RISK MANAGEMENT REPORT BANCO DO BRASIL S.A.

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2 RISK MANAGEMENT REPORT BANCO DO BRASIL S.A. 2nd quarter of 2011

3 Summary List of Tables... 3 List of Figures Introduction CEO s Message Governance... 8 Risk Exposure... 8 Types of Risks... 8 Corporate Risk Governance Risk Management Process Reports Regulation Basel Accord Background Basel I Market Risk Amendment Basel II Basel III Basel II at Banco do Brasil Regulations Financial Conglomerate Financial Conglomerate Credit Risk Market and Liquidity Risks Operational Risk Non-financial Companies Capital Regulatory Capital Referential Equity (PR) Required Referential Equity (PRE) Basel Index (IB) Economic Capital Banco do Brasil S.A. 2

4 List of Tables Table 1. Timetable for Basel III Implementation in Brazil Table 2. Credit-risk exposure by Risk Weights Table 3. Average credit-risk exposure in each quarter Table 4. Credit-risk exposure by geographic region and country Table 5. Credit-risk exposure of the financial conglomerate by economic sector Table 6. Credit-risk exposure of the economic-financial consolidated group by economic sector: Table 7. Amount of transactions in arrears Table 8. Concentration levels of the ten biggest clients in relation to the total from lending transactions Table 9. Flow of transactions written-off Table 10. Stock of allowances for doubtful accounts Table 11. Loss operations assigned, with substantial transfer of risks and benefits Table 12. Value of the exposures derived from acquiring FIDC and CRI Table 13. Notional value of contracts to be liquidated in clearing house liquidation systems, in which the house acts as central counterparty Table 14. Notional value of contracts subject to counterparty credit risks in which clearing houses do not act as central counterparty Table 15. Notional value of contracts where clearing houses did not act as central counterparty, and which do not have guarantees Table 16. Notional value of contracts where clearing houses did not act as central counterparty, and which do have guarantees Table 17. Positive gross value of contracts subject to counterparty credit risks, not taking into account the positive values from compensation agreements, as set forth in CMN Resolution 3.263/ Table 18. The value of guarantees which cumulatively meet the requirements of paragraph VI, Article 8, of Bacen Circular 3.477/09: Table 19. Notional value of credit derivatives Table 20. Mitigated value of exposure, weighted by respective risk factors Table 21. Derivative financial instruments in the country and abroad, by market risk factor, with and without central counterparty 2Q Table 22. Derivative financial instruments in the country and abroad, by market risk factor, with and without central counterparty 3Q Table 23. Derivative financial instruments in the country and abroad, by market risk factor, with and without central counterparty 4Q Table 24. Derivative financial instruments in the country and abroad, by market risk factor, with and without central counterparty 1Q Table 25. Derivative financial instruments in the country and abroad, by market risk factor, with and without central counterparty 2Q Table 26. Total value of the Negotiable Portfolio by relevant market risk factor, divided into positions bought and positions sold 2Q Table 27. Total value of the Negotiable Portfolio by relevant market risk factor, divided into positions bought and positions sold 3Q Table 28. Total value of the Negotiable Portfolio by relevant market risk factor, divided into positions bought and positions sold 4Q Banco do Brasil S.A. 3

5 Table 29. Total value of the Negotiable Portfolio by relevant market risk factor, divided into positions bought and positions sold 1Q Table 30. Total value of the Negotiable Portfolio by relevant market risk factor, divided into positions bought and positions sold 2Q Table 31. Phases of the operational risk management process Table 32. Monitoring of operating losses Table 33. Referential Equity Table 34. Capital and Retained Earnings Table 35. Equity valuation adjustments Table 36. Non Controlling Participation Table 37. Perpetual Bonds Table 38. Subordinated Debt Table 39. Subordinated Debt Eligible as Capital Table 40. Perpetual Bonds Table 41. Financial Instruments excluded from the PR Table 42. PR historical series Financial Conglomerate Table 43. PR historical series Consolidated Economic and Financial Table 44. Required Referential Equity for the Financial Conglomerate Table 45. Required Referential Equity for the Consolidated Economic Financial Table 46. The Basel ratio and capital margin Financial Conglomerate Table 47. The Basel ratio and capital margin Consolidated Economic and Financial Table 48. Economic Capital Table 49. Distribution of economic capital in the credit portfolio Table 50. Economic capital for market risk, by risk factors Table 51. Economic capital for operational risk, by loss event category Banco do Brasil S.A. 4

6 List of Figures Figure 1. Governance Structure Figure 2. Management Structure and Process Figure 3. Basel II Pillars Figure 4. Capital allocation Figure 5. Pillar III Structure Figure 6. Credit-risk management Figure 7. Credit-risk management structure Figure 8. Operational risk management structure Banco do Brasil S.A. 5

7 1. Introduction BB considers risk and capital management as its fundamental vectors for decisionmaking, providing greater stability, better capital allocation, and optimization of the risk-return ratio. The objective of this section is to inform shareholders and interested parties of the management practices and policies that comprise risk management at BB. Banco do Brasil S.A. 6

