Creating Shareholder ValueCreating Shareholder Value

Alan Jette – SVP Treasury & Balance Sheet ManagementAlan Jette – SVP Treasury & Balance Sheet Management

Presentation to the ICPMPresentation to the ICPM

3 June 20083 June 2008

2

Emperor Exposed – What Went Wrong?

• The last year has been a wrecking yard of bank earnings, writedowns, and shotgun mergers to avoid bankruptcies / insolvencies

Fundamentally banks lost track of what creates shareholder value

ABCP

3

Creating Shareholder Value

• Bank’s create Shareholder Value Added (SVA) by adhering to a disciplined Risk Adjusted Performance Measurement (RAPM) process focusing on:

– Risk adjusted earnings on Required Risk Based Capital

– Generating stable, sustainable, growing earnings over time

Shareholder Value

MV

BV

ROE - Cost of Equity

Cost of Equity - Growth= = 1 +

PositiveEconomic Profit

Stable EarningsSustainable

Growth

Product Profitability P&L

Net Interest Income

+ Fee Income

+ Net Interest on Equity

- Expected Credit Losses

= Net Revenue

- Expenses & Taxes

= Net Income after Tax

- Risk Based Capital Charge

= Economic Profit (EP)

TD’s Intrinsic Value Formula

4

RAPM – Key Components

• Components

1. Funds Transfer Pricing - assigns fully hedged cost of funds to all lending and deposit exposures

2. Expected Credit Loss Assessments for pricing and provisioning

3. Risk Based Capital Allocations

4. Differentiation between Productive and Non-Productive risk

• Keys to Success

– No exceptions or sacred cows

– No internal arbitrage opportunities

– No black boxes - full transparency of process, and results

5

Funds Transfer Pricing System

• All loan and deposit positions transfer priced explicit cost of funds on a fully hedged, option adjusted funding basis

• Liquidity premiums are assigned with an explicit term structure independent from market risk

• Market and liquidity risk is transferred to treasury and managed centrally

Net Interest Income - Fully Hedged and Transfer Priced

1.5

2.5

3.5

4.5

5.5

6.5

7.5

6m 1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr

%

Cost of Funds Deposits Loans

Fully Hedged Option Adjusted Cost of Funds

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

6m 1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr

%

Gov't Sw aps Cost of Funds Option Adjusted COF

Liquidity Prem Term Structure

Option Cost

FTP allocates true funding costs and creates transparency of results

6

Expected Credit Loss and Risk Based Capital

• Product pricing and provisioning should reflect fair “through the cycle” credit costs and a risk adjusted capital allocation calibrated to absorb extreme “tail” events

Adjusted TDCT Residential Mortgage Credit Loss

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

Pro

visi

on

s fo

r C

red

it L

oss

Residential Mortgage Capital Provision

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

Pro

visi

on

s fo

r C

red

it L

oss

Greater conservatism should be used for “untested” risks (Subprime)

Expected Credit Losses

• Reflect through the cycle credit costs

2 cycle average

10yr avg

Credit Risk Capital

• Calibrate “tail” to absorb true 1 in 2000 event (AA default prob)

7

Differentiate Between Productiveand Unproductive Risks

Market Risk (non Trading)

• Market risk is not a productive risk for a personal & commercial Bank

• Exposures do not effectively leverage the retail franchise

US Banks: “we have to take interest rate risk to make money”

Theory: don’t need a retail bank infrastructure for investor to earn returns from market risk

• Structural interest rate gap positions are an explicit position and view/bet on the market

• Option Hedging

– Locks in expected costs and eliminates potential for earnings variability

– Does not create incremental costs

– Reduces economic capital required

8

3. Differentiate Between Productive and Unproductive Risks

Credit Risk

• Organic credit risk is a productive risk for a Personal & Commercial Bank

• Leverage the Bank’s franchise value to intermediate with individual customers

– Creates excess spread relative to long run expected losses and capital costs

• Wholesale credit exposures is more efficient and presents lower opportunities for risk adjusted returns

– Securitization market

– Purchased whole loan

– Syndications

9

US Bank Strategies to IncreaseNominal Returns

1. Interest Rate Gap Carry Trade

2. Credit Carry Trade

3. Structured Products with Embedded Optionality

10

Classic Gap Trade Trap

• Large Carry from Steep Yield Curve (2003-04)

– Bank’s enticed to borrow short term and lend long

– Earn substantial non-franchise earnings (some cases up to 40% of total)

• Yield Curve Flattens and Carry Declines (2005)

– Carry yield declines as short term roll-over borrowing costs rise

– Doubles down carry volumes to main earnings contribution

• Yield curve flat / inverted (2006-07)

– Negative contribution to earnings– Locked into positions/losses as MV assets

now less than MV liabilities – Exiting will realize remaining losses

Gap Carry(5yr Libor minus 3mth Libor)

