Risk- and capital management SpareBank 1 SR-Bank

Transcription

1 Risk- and capital management 2011 SpareBank 1 SR-Bank

2 Risk- and capital management in SpareBank 1 SR- Bank 2011 This document has been prepared to provide the market with the best possible information on SpareBank 1 SR-Bank's risk and capital management. It is also intended to cover the stipulated requirements for publication of risk information in accordance with the "Capital Requirements Regulations". The group s information strategy emphasises an extended dialogue with the different stakeholder groups, where openness, predictability and transparency are vital factors. The information shall be correct, relevant and timely with regard to the group's development and results, and it shall ensure that the group's different stakeholder groups can keep continuously updated and create confidence in the investment market. The core purpose of the banking industry is to create value by assuming deliberate and acceptable risk. SpareBank 1 SR-Bank therefore invests significant resources in further development of risk management systems and processes in line with leading international practice. SpareBank 1 SR-Bank makes extensive use of risk models in their risk management. Risk and capital management in SpareBank 1 SR-Bank supports the group s strategic development and achievement of goals while ensuring financial stability and sound management of assets. The economic cycle in Rogaland shows that growth is approaching the same level as in 2008 before the financial crisis, and continued strong growth is expected in SpareBank 1 SR-Bank's market area in The high rate of growth does, however, present challenges in the form of a lack of qualified manpower, transportation challenges and the lack of housing. In addition, it is uncertain how a euro crisis and sovereign debt crisis in certain countries will affect the Norwegian economy. There is at the same time strong growth in oil investments, and the large oil discoveries in the North Sea in 2011 will contribute to a higher level of activity for oil-related industry. According to Statistics Norway 2 a total of NOK 146 billion was invested in 2011, and the latest estimate for investments in 2012 is NOK 186 billion. The high level of activity has triggered the development of some fields at the same time as there is a high level of upgrade activity on many fields on the Norwegian continental shelf. The overall risk exposure for SpareBank 1 SR-Bank is moderate. The core (Tier 1) capital ratio for SpareBank 1 Gruppen was 10.6 per cent at the end of the fourth quarter of The Board of Directors of SpareBank 1 SR-Bank has proposed strengthening the bank's equity by a maximum of NOK 1.5 billion through a pre-emptive rights issue of ordinary shares in the first half of The issue is guaranteed by the company's largest shareholder and companies in the SpareBank 1 Alliance. SpareBank 1 SR-Bank has a solid financial standing and a leading position in the strongest growth region in Norway. The new issue will strengthen the group's ability to satisfy the customers financing needs in an offensive manner. The proposed share issue will also contribute to strengthening the group's capital adequacy in advance of the expected regulatory amendments. SpareBank 1 SR-Bank is considering to have a sound liquidity buffer, and the group finds that the liquidity in the European credit market at the start of 2012 is better than the last half of Credit risk represents a significant part of the group's risk. The credit quality of SpareBank 1 SR- Bank's portfolio is good and has been stable over the last year. SpareBank 1 SR-Bank has a diversified portfolio. The retail market represents 25 per cent of the total loan exposure of SpareBank 1 SR-Bank, which consists primarily of high-quality mortgage loans. The percentage of loans with a debt to asset ratio of over 90 per cent has declined over the last year as a result of stricter guidelines for home mortgages. The group's largest sectoral concentration is in the area of commercial property, which represents around 10 per cent of the total loan portfolio (EAD), including the retail market. The 1 Economic Barometer for Rogaland, fourth quarter of Statistics Norway. 2

3 property portfolio intended for rental consists primarily of long-term leases with financially solid tenants. At the beginning of 2012 SpareBank 1 SR-Bank is well-equipped to create value for the region the group is part of. 3