8 2. CEO s Message Participation by the country s representative in the Basel Committee on Banking Supervision in Switzerland is a source of pride for Brazilians, reaffirming the new level of stability achieved by Brazil s financial system. As is well-known, banking system sustainability is indissolubly linked with riskmanagement policies and mechanisms. The methods of identifying, measuring, assessing, monitoring, and controlling risk safeguard financial institutions in adverse situations and provide support for positive, recurring earnings over time. The expectation of smaller bank spreads reinforces that conviction. Just as important as increasing the volume of business is the consistency of a company s risk governance and the efficiency of its management processes. Institutions that are able to transcend mere compliance with regulatory requirements and take risk into account in a quick and accurate way when making decisions are the ones that will rise to the challenge. Brazil s participation in the Basel Committee on Banking Supervision will encourage broader, timelier adoption of international prudential standards. These new frontiers of the regulatory environment will require Brazilian financial institutions to become more agile and adaptable. In these aspects the bank is mature and conscious of its commitment to its clients, shareholders, investors, and society. Banco do Brasil continually seeks to keep pace with best management practices, including its risk-management architecture, which has a multidimensional scope to address credit, liquidity, market, and operational risks. The specifics are described in this space. Aldemir Bendine Banco do Brasil S.A. 7

9 3. Governance Risk Exposure Changes to the global financial environment, such as market integration through globalization, the emergence of new transactions and products, increasing technological sophistication, and new regulations, have made financial activities and processes - and their risks - ever more complex. Additionally, the lessons learned from financial disasters, such as those of the Metallgesellschatt Group and Barings, have helped show the essential need for risk management in the banking industry. These factors have influenced regulatory agencies and financial institutions to invest in risk management, seeking to strengthen the financial health of banks and to prevent detrimental effects on the financial system. In concert with this outlook, BB has invested in the continual improvement of its riskmanagement process and practices, in accordance with international market benchmarks and the New Basel Accord, known as Basel II, and by the fine-tuning provided by Basel III. Types of Risks The main risks to which BB is exposed in its business are: Situational Risk: arises from the possibility of losses caused by changes to political, cultural, social, economic, or financial conditions in Brazil and other countries. It includes the following risks: a) Strategic Risk risk of losses from adopting unsuccessful strategies, taking into account the dynamics of business and competition, political changes in the country and abroad, and changes in the domestic and global economy; b) Country Risk understood as the possibility of losses associated with nonfulfillment of financial obligations according to negotiated terms by a borrower or counterparty located outside of the country, resulting from actions taken by the government of the country where the borrower or counterparty is located; and transfer risk, understood as the possibility of difficulties occurring during currency conversion of funds received; and c) Systemic Risk Possibility of losses due to the financial difficulties of one or more institutions that cause substantial damage to others, or a disruption of normal operations of the national financial system. Credit Risk: defined as the possibility of losses associated with non-fulfillment by a buyer or a counterparty of their respective financial obligations according to negotiated terms, the devaluation of a loan agreement due to a drop in the borrower s risk rating, a decline in gains or earnings, advantages offered during renegotiation, and recovery costs. Among other things, credit risk is defined as including: Banco do Brasil S.A. 8

10 counterparty credit risk, understood as the possibility of a given counterparty not fulfilling its obligations related to settlement of transactions that involve trading financial assets, including those related to the settlement of financial derivatives; country risk understood as the possibility of losses associated with nonfulfillment of financial obligations according to negotiated terms by a borrower or counterparty located outside of the country, resulting from actions taken by the government of the country where the borrower or counterparty is located; and transfer risk, understood as the possibility of difficulties occurring during currency conversion of funds received; the possibility of having to make disbursements to honor guarantees, bonds, coobligations, credit commitments, or other transactions of a similar nature; and the possibility of losses associated with a loan broker or intervening party not fulfilling their financial obligations according to negotiated terms. Image Risk: possibility of losses from the institution having its name sullied on the market or with authorities, as a result of negative publicity, whether true or not. Market Risk: the possibility of losses from fluctuations of the market value of positions held by a financial institution. It includes the risks of transactions subject to fluctuations of exchange rates, interest rates, share prices, and commodity prices. Legal Risk: this can be defined as the possibility of losses due to fines, penalties or indemnities arising from actions by regulators, and losses due to unfavorable rulings in lawsuits and administrative actions. Liquidity Risk: is the occurrence of imbalances between tradable assets and liabilities payable - "mismatches" between payments and receipts - which can affect the institution s payment ability, taking into account the various currencies and settlement terms of its rights and obligations. Operational Risk: possibility of losses due to failures, deficiencies, or improper internal processes, people and systems or external events. This definition includes the legal risk associated with improper or deficient contracts signed by the institution, as well as sanctions resulting from noncompliance with legal provisions and compensation for damages to third parties resulting from activities engaged in by the institution. Banco do Brasil S.A. 9

