The IRB Project in Overview Laurie Mayers Group Head of Basel 2 &

1. The IRB Project in Overview Laurie Mayers Group Head of Basel 2 & Credit Risk Systems Co-ordination The Royal Bank of Scotland Group

2. Agenda 1 Guiding Principles Challenges Facing Banks General Approach Wholesale IRB Retail IRB Implementation of Infrastructure Managing Expectations 2 3 4 5 6 7

3. Guiding Principles • Consistency • Models are developed centrally or within Divisions with central oversight to ensure consistency of approach and standards • The aim is to create ‘Centres of Excellence’ across the Group • Models are made available to other parts of the Group through systems infrastructure • Appropriateness • Centrally developed models must be modified for roll out to portfolios to reflect jurisdiction requirements, legal differences or other specificities • Strategic Objectives • Focus on costs and benefit: model development/enhancement driven by materiality of portfolios and data availability • Common Infrastructure • As much as possible, models are implemented on common systems, with access provided via the internet and aligned where possible to risk workflow processes • Guided by Prudent Risk Management Practice • Model development and use should enhance internal risk management practice • Avoid implementing a solution in line with the Basel 2 minimum standards that represents a “step backwards” for internal risk management

4. Challenges Facing Banks - Group Level Issues Internationally active banks face the following challenges: • Home: Host Issues • Implementation and validation requirements may differ between geographies, even within the EU • Scope of application differs between geographies (e.g. USA vs EU) • Use Test requirements • Managing significant cultural change in a very short period of time • Incorporation of IRB “thinking” into budgeting and forecasting processes and acquisition and disposal strategies • Education & Communication: • Engaging and educating Board and Executive Management • Achieving and maintaining sufficient focus given 2007 timeframes • Communication and training for risk management, audit, finance and strategy staff • Resources • Budgets and business prioritisation • Acquiring sufficient skills and resources to get the work done in required timeframes

5. GROUP FUNCTIONS Challenges Facing Bans - Scale of the Problem • WHOLESALE DIVISIONS • Corporate & Investment Bank • Corporate & Commercial Bank • Financial Markets • Lombard Leasing • Greenwich Capital • MIXED WHOLESALE/RETAIL • DIVISIONS • - Citizens • Ulster Bank • Wealth Management • RETAIL & INSURANCE DIVISIONS • Retail Direct • Retail Bank • Direct Line

6. Wholesale IRB – Challenges • Implementation of IRB within the wholesale divisions of RBSG is not a single model problem, it is a many model problem • In the wholesale divisions of RBSG, there are at least 25 models that need to be developed or brought into compliance with Basel standards

7. Wholesale IRB – Approach • Banks use different types of corporate grading depending on their chosen risk management approach: • Some banks derive PDs and determine LGDs • Some assign ratings and map these ratings to PDs • All models/approaches include a significant input based on expert judgment, both from credit risk officers and relationship managers • Validation: • Banks validate PDs against actual experience and/or external data, covering a broad range of practice reflecting availability of internal data • RBSG Focus: • Our focus has been on accurate ratings of counterparties in order to maintain credit quality within the portfolio and to ensure appropriateness of pricing • For the most part we use scorecard based approaches mapped to external sources of PDs • Significant work will need to be done to increase the robustness of models to meet Basel 2 standards

8. Wholesale IRB – Implementation Issues The Accord deviates from current risk management practice: • Definition of Default for Leasing (90 day definition of default) and requirement for automatic cross default • Requirement for LGD to cover losses in an economic downturn • Good Quality Portfolios: we are still trying to decide what approach to take for good quality, low loss experience business portfolios, such as Project Finance and Leasing • The collection of sufficient historical data is complicated by the merger of two institutions and migration onto common platforms

9. Wholesale IRB – Evolution and Pragmatism? • Evolution: In meeting the full requirements of IRB, banks need to be allowed the opportunity to: • Evolve their practices as they improve the quality of their internal data and model sophistication • Educate and train staff and management, the front office and the investor community • Pragmatism: • RBSG supports the concept of a single IRB, combining the Foundation and Advanced IRB approaches • Allow banks to make pragmatic decisions whether to develop data histories for certain portfolios on a cost/benefit basis • Would allow banks to evolve through a single IRB, initially using regulatory inputs for LGD and EAD for some portfolios and internal assessment for others. Such an approach would logically lead to the removal of the ‘cliff effects’ and other/perverse incentives that exist to some extent between FIRB and AIRB

10. Retail IRB – Application • Within the UK, Retail practices are already more closely aligned to the proposed Basel 2 standards • Systems are already more automated, working on centralised platforms with less expert judgment • Typically, different types of models are used for mortgages, cards and personal/SME businesses • Banks typically use multi-factor models, either application or behavioral scoring, to provide a point-in-time and/or on-going prediction of default and loss given default • Generally, models are more dynamic based on point-in-time estimates of default having a forward looking default horizon of 12 months

11. Retail IRB – Challenges A different range of technical issues arise within Retail portfolios: • Definition of Default: many banks already use Definitions of Default that are more complex (and appropriate) than just a monitoring of days past due • Need for permanent use of Point-In-Time vs Through the Cycle estimates of default • SME/Retail Boundary €1m: Addressing the boundary issue for IRB may mean that banks will be asked to calculate capital differently from the way they manage risk However, the following issues are common with Wholesale: • Demand for budget and skilled resources (but to a lesser extent) • The cultural change Basel 2 implementation will represent • Collection of sufficient historical data complicated by merger of two institutions

12. Implementation of Infrastructure What does it comprise? • Model Development • Automation and development of models • Implementation of bottom up aggregation, storage and reporting infrastructure • Reconciliation of risk and finance data • Enhanced MI capabilities

13. Managing the Market • Comparability • “The national differences on WRA calculations will be so subjective for the large banks as to create genuine uncertainty over relative capital strength and, in turn, cash flows and market values. A further layer of “information asymmetry” will, in other words, enter the equation.” (William de Winton, Morgan Stanley) • Complexity • Concepts of grading and portfolio modeling not widely understood within banks or by the market • Disclosures Under Pillar 3 • Need to be comprehensible to the market, so information disclosed is not misunderstood or compared inappropriately • Rating Agency Views • How will their views on capital adequacy change in light of more volatile WRAs and Tier 1 ratios?