4 1. SPAREBANK 1 SR-BANK VISION, OBJECTIVE AND CORE VALUES STRATEGIC TARGET SPAREBANK 1 SR-BANK IN BRIEF KEY FINANCIAL FIGURES FOR CONVERSION OF SPAREBANK 1 SR-BANK TO A PUBLIC LIMITED COMPANY (ASA) SPAREBANK 1 ALLIANCE CAPITAL ADEQUACY REGULATIONS INTRODUCTION TO CURRENT CAPITAL ADEQUACY REGULATIONS - BASEL II INTRODUCTION TO THE PROPOSAL FOR NEW REGULATIONS - BASEL III BANKING LAW COMMISSION'S PROPOSAL EBA - REQUIREMENT OF A 9 PER CENT PURE CORE CAPITAL ADEQUACY RATIO FOR SYSTEMICALLY IMPORTANT BANKS ASSESSMENT OF PROPOSAL FOR NEW REGULATIONS CONSEQUENCES OF BASEL III FOR SPAREBANK 1 SR-BANK PILLAR 1 MINIMUM REQUIREMENTS FOR SUBORDINATED LOAN CAPITAL CHOICE OF METHODS AT SPAREBANK 1 SR-BANK FINANCIAL STRENGTH TARGETS Regulatory capital IRB ambitions for SpareBank 1 SR-Bank PILLAR 2: GROUP'S INTERNAL RISK AND CAPITAL ADEQUACY ASSESSMENT OBJECTIVE OF RISK AND CAPITAL MANAGEMENT IN SPAREBANK 1 SR-BANK RISK EXPOSURE AT SPAREBANK 1 SR-BANK Trade and industry structure of the Group's market areas Macroeconomic outlook Overall risk exposure for SpareBank 1 SR-Bank Credit risk Market risk Operational risk Liquidity risk Ownership risk Business risk Reputation risk Strategic risk Compliance risk STRESS TEST FRAMEWORK FOR MANAGEMENT AND CONTROL Description of the framework for management and control Strategic target for the group Risk identification and analysis Capital allocation Financial projections and stress testing Evaluation and measures Reporting and follow-up Organisation and organisational structure Credit risk Market risk Operational risk Funding risk Ownership risk Business risk Reputation risk Strategic risk Compliance risk DESCRIPTION OF RISK MODELS AND METHODOLOGY Scenario model Credit risk

5 4.5.3 Market risk Operational risk Ownership risk Business risk Reputation risk Strategic risk Diversification effects PILLAR 3: DETAILED INFORMATION ON REGULATORY CAPITAL ADEQUACY CONSOLIDATION PRIMARY CAPITAL CREDIT RISK - GENERAL INFORMATION ON CREDIT RISK, DEFAULT AND IMPAIRMENT Portfolio information based on regulatory estimations Minimum regulatory capital requirement MARKET RISK Portfolio information long-term investments Minimum regulatory capital requirement OPERATIONAL RISK COMPARISON OF REGULATORY CAPITAL AND RISK-ADJUSTED CAPITAL

6 1. SPAREBANK 1 SR-BANK 1.1 Vision, objective and core values Figure 1: Vision, objective and core values 1.2 Strategic target SpareBank 1 SR-Bank shall be Southern and Western Norway's most attractive supplier of financial services based on: Good customer experiences Strong team spirit and professionalism Local roots and decision-making power Financial strength, profitability and confidence in the market 1.3 SpareBank 1 SR-Bank in brief SpareBank 1 SR-Bank is currently Southern and Western Norway's leading financial group with total assets of NOK 131 billion. SpareBank 1 SR-Bank has been one of the most profitable banks in the Nordic region over the past 15 years. The profit before tax for the group was NOK billion in The group's market area is Rogaland, Hordaland and the Agder counties, and the number of customers is approaching There are approximately employees. The group has 53 offices in 38 municipalities and is the market leader with 26 municipalities/county authorities as main bank customers in the market area. SpareBank 1 SR-Bank is a financial group with a complete product range in the retail market, corporate market and the public sector. In addition 6