11 Corporate Risk Governance The risk-governance model adopted by BB involves a committee and subcommittee structure, with the participation of many units at the bank, addressing the following issues: a) separation of duties: business versus risk; b) specific structure for risk assessment/management; c) defined management process; d) decisions at several hierarchical levels; e) clear rules and authority structure; and f) referring to best management practices. CRG Subcomimtees Portfolio Management and simulations integrated Rating and Measuring Management and Control Models Information Database Market Risk Credit Risk Operation al Risk Other Risks Figure 1. Governance Structure All decisions related to risk management are made jointly and in accordance with BB s guidelines and rules. Banco do Brasil s risk governance, covering the multiple bank and its wholly owned subsidiaries, is centralized in the Global Risk Committee (GRC), consisting of a steering committee, whose main purpose is to establish strategies for risk management, overall risk-exposure limits and levels of conformity and capital allocation in light of risks. Seeking to streamline the management process, several subcommittees were set up to address Credit Risk (CRS), Market and Liquidity Risk (MLRS), and Operational Risk (ORS); they make decisions and/or instruct the GRC, and have delegated decision-making power. The Risk Management Board (DIRIS), which reports to the Office of the Vice President for Credit, Financial Control, and Global Risk, is responsible for managing credit, market, liquidity, and operational risks. This integration provides synergy among processes and specialization, contributing to better allocation of capital while adhering to the New Basel Accord. Banco do Brasil S.A. 10

12 President & Vice- Presidents Global Risk Committee CRG Decision Officers SRML SRC SRO Risk Management Board Boards Business Aréas de Negócio Units Monitoring Aréas de Negócio Units Figure 2. Management Structure and Process Decisions are reported to intervening units through decisions that objectively express the position taken by executive management, guaranteeing application throughout the bank. Risk Management Process The risk-management process involves a continuous flow of information, abiding by the following phases: a) preparation: data gathering and analysis phase. During this stage, risk measures are analyzed and proposed for discussion and deliberation in the subcommittees, and if necessary, for later discussion and deliberation in the GRC; b) decision: decisions are made jointly at the appropriate levels and reported to the intervening units; c) execution: the intervening units implement the decisions made; and d) monitoring/management: the Risk Management Board oversees the process, evaluating compliance with deliberations and their impacts on BB, reporting the status of these actions to the appropriate forum (subcommittee or GRC). Oversight of these decisions and reporting to subcommittees/grc allows for improvement of the management process. Reports Risk-management reports provide support for risk-related decisions in the subcommittees, the Global Risk Committee, the Board of Officers, and the Board of Directors. They are prepared every month and have qualitative and quantitative managerial information about the bank s exposure to risk. They support the Banco do Brasil S.A. 11

13 information disclosed to the market in the Management Report and the Performance Analysis Report. 4. Regulation Basel Accord The rules established by the Basel Committee, from the outset, have always sought to create an international standard that regulators could use to defend the market against risks specific to the financial industry. Background In 1973, the global financial market was undergoing a period of intense volatility with the end of the International Monetary System based on fixed exchange rates. Liberalization of rates required measures to minimize the system s risk. The fragility reached a critical level in 1974 with the occurrence of disruptions on international markets, such as the failure to settle currency contracts due to the insolvency of Germany s Bankhaus Herstatt. At the end of that year, those in charge of banking oversight in the G-10 countries decided to create the Committee on Banking Regulation and Supervision of Practices, headquartered at the Bank of International Settlements (BIS) in Basel, Switzerland. Thus the name, the Basel Committee. The Committee consists of representatives from central banks and authorities with formal responsibility for banking oversight in the G-10 member countries. This Committee discusses issues related to the banking industry, seeking to improve the quality of banking supervision and to strengthen the security of the international banking system. The Committee does not have formal authority for supranational supervision, but it has the goal of inducing behavior in countries that are not members of the G-10. By following committee guidelines, those countries will contribute to improving practices on the international financial market. Basel I In July 1988, after an intense debate, the Basel Accord was executed, defining the mechanisms for measuring credit risk and establishing the minimum-capital requirements to endure risks. This accord is now known as Basel I. The accord s objectives were to strengthen the health and the stability of the international banking system and to minimize the competitive inequalities among internationally active banks. These inequalities were the result of different minimumcapital requirement rules by national regulators. The 1988 Basel Accord defined three concepts: Banco do Brasil S.A. 12

14 Regulatory Capital - the amount of own capital allocated to cover risks, considering the parameters defined by the regulator; Asset Risk Weighting Factors - the exposure of assets (on and off balance sheet) to credit risk is adjusted by varying weights based primarily on the borrower s profile; and Minimum Capital Index to Cover Credit Risk (Basel Index or BIS Ratio) - quotient between risk-bearing capital and risk-weighted assets (on and off balance sheet). If the amount calculated is equal to or greater than 8%, the bank s capital level is sufficient to cover credit risk Market Risk Amendment The advance made with Basel I, in terms of regulations and capital requirements to cover credit risk, was undeniable. However, a few criticisms emerged, making it necessary to improve upon that document within the Basel Committee. Among the adjustments was the need to set aside capital to cover market risks. Thus, in January 1996, an addendum to Basel I was published, called the Market Risk Amendment, whose main features are: expansion of controls over risks incurred by banks; extension of requirements to define minimum (or regulatory) capital, incorporating market risk; and possibility of using internal risk-measurement models, provided that they are approved by local regulators. Basel II Since the Basel Committee s creation in 1975, banking regulation has made significant strides. Thus, in June 2004, the Committee published the New Capital Accord, commonly known as Basel II, with the following objectives: to promote financial stability; to strengthen the capital structure of institutions; to favor the adoption of best risk-management practices; and to encourage greater transparency and market discipline. Basel II proposes a focus that is more flexible for capital requirements and more robust in terms of strengthening banking supervision and stimulating greater transparency in disclosing information to the market, based on three major premises: Pillar I - strengthening the capital structure of institutions; Pillar II - encouraging the adoption of best risk-management practices; and Pillar III - reducing the asymmetry of information while favoring market discipline. Banco do Brasil S.A. 13

