Westpac and the new financial regulations

1. Westpac and the new financial regulations Do we think that Basel’s faulty?

2. Contents • A brief biography – how did I end up running the Basel program? • A brief description of Westpac – how does it compare to global peers? • Westpac and Basel II

3. My resume • Law school dropout • Honours in Pure Maths and Statistics • UNSW graduate • 8 years experience in Australian banking industry • Manage Westpac’s sponsorship of Co-op program • Responsible for Basel II and Active Portfolio Management

4. Why would a quant be interested in Basel II? • New global financial regulations from 2007 • 3 Pillars • Regulation, Supervision, Disclosure • The regulations favour banks with sophisticated credit and operational risk management data, processes and analysis • ie, all Australian major banks • APRA requires the Australian majors to be compliant with the most sophisticated approaches for both credit and operational risk

5. Economic Capital has been an area of intensive research for the last 8 years • Current banking regulations are not risk-sensitive • Basel II permits different methods for measuring credit and operational risk • If sophisticated methods are used, there is greater alignment between the capital needed in order to operate and the capital needed in order to be allowed to operate

6. An introduction to Westpac Banking Corporation

7. Westpac at a glance • Established 1817 • Top 100 bank globally1 • Core markets of Australia, New Zealand and near Pacific • 7.5 million customers • Aa3/AA- rating • Leader in sustainability • Euromoney June 2003 • Cash earnings basis • As at 30 June 2003

8. London New York Sydney Wellington Westpac at a glance Net profit after tax Share price performance Westpac operates a full range of traditional banking services with operations focused across Australia, New Zealand and Pacific Region Over a period of 5 years total return for Westpac has been in excess of 59% NPAT by business segment Global locations Westpac has 24 hour global coverage, with offices in Australia, New Zealand, New York and London All business segments contributed to the 1H03 result with Business & Consumer Banking providing the largest contribution

9. Consistent shareholder return Oliver, Wyman & Company global Shareholder Performance Index1 (SPITM) - 2002 1 Shareholder Performance Index – annual benchmark for volatility-adjusted shareholder value performance amongst the largest financial institutions in the world.

10. Leader in sustainability – gaining recognition • Ranked number one in the global banking sector by the Dow JonesSustainabilityIndex • Ranked third globally in the banking sector by oekom Corporate Responsibility Rating • United Nations Association of Australia Triple Bottom Line Award 2002 2003 Social Impact Report1 Reporting on Westpac’s corporate responsibility policies, practices and performance 1 Available at www.westpac.com.au under ‘Westpac Info’, then ‘Social accountability’

11. Westpac’s Basel II experience What are the two most important things to know?

12. Number 1… Basel is a long way away

13. Number 2… Basel II is very good news • Good for APRA • Good for Australian banks • Good for investors and those who analyse Australian banks • Despite the challenges… • Basel II is good for Westpac

14. Basel II is good for APRA • Provides deeper insight into bank risk management • Gives greater comfort in the robustness of risk management practices in Australia • Compliance simplifies operational risk management practices • APRA has provided significant input to the Accord

15. APRA expects the 4 Australian majors to comply with the most sophisticated models International peer analysis shows Australian bank risk-adjusted assets to decrease by more than any other jurisdiction APRA expects “moderate” capital relief for the 4 majors and “modest” relief for regional banks Differences are attributable to: balance sheet structure different risk profiles Basel II shows Australian banks to be safe

16. Basel II is good for bank stakeholders Consistent disclosure Debt investors & Rating Agencies Global comparability Greater rigour of balance sheet analysis Equity investors/analysts More finely honed modelling assessing relative risk between issuers Better understanding ofrisk / reward Fundamental value

17. Basel II reduces the perceived ‘black box’ component of a bank’s business Disclosed risks Disclosed risks Increased transparency Risks Undisclosed risks Reduced ‘Black Box’ Undisclosed risks Today Pillar 3

18. Westpac disclosed its Basel II results early

19. ….which is starting to pay dividends • Equity investors: • Preliminary results support relative improvement in P/E’s of Australian Banks • Tangible evidence of lower risk profile of Westpac • Equity investors starting to engage on Basel II • Debt investors: • Australian issuers already starting to see price differential in offshore capital markets • Greater data granularity will lead to refinement of pricing decisions (measured in bps)

20. Making credit data accessible is time consuming Discretion needed to avoid disrupting the Australian Securitisation Industry Proposing an objective way to make LGD’s conservative Suggestions that a significant pro-cyclicality capital buffer be required – not supported by Westpac stress testing Basel II compliance hurdles can be overcome

21. Conservative LGDs – part of pillar 1 “… it is important that banks utilise default-weighted averages… in computing loss severity estimates. Moreover, for exposures for which LGD estimates are volatile over the economic cycle, the bank must use LGD estimates that are appropriate for an economic downturn if those are more conservative than the long-run average” – Para 430 • US and UK regulators have not provided clear guidance on what this means

22. Westpac’s LGDs are both conservative and compliant WBC submission in QIS 3 study WBC actual LGD 1Costs include legal fees and other workout costs

23. Why not discount at the cost of equity? • Basel II implementation should not get any more complicated • US and UK proposals for conservative LGDs introduce subjectivity where none need exist • The 4 major Australian banks report very similar costs of equity so LGDs will be readily comparable between peers

24. Credit stress tests are becoming an increasingly important part of the Accord “…the bank must perform a credit risk stress test to assess the effect of certain specific conditions on its IRB regulatory capital requirements. …. The bank’s stress test in this context should, however, consider at least the effect of mild recession scenarios. In this case, one example might be to use two consecutive quarters of zero growth to assess the effect on the bank’s PDs, LGDs, and EAD, taking account – on a conservative basis – of the bank’s international diversification” - Para 397 “… the bank must include a consideration of….. the ratings migration of at least some of its exposures” - Para 398

25. Basel II is good for Westpac • Westpac has been working on Basel compliance for three years • Early results support the hypothesis that we were “safer” than previously perceived • Deeper analysis with each iteration of the Accord - yet to find evidence to contradict this assertion • Feedback from stakeholders has been positive

26. And isn’t that good news!