-1.0

-0.5

0.0

0.51.0

1.5

2.0

2.5

3.0

2003 2004 2005 2006 2007

% Y

ield

Gap Notional

0

5,000

10,000

15,000

20,000

2003 2004 2005 2006 2007

($M

illio

ns)

Gap Net Interest Income

-100

0

100

200

300

2003 2004 2005 2006 2007

($M

illio

ns)

11

Disappearing Gap NII leads to Credit Carry Trade

• Pressure to replace declining gap earnings leads to credit carry

– Investors demand QoQ earnings growth

• ‘Non-Prime’ Mortgage products such as HELOC and 2nd Lien Mortgages offered large gross yields

– Yields not properly risk adjusted for true credit risk and capital costs

• 2007/08 – Mortgage market implodes

• Other firms replaced gap carry losses with structured interest rate risk yields

– Nominally positive yield carry is negative value on risk / option adjusted basis

Non-Core Net Interest Income

-100

0

100

200

300

400

2003 2004 2005 2006 2007

($M

illio

ns)

Gap NII Credit NII

'Non-Prime' Mortgage Notional

0

4,000

8,000

12,000

16,000

2003 2004 2005 2006 2007

($M

illi

on

s)

US NonPrime Mortgage - Credit Carry

-500

50100150200250300350

Lib

or

+ S

pre

ad

Agency MBS 30yr OAS 'Non Prime' Gross Yield

Option and Credit Carry

12

What Went Wrong

• Competitive pressures and market forces reduced core earnings growth

• Banks implemented strategies to generate non-core, non-controllable sources of earnings

• Inflated market valuations based on reported, nominal earnings growth created the need to sustain earnings over time

• Lack of transparency as to sources of earnings

• Lack of understanding and required disclosures around quality of earnings, balance sheet capacity utilization and liquidity risk by

– Senior management 3-4 levels removed from risk taking– Boards– Shareholders– Regulators– Rating Agencies

• Did boards understand the “type” earnings firms were generating?

• Did shareholders understand the type of earnings they were valuing?

13

Structural Incentives - Regulatory

• Regulatory capital rules distort economic incentives– Tier 1 Leverage Test establishes a floor capital to asset ratio– Creates minimum capital requirement and earnings hurdle regardless of risk based

capital requirements– Banks penalized for operating a low credit risk strategy and rewarded for increasing

risk– No capital related to non-credit risks such as structural interest rate risk

Effective US Regulatory Capital by Risk Weight

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

0% 10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

120%

Risk Weight

T1

Cap

ital

Req

't (%

ass

et)

Tier 1 Leverage Test (6% of nominal)

Risk Based Capital Requiement

Penalizes low risk strategies

Uncontrained Risk (Basel 1 max 100%)

14

Structural Incentives - Compensation

• Compensation schemes did not create the proper incentives

• Standard compensation schemes focused on

– Year over year EPS growth

– Top line revenue growth

• Performance targets short term and not aligned with creating shareholder value

• UBS Shareholder Report Quote

“ Structural incentives to implement carry trade: the UBS compensation and incentivisation structure did not effectively differentiate between the creation of alpha versus creation of return based on a low cost of funding”

“Bonuses were measured against gross revenue … with no formal account taken of the quality or sustainability of those earnings”

15

Paying the Price

• After the decline in Gap Earnings and loss of NII growth – US Bank’s still didn’t show price declines

• Consolidation premiums actually increased

• But now – buyers can’t afford and sellers too risky

1 Yr Total Portfolio Return

30%

40%

50%

60%

70%

80%

90%

100%

110%

May

-07

Jun-

07

Jul-0

7

Aug

-07

Sep

-07

Oct

-07

Nov

-07

Dec

-07

Jan-

08

Feb

-08

Mar

-08

Apr

-08

Date

$ p

er S

har

e

TD-TSX L Cap

US Bank YoY Change in M arket Cap

-90%

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

TD

(C

$)

PN

C

MT

B

BB

T

WF

C

BA

C

KE

Y

ST

I

CO

F

RF

SO

V

WB

FIT

B

C WM

NC

C

% Change (YoY)

16

Culture not Process

TD Experience

“It’s the culture of risk management which saves you” – CEO

• Creating and maintaining franchise value is central to the kinds of risks you take and in what quantity

• The retail bank franchise generates stable, predictable and sustainable core earnings that create economic profit and SVA

• Its fundamental that if something generates an abnormal excess return it must have more risk than you are measuring – you are being transferred the risk

• The culture must support the requirement for transparency and explainability of financial results

17

Culture not Process

Danger Signs

• Businesses earning high nominal income

• Over reliance on equivalent exposure measures that don’t generate material need for capital on large notional positions

• Securities that earn returns well in excess of stated risk profile

– AAA CDO’s trading at L+100

• Strategies that rely on increasing balance sheet capacity to remain “hedged”

Practical Constraints

• Set “Dumb Limits” on exposure especially when tail risk is unknown

• Don’t rely on outside evaluation of risk

• Understand the drivers of excess (alpha) returns