15 PILAR I Minimum Capital Requirements PILAR II Banking Supervision and Governance PILAR III Market Discipline Risks - Credit - Market - Operational Assessment in how banks are adjusting needs to risks incurred Disclosure of relevant information to the market Solidity Management of the national financial system and financial information Lessen asymmetry of information Figure 3. Basel II Pillars System Stability Pillar I defines the treatment to be given to determine capital requirements in light of risks incurred in the activities engaged in by financial institutions. In relation to the 1988 Accord, Basel II introduces a capital requirement for operational risk and refines the discussion of credit risk. Credit Risk Market Risk Operational Risk IRB Models Standard Advanced Standard Aproach Standard Standard Simplified IRB Model Standard Aproach IRB Model Advanced Standard Aproach Standard Standard Alternative ********** ********** Basic Figure 4. Capital allocation Modified Maintened Added Basel II encourages the adoption of proprietary models to measure risks (credit, market, and operational), with differing degrees of complexity, subject to regulatory approval, and the possibility of benefits from lower capital requirements by adopting internal approaches. Pillar II reaffirms and strengthens the participation and role of the regulator in the banking supervision process and evaluation of risk governance at institutions, and how they manage capital to deal with the risks that they incur. Banco do Brasil S.A. 14

16 Pillar III recommends the creation of instruments and conditions to lower systemic risk caused by asymmetric information, encouraging and favoring market discipline and transparency of information about risk-management practices. The combination of these three major elements on which the entire Basel II philosophy is based can be defined, in short, as the pursuit of refining riskmanagement and control practices. Pillar I Minimum Capital Requirements Under Pillar I, various alternatives are proposed to determine capital requirements in keeping with the financial institution s size, complexity, and technical capacity, in order to measure risk. It sought to include a variety of measurement approaches, considering the use of (advanced) internal models as well. The main changes with respect to the first accord are: the sophistication of credit-risk measurement methods; and the inclusion of metrics for operational risk. Even though the internal models to calculate capital allocation require a greater degree of complexity, sophistication and investment, they allow for reducing the capital to be set aside in better reflecting the bank s internal structure. Pillar II Governance and Supervision Process The supervision process establishes rules for risk management. The Committee established four essential principles of supervisory review that demonstrate the need for banks to evaluate capital adequacy in relation to risks assumed and for supervisors to review their strategies and to adopt relevant attitudes in light of these assessments. They are: 1. First Principle: banks must have a process to estimate their capital adequacy in relation to their risk profile and have a strategy to maintain sufficient levels of capital; 2. Second Principle: supervisors should assess the banks strategies, adequacy estimates, and ability to monitor and to guarantee their compliance with minimum capital requirements; 3. Third Principle: supervisors expect, and may require, banks to operate over the minimum capital requirements; and 4. Fourth Principle: supervisors may intervene in advance and require banks to take prompt actions if their capital level falls below the minimum level. Banco do Brasil S.A. 15

17 According to Pillar II, executive management is responsible for both the risk-exposure strategy and compatible levels of capital. The main features of having a rigorous process to assess capital adequacy should involve: supervision of the bank s executive management and board of directors; solid assessment of capital needs to tolerate business risks; comprehensive assessment of risks; monitoring and reporting; and review of internal controls. Pillar II emphasizes banks need to have an adequate volume of capital to tolerate all risks involved in their business. Capital should not be viewed solely as the only option that regulators may use to address risk issues, but also internal controls and riskmanagement processes that turn out to be insufficient or inadequate. Other means may be used to deal with risk management, such as applying internal exposure limits; strengthening allowance and reserve levels; and refining internal controls in general. Pillar III Market Discipline This represents the set of information-disclosure requirements that will allow market players to evaluate the essential information in the institution s structure, capital measurements, risk exposure, risk-management processes, and capital adequacy. Pillar III is based on four categories/divisions: a) scope of application - represents the relationship between recommendations and the bank s structure; b) capital - demonstrates the bank s capacity to absorb eventual losses; c) risk exposure - demonstrates the support for assessing the intensity of risks and the ways of evaluating them; and d) capital adequacy - enables judgment of capital sufficiency in light of risks being incurred. Scope of Application -Qualitative aspects -Quantitative aspects Capital Structure - Qualitative aspects - Quantitative aspects Capital Adequacy - Qualitative aspects - Quantitative aspects Credit Risk Market Risk Operating Risk Equities Qualitative and Quantitative aspects Qualitative and quantitative aspects Qualitative and quantitative aspects Qualitative and quantitative aspects Figure 5. Pillar III Structure Quality of informatios to the market Banco do Brasil S.A. 16

