approach to:

- Credit Risk

- Market Risk

- Operational Risk

New risk based Regime

Different levels of sophistication allowed

Banks can use models to set credit and operational risk

Pillar 1

Market Disclosure:

Risk profile

Risk Management processes

Adequacy of Pillar 1 capital position

Composition of capital

Pillar 3

Firm Assessment and supervisory review:

Risks not in/adequately covered in Pillar I

Assessment of capital needed to cover the risks

Forward looking firm wide stress testing

Overall supervisory assessment

Pillar 2

Pillar 1: Formulaic approach has greater risk coverage (credit, market and operational risk) and allows the use of internal models

Pillar 2: Supplemented by internal risk assessment of all risk types and supervisory review

Pillar 3: Market discipline through enhanced disclosures


Reforming the regulatory capital regime

Basel III

Increasing quality of regulatory

capital All capital must have

loss absorbency

features

Increasing the quantity

of capital

Changes to regulatory deductions

Forward looking

provisions

Capital buffers

Counterparty credit risk

capital requirements

Transition path for Basel III Reforms Key Basel III Capital Reforms


Introduction of Capital Buffers

Countercyclical capital buffer

countercyclical capital buffer should be built up when aggregate growth in credit and other asset classes are judged to be associated with a build-up of system-wide risk, and drawn down during stressed periods. CRR

Countercyclical buffer within a range of 0% 2.5% of common equity

Purpose of buffer is to achieve the broader macroprudential goal of protecting banking sector from periods of excess aggregate credit growth

Capital Conservation Buffer

The Capital Conservation Buffer is 2.5% of CET1.

Purpose of the buffer is to ensure that firms accumulate, during periods of economic growth, a sufficient capital base to absorb losses in stressed periods.

Impact of the Capital Buffers

The combined buffer (capital conservation buffer plus countercyclical capital buffer) must be met with CET1 capital by all firms.

Firms which do not meet the combined buffer become automatically subject to distribution constraints and must submit a capital conservation plan to the regulator explaining how they will meet the combined buffer within an appropriate timeframe.

Economic Cycle

Capital Conservation Buffer: fixed 2.5% CET1 only to be drawn in stress conditions

Countercyclical Capital Buffer: variable 0-2.5% depending on economic cycle


Tackling "Too Big to Fail"

Global Systemically Important Banks (G-SIBS)

The financial crisis revealed the Global economy to be vulnerable to the failure of large internationally active financial institutions to a surprising and unforeseen degree.

International policy-makers have developed additional policy measures to apply to G-SIBS to mitigate the risk that they pose to the global financial system and which other regulatory reforms are not perceived to address. The G-SIB assessment methodology is one of a number of measures aimed to:

Reduce the probability of G-SIB failure by increasing going-concern loss absorbency.

Reduce the impact of G-SIB failure by strengthening global recovery & resolution frameworks.

Bucket

(Buffer Capital %) G-SIBS in alphabetical order by bucket

5 (3.5%)

None

4 (2.5%)

HSBC JP Morgan Chase

3 (2.0%)

Barclays BNP Paribas

Citigroup Deutsche Bank

2 (1.5%)

Bank of America Credit Suisse Goldman Sachs

Group Agricole Mitsubishi UFJ FG Morgan Stanley

Royal Bank of Scotland UBS

1 (1.0%)

Bank of China Bank of New York Mellon BBVA Groupe BPCE Industrial and Commercial Bank of China

ING Bank Mizuho FG Nordea Santander

Standard Chartered State Street Sumitomo Mitsui FG Unicredit Group Wells Fargo

Category (and weighting)

Individual indicator Weighting

Cross-jurisdictional activity (20%)

Cross-jurisdictional claims 10%

Cross-jurisdictional liabilities 10%

Size (20%) Total exposures as defined for use in the Basel III leverage ratio

20%

Interconnectedness (20%)

Intra-financial system assets 6.67%

Intra-financial system liabilities 6.67%

Securities outstanding 6.67%

Substitutability/financial institution infrastructure (20%)

Assets under custody 6.67%

Payments activity 6.67%

Underwritten transactions in debt and equity markets

6.67%

Complexity (20%) Notional amount of over-the-counter (OTC) derivatives

6.67%

Level 3 assets 6.67%

Trading and available-for-sale securities

6.67%


Holding sufficient liquidity

Banks should have sufficient high quality, unencumbered assets in order to meet stress scenario, specified by the supervisor.

Stock of high quality liquid assets

> 100% (broadened to include more sovereigns and Level 2 assets 40% of stock e.g., covered bonds, non-financial corporates).

Net cash outflows over 30 days

Run off rate floors reduced e.g., retail/SME-SME lowered to 5% (stable), 10% (less stable).

Intended to promote longer-term structural funding by requiring that the ratio of available stable funding to required stable funding exceeds 100% over a one year time horizon

Available amount of stable funding > 100%

Increased stable funding % for core retail businesses

Lower required stable funding for residential mortgages 65% not 100%

Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR)

Reporting

Contractual cash flow mismatch reporting (regulatory report)

Concentration of funding (regulatory report)

Available unencumbered assets (regulatory report)

Market-related monitoring tools


Non-risk based leverage cap

Build up of Leverage prior to crisis

In the years before the financial crisis, leverage in the financial system increased markedly. Growth in assets outstripped growth in capital.

Basel III Leverage Ratio

The leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets. The leverage ratio is still under discussion but current indications are that it will be 3%.

There are long timelines to disclosure (2015) and implementation (2018). Gives time to adjust ratio but market may front run.

If it binds it will provide incentives to search for yield and may encourage offloading high quality assets.


Lack of working capital lending to the corporate sector


The problem of a lack of working capital lending by banks

Similar problems exist in the UK and Europe

Consequences for the economy are lack of investment and a prolonged recession

The reasons are highly leveraged banks with significant NPLs and poor liquidity

This creates a vicious circle negatively impacting asset values and further deteriorating bank security values


Measures introduced

Government and public pressure on banks (did not work!)

Low (negative) real interest rates and quantitative easing

releasing liquidity by purchase of assets

Government guaranteed corporate lending

"Funding for Lending Scheme (FLS)" introduced in 2012 with the aim to increase bank lending by 70bn

Bank of England allows commercial banks to borrow funds cheaply so that banks pass this on as cheap loans to businesses

Debate as to the success of the scheme, with net lending down (either due to banks unwilling to lend or business unwilling to take on additional debt)

Government assisted house purchase schemes "Help to buy"

Equity loan 10bn of additional investment to help home ownership. The government provides an equity loan up to 20% of the value of the new build home if purchaser provides 5% deposit. The loan is interest free for first 5 years

Mortgage guarantee aims to increase the supply of high loan-to-value mortgages by offering a government guarantee to lenders who provide mortgages to people with a deposit of between 5% and 20%


Questions from the floor. Thank you

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