18 The rationale for creating this third pillar is to complement minimum capital requirements (Pillar I) and the supervisory review process (Pillar II). This means that with the development of rules that encourage and require more open information about banks risk profiles and capitalization levels, market players will feel encouraged to exercise discipline on this market. The use of certain transparency levels will be the benchmark for recognition and qualification of a financial institution in a specific capital-measurement approach. Examples include disclosing qualitative information about the structure of internal rating systems and the process to manage and to recognize the mitigation of credit risk. To guarantee compliance with transparency, Basel II calls for supervisors to have a greater number of persuasive instruments, ranging from dialogue with the bank s management to financial fines, depending on the disclosure deficiency in question. With this format, the role of regulators grows in the sense of accessing and evaluating banks positions, given their risk exposures, with an emphasis on their supervisory role. By encouraging open information, the New Accord seeks to potentialize market players power of evaluation and action. Basel III Given the guidelines from the Basel Banking Supervision Committee, the Central Bank of Brazil (BACEN) published Notice 20,615 on 2/17/2011, which set out preliminary guidelines and a timetable for implementation in Brazil of the capital structure, leverage, and liquidity requirements known as Basel III. The main definitions and guidelines of this notice are presented below: a) New definition of capital: Tier I Capital of Referential Equity (PR) will consist of two parts: Principal and Additional Capital; b) Principal: will essentially consist of capital stock and retained earnings, after deduction of following items from Common Equity Tier 1 (CET1): deferred tax assets from temporary differences; deferred tax assets from tax losses and a negative basis for the social contribution on net income; premiums paid in acquiring investments based on the expectation of future profitability and payroll rights, constituted starting on 01/01/2012; deferred permanent assets and other intangible assets; assets related to defined-benefit pension funds to which the financial institution does not have unrestricted access; holdings of non-controlled insurance firms; investments in own shares (treasury stocks); minority holdings that exceed the minimum required of CET1 and Capital Conservation Buffer, defined in paragraph 16 of the notice, recorded at financial institutions that are part of a financial conglomerate or in the consolidated economic/financial group; and funding instruments issued by other financial institutions. Banco do Brasil S.A. 17

19 Deferred tax assets from temporary differences and significant investments in non-controlled insurance firms may be recognized in the capital structure up to an individual limit of 10% of Common Equity Tier 1, and in the aggregate, along with other capital adjustments cited in paragraph 4 of the notice, up to 15% of Common Principal. These deductions shall occur progressively between 07/01/2012 and 01/01/2018. c) Additional Capital: the trend is for it to consist of authorized hybrid capital and debt instruments that meet the requirements of loss-absorption during a financial institution s operation; of subordination; of perpetuity; and of non-cumulative dividends; d) Tier II Capital: it will likely consist of hybrid capital and debt instruments that do not qualify to be part of Additional Capital, along with subordinated debt instruments. For instruments that do not meet the eligibility requirements set out in Basel III, including the conversion clauses disclosed in the Basel Committee press release on 01/13/2011 (BIS, Press Release 03/2011), a gradual timetable for deductions will be defined, initially forecast as follows: 10% deduction of the nominal value of ineligible instruments, on 01/01/2013, adding 10% a year, so as to be completely excluded by 01/01/2022. The rule states that the BACEN shall publish a new referential equity definition by December 2011; e) New minimum capital indices: two new indices were created: i) the Minimum CET1, consisting of the ratio of CET1 to risk-weighted assets (RWA); and ii) Minimum Tier I Capital Index, consisting of the ratio of Tier 1 Capital and RWA; f) Counterparty credit risk: modifications are anticipated to the capital requirements for counterparty credit risk, both for the standard approach and for internal risk rating (IRR) based approaches, to guarantee the inclusion of relevant risks in the capital structure; g) Conservation Capital: this amount will complement the minimum regulatory requirements and will consist of elements accepted to comprise CET1; h) Countercyclical Capita: this should also consist of elements accepted in the CET1 and will be required in the event of excessive growth of credit associated with the potential accumulation of systemic risk. The established timetable notwithstanding, any increases to the percent of Countercyclical Capital will be published by the BACEN at least 12 months in advance; i) Leverage Index: Basel III recommends implementation of a Leverage Index as a complementary capital measure, determined by dividing Tier I Capital by the amount of total exposure. As of 01/01/2018, the minimum required amount for the Leverage Index is scheduled to begin, initially forecast at 3%; and j) Liquidity measures: two liquidity indices are proposed, one short-term and the other long-term, as described below: Short-Term Liquidity Index (LCR): the purpose is to demonstrate that institutions have highly liquid funds to make it through a scenario of acute Banco do Brasil S.A. 18

20 financial stress lasting one month, and it will be calculated based on the ratio of highly liquid assets to net outflows over a period of up to 30 days; and Long-Term Liquidity Index (NSFR): this seeks to encourage institutions to finance their activities with more stable funding sources and will be calculated by the ratio of total available stable funding to total required stable funding. The timetable for implementing the Basel III recommendations in Brazil is shown in Table 1. Table 1. Timetable for Basel III Implementation in Brazil (F = 0,11) (F = 0,11) (F = 0,11) (F = 0,09875) (F = 0,0925) (F = 0,08625) (F = 0,08) Common Equity Tier 1 4,5% 4,5% 4,5% 4,5% 4,5% 4,5% 4,5% Additional Tier 1 5,5% 5,5% 6,0% 6,0% 6,0% 6,0% 6,0% Total Capital 11,0% 11,0% 11,0% 9,875% 9,25% 8,625% 8,0% Capital Conservation Buffer ,625% 1,25% 1,875% 2,5% Capital + Capital Conservation 11,0% 11,0% 11,0% 10,5% 10,5% 10,5% 10,5% Countercyclical Buffer - 0,625% 1,25% 1,875% 2,5% 2,5% 2,5% Source: BACEN Notice 20,615/ Basel II at Banco do Brasil Implementation of Basel II at BB is being overseen by the Risk Management Office (DIRIS), which is in charge of coordination and preparation to meet the Basel II requirements. Upon analyzing the New Capital Accord and BACEN regulations, it became clear that further actions needed to be taken among the product and service management units to enable BB to comply with the regulator s requirements, abiding by the phases set out in BACEN Notices /04; /07; and /09. In order to provide continuity to the evolving process of risk and business management practices, the bank made a strategic decision to adopt internal models for market, credit, and operational risk in order to be able to use advanced approaches by the deadlines initially set in BACEN Notice /09. Market Risk Within the market-risk environment, there were revisions of both overall and specific limits, and of the Market Risk Capital Requirement Stress Test Program, both in line with the stipulations of BACEN Circular 3.478/09, which addresses internal market-risk models. Regarding liquidity risk, the bank s exposure is minimal, given its leading active position in highly liquid federal government bonds. Credit Risk In terms of credit risk, BB uses proprietary methodologies to rate clients risks. Developed according to best market practices and concepts introduced by the Basel Accord, these statistical models take into account background (credit score), credit history (behavior score) with the bank and the market, and the use of banking products. Banco do Brasil S.A. 19

21 Operational Risk To manage operational risk, Banco do Brasil - adhering to best market practices - monitors operational losses by making use of systematized internal databases, exposure limits, and key risk indicators, in addition to risk matrices to evaluate relevant outsourced services. Seeking continual improvement of the operational-risk management process, in 2010 BB implemented specific limits for operational losses related to Labor Issues, Business Failures, Process Failures and External Fraud and Theft, with the goal of providing more flexibility when proposing mitigation actions. Particularly important was the work done to adjust to the guidelines published by the BACEN in Notice /09, which involved using four essential elements in the internal model for measuring operational risk: Internal Database, External Database, Scenario Analysis, Internal Control Factors, and Business Environment. To prevent, correct, or inhibit weaknesses that might cause risks to BB, and to reduce losses and to strengthen the risk culture, the Technical Risk Recommendation was created, issued to units that manage processes or products when a need is identified to take a loss-mitigation action, and to guarantee compliance with the responsibilities defined in the risk-management phases. Banco do Brasil S.A. 20

22 6. Regulations The BACEN, in concert with the procedures of regulators in developed countries, has issued a series of prudential regulations. Current regulations can be consulted on its website. Banco do Brasil S.A. 21

23 7. Financial Conglomerate Risk management in the Banco do Brasil financial conglomerate is comprehensive and covers credit, market, liquidity, and operational risks. Management activities are performed by specific, specialized structures, pursuant to objectives, policies, strategies, processes, and systems described in each of these risks. Even though activities focus on credit, market, liquidity, and operational risk, the bank uses mechanisms to guarantee capital sufficiency to cover other risks incurred. Banco do Brasil S.A. 22

24 8. Risk Management 8.1 Financial Conglomerate Credit Risk Management Objectives Exposures subject to credit risk are a big part of Banco dobrasil s assets. That is why risk management of these exposures is fundamental for the bank to achieve its objectives. Banco do Brasil s credit risk is managed according to best market practices and following banking supervision and regulatory rules. It seeks to identify, measure, control, and mitigate the risk of exposure, contribute to maintaining the bank s health and solvency, and guarantee that shareholders interests are being met. Credit-risk management at the financial conglomerate involves credit policy, management strategies, management processes, operational procedures, and management systems, as shown in the figure below: CREDIT POLICY CA MANAGEMENT STRATEGY CRG SRC MANAGEMENT PROCESSES DICRE OPERATIONAL PROCEDURES DIRAO MANAGEMENT SYSTEMS DIRIS STRATEGIC LEVEL OPERATIONAL LEVEL TATICAL LEVEL RISK MANAGEMENT STRUCTURE Figure 6. Credit-risk management Note: CA = Board of Directors; CRG = Global Risk Committee; SRC = Credit Risk Subcommittee; DICRE = Credit Board; DIRAO = Asset Restructuring Board; DIRIS = Risk Management Board. Banco do Brasil S.A. 23

25 In accordance with CMN Decision 3.721/09, the Board of Directors (CA) approved the credit-risk management structure of Banco do Brasil, consisting of the Global Risk Committee (CRG), Credit Risk Subcommittee (SRC), Credit Board (DICRE), Operational Asset Restructuring Board (DIRAO), and Risk Management Board (DIRIS). Given that the DIRIS is the unit at the bank in charge of overall risk management and does not have any ties to the management of third-party funds or to performing transactions subject to credit risk, the CA appointed the Director of Risk Management as the person in charge of BB s credit-risk management with respect to the BACEN. This credit-risk management structure is compatible with the nature of transactions, the complexity of products and services, and in proportion to the size of the credit-risk exposure incurred by Banco do Brasil. Credit Policy Banco do Brasil s credit policy contains strategic guidelines to direct credit-risk management actions at the financial conglomerate. It is approved by the Board of Directors and reviewed every year. It is available to all employees, and applies to all business that involves credit risk. The policy is divided up into four blocks: General Aspects, Assuming Credit Risk, Collections and Credit Recovery, and Credit Risk Management. Each block has a broad set of statements that encompass all stages of credit-risk management at Banco do Brasil. Listed below are a few of the topics addressed in Banco do Brasil s credit policy: concept of credit risk; conditions for assuming risk; separation of duties; guidelines for collections and credit recovery; joint decisions; expected loss, economic and regulatory capital; risk appetite; allowance and capital levels; risk limits; stress tests and sensitivity analysis; and client rating; capital planning Banco do Brasil S.A. 24

26 Management Strategies Management strategies are established by the CA and the CRG, and implemented tactically by the SRC, all in accordance with the credit-risk management objectives and credit policy of Banco do Brasil. The CRG consists of the President and Vice Presidents of the units involved with credit-risk management. The Committee sets strategies for credit-risk management, defines overall exposure limits, and approves capital allocation. The SRC was created to make faster decisions about credit-risk management. It is a tactical structure, subordinated to the CRG, which has delegated decision-making authority to deliberate on certain issues, instructing the CRG on other issues. The SRC consists of officers from the units involved in credit-risk management, coordinated by the Director of the Risk Management Board. Credit-risk management strategies guide actions at the operational level. Strategic decisions include: materializing the risk appetite of Banco do Brasil; approving credit-risk management models; setting goals for fulfillment, recovery, maximum loss, and quality of the credit portfolio; setting risk and concentration limits; keeping adequate levels of allowances and capital; and management of the risk-return ratio Management Processes According to Banco do Brasil s credit-risk management structure, the Credit (DICRE), Operational Asset Restructuring (DIRAO) and Risk Management (DIRIS) units are responsible for implementing strategic decisions approved by the CA, CRG and SRC, keeping exposure at the risk levels set by the executive management. The DICRE focuses on clients and operations. Its main products are: registration, marketing studies and information on economic sectors, methodologies (risk, risk components, and credit limits), risk analysis (clients, operations, projects, economic sectors, countries, and projects), pre-validation and monitoring of risk methodology and credit-risk components, study of investment and leasing transactions, economic/financial evaluation and diagnosis of businesses/business groups, monitoring the credit portfolio, and producing inputs to price credit risk. The DIRAO deals with, collects, and recovers problem credits. Its main products are: models to rate clients under collections and recovery, collection and recovery strategies, recovery quality indicators, management of collections and recovery channels, rescheduling debt, restructuring transactions, setting negotiating floors and methodologies for dealing with problem credits and/or defaults. The DIRIS focuses on managing the credit risk of aggregate positions. Its main products are: policies, risk limits, credit risk models, information on credit risk, Banco do Brasil S.A. 25

27 indicators of credit portfolio quality, capital allocation as a function of risk, management of the credit portfolio s risk, and monitoring of risk versus return. DICRE DIRAO DIRIS Manage default portfolio Prepare sector studies and a panorama Control risk limits for aggregate exposure Analyze clients and set limits Analyze credit risk of transactions Develop models and strategies to deal with, collect, and recover problem credits Manage collection and recovery channels Determine regulatory capital for credit risk Determine economic capital for credit risk Create and monitor credit-risk methodologies Propose strategies to pursue debts in higher courts Manage credit portfolio Figure 7. Credit-risk management structure The processes and procedures of the credit-risk management structure are validated and evaluated by two internal units at different points in time, a fact that ensures adequate separation of duties and the independence of work. The Internal Control Board (DICOI) is responsible for validating the financial conglomerate s risk determination and measurement models and the bank s internal control system. Internal Audit (AUDIT) periodically evaluates credit-risk management processes to verify whether they are consistent with the strategic guidelines, credit policy, and internal rules. In addition to the units above, independent auditors analyze some of the processes and procedures of credit-risk management, helping to verify whether they are in accordance with regulatory requirements and internal definitions. Communication and Information Processes Disclosure of credit-risk information is a continual and ongoing process. The premises considered when selecting and disclosing information include: best practices, banking laws, user needs, the bank s interests, confidentiality, and the relevance of the information. The communication and information on credit-risk management is provided to internal and external clients, pursuant to the following processes: Banco do Brasil S.A. 26

28 Communication process for internal clients The operational units of the credit-risk management structure always communicate with upper management about risk exposure in order to monitor management actions and for executive management to make decisions. The communication process involves several reports on credit-risk management. These documents are produced periodically and are the result of analyses done by professionals from the units. They demonstrate the credit risk of all exposure or in certain portfolios, such as: Credit Risk Exposure Portfolio Report; BB vs. SFN Comparison Report (BACEN data); Bank Comparison Report (accounting data from banks); Capital Management Report; Risk-Return Analysis of the Credit Portfolio; Stress Monitoring Report; and Risk Panel. Communication process for external clients The operational units of the credit-risk management structure produce information for external users and send it to the Investor Relations Unit (IRU). The IRU discloses this information to the market, as a transparent governance practice, allowing investors and interested parties to monitor risk-management actions and the evolution of credit risk, and to prove the bank s capital adequacy to cover all of the risks that it has assumed. Information for external users is provided on a publicly accessible location, easily found on the bank s website. The following documents are published: Performance Analysis Report; Notes to the Financial Statements; and Annual Report. Measurement Systems Credit risk is measured in many ways: by default, arrears, portfolio quality, allowance for doubtful accounts, concentration, expected losses, and regulatory and economic capital requirements, among others. The quantity and nature of our operations, the diversity and complexity of our products and services, and the volume exposed to credit risk require systematic measurement of credit risk at Banco do Brasil. The bank has enough databases and corporate-system infrastructure to ensure comprehensive measurement of credit risk. Some of these risk measures are highlighted below. Banco do Brasil S.A. 27

29 Concentration The bank developed and implemented a system to measure and monitor credit-risk concentration in the corporate portfolio. The model is based on the Herfindahl Index. It evaluates concentration based on borrowers credit risk, and it considers the interrelationship of the various economic sectors that comprise the corporate credit portfolio. Expected Loss The bank also developed specific methodologies and proprietary systems to determine risk components 1 that are used to determine expected loss and economic capital. Expected loss is used in numerous processes and procedures, such as: pricing products and services, verifying allowance levels, and calculating riskadjusted return on capital (RAROC). In addition, an analysis of historic expected loss provides important information about the behavior of credit risk. Regulatory and Economic Capital Requirements The bank measures the regulatory capital requirements for credit risk through a standard simplified approach, whose procedures for calculating Risk-Weighted Exposure were published by the BACEN in Circular 3.360/07, and updates. These procedures were implemented in a proprietary system that determines the capital requirements quickly and securely, allowing for timely verification of the bank s solvency under the regulator s rules. The bank uses regulatory-capital information to assess the efficiency of capital allocation and planning. The bank developed an internal model to measure economic capital whose theoretical foundation is based on an actuarial approach that is now very widely used in the banking industry. Because it was modeled internally, this measure better reflects the risk profile of exposure, which is why it is used managerially in calculating RAROC and in measuring the Herfindahl concentration index. Additionally, the analysis of the historic evolution of economic capital provides important information on capital consumption resulting from exposure of certain clients and/or segments of clients. 1 It is in the refining stage, to comply with regulatory requirements. Banco do Brasil S.A. 28

30 Mitigation Policy Banco do Brasil has a conservative attitude toward credit risk. When doing any business subject to credit risk, the bank s general rule is to tie it to a mechanism that will provide partial or complete hedging of the risk incurred. In managing credit risk on the aggregate level, to keep exposure within the risk levels determined by executive management, the bank seeks to transfer or to share credit risk. The use of credit-risk mitigating instruments is stated in the credit policy, present in strategic decisions, and formalized in credit rules, affecting all levels of the organization and covering all stages of credit-risk management. Credit rules provide clear, comprehensive guidelines for the operational units. Among other aspects, the rules address ratings, requirements, choices, assessments, formalization, control, and reinforcement of guarantees, assuring the adequacy and sufficiency of the mitigator throughout the transaction s cycle. Strategies to Monitor the Effectiveness of Mitigators Strategies that monitor the effectiveness of credit-risk mitigation consist of: continually monitoring credit-risk exposure and comparing the default index with the level of allowances for exposure, with and without related guarantees; constantly managing capital and comparing regulatory capital requirements with economic capital consumption of exposure, with and without related guarantees; and periodically evaluating information from collection and recovery of credits and determining which mitigators contribute effectively to exercising the bank s rights. Processes for Monitoring the Effectiveness of Mitigators Monitoring the effectiveness of mitigators is part of the bank s credit-risk management processes. For example, there are the processes to monitor credit-risk exposure, the risk ratings of credit transactions, capital management, and collections and recovery of credits. The processes of monitoring credit-risk exposure and rating credit-transaction risks produce important information for verifying the effectiveness of mitigating instruments. A low default index in certain segments of the credit portfolio and a low level of allowances in certain transactions may mean that the existence of guarantees tied to exposure is lowering credit risk. The capital management process allows for verifying whether a lower regulatory capital requirement and/or less consumption of economic capital in a given product or service is related to the existence of guarantees tied to exposure to credit risk, lowering the bank s exposure to credit risk. The process of collecting and recovering credits generates information that enables the bank to verify which mitigating factors were the most important for receiving credits in default and for recovering problem credits, allowing for a revision of the criteria for choosing guarantees, allowances, and capital allocation. Banco do Brasil S.A. 29