7 to the actual banking operations, the group possesses expertise in funding, foreign exchange advice, funds management, securities trading, insurance, real estate brokering and financial advice. The group's headquarter is located in Stavanger. Summary of companies in the SpareBank 1 SR-Bank Group is illustrated in the figure below. Figure 2: Wholly-owned and partly owned companies in the SpareBank 1 SR-Bank group 1.4 Key financial figures for 2011 Profit before tax: NOK 1,495 million Profit after tax: NOK 1,081 million Return on equity after tax: 11,2 per cent Impairment losses on loans: NOK 139 million Net interest income: NOK 1,756 million Net commission and other income: NOK 1,192 million Net return on investment securities: NOK 319 million Lending growth (including loans transferred to SpareBank 1 Boligkreditt AS and SpareBank 1 Næringskreditt AS) over past 12 months: 11,2 per cent Growth in deposits over past 12 months: 5,4 per cent Earnings per equity certificate: NOK 5,42 The Board proposes a dividend of NOK 1,5 per equity certificate. Core (Tier 1) capital ratio (taking into account the Board's dividend proposal): 10,6 per cent 7

8 1.5 Conversion of SpareBank 1 SR-Bank to a public limited company (ASA) On 1 January 2012 SpareBank 1 SR-Bank was converted to a public limited company. The first listing date as a limited savings bank on Oslo Stock Exchange was 2 January The aim of the conversion to a limited savings bank is to secure long-term, sound and profitable operations for SpareBank 1 SR-Bank, at the same time as its role as a responsible builder of society in the region where the bank is located will be developed further. The conversion of SpareBank 1 SR- Bank will help SpareBank 1 SR-Bank grow stronger in the equity and debt capital markets, so that the bank can continue to be in the forefront of developments in the region where the bank operates. 1.6 SpareBank 1 Alliance The SpareBank 1 Alliance is a banking and product alliance in which the SpareBank 1 banks in Norway cooperate through the holding company SpareBank 1 Gruppen AS. The paramount goal of the SpareBank 1 Alliance is to secure the individual bank's independence and regional ties through robust competitiveness, profitability and financial strength. The SpareBank 1 Alliance is one of the largest providers of financial services in Norway, and it is a competitive alternative to traditional financial groups. The SpareBank 1 Group owns and develops companies that provide financial services and products. The SpareBank 1 Alliance is Norway's third-largest financial group. The group is a binding banking and product alliance in which the SpareBank 1 banks cooperate through the jointly-owned SpareBank 1 Gruppen AS. The Norwegian Confederation of Trade Unions (LO) is another owner and partner through SpareBank 1 Gruppen AS. The figure below provides a summary of the ownership structure of the SpareBank 1 Alliance. 8

9 Figure 3: SpareBank 1 Alliance 9

10 2. CAPITAL ADEQUACY REGULATIONS 2.1 Introduction to current capital adequacy regulations - Basel II The EU's capital adequacy directive was introduced in Norway January The regulations are based on a standard for capital adequacy calculations from the Bank for International Settlements (BIS). The object of the capital adequacy requirements is to strengthen stability in the financial market by means of: More risk-sensitive capital requirements Improved risk management and control Closer supervision More information to the market The capital adequacy regulations are based on three pillars: Pillar 1: Minimum regulatory capital requirements Pillar 2: The bank's internal risk and capital adequacy assessment and individual supervisory review Pillar 3: Disclosure of information Further information on the various pillars can be found in Section 3 (Pillar 1), Section 4 (Pillar 2) and Section 5 (Pillar 3). In Section 6 a comparison has been made of the need for regulatory capital in relation to internal calculations based on risk-adjusted capital. 2.2 Introduction to the proposal for new regulations - Basel III The European Commission presented its proposal for the implementation of Basel III in the EU on 20 July This corresponds with the Basel Committee's new minimum requirements for the banks' capital adequacy (Basel III). The new minimum requirements will take effect from 1 January 2013 with various transitional arrangements, which entail that they will be in full effect from 1 January It is expected that CRD IV will be adopted by the EU in the spring of The introduction of the CRD IV as a so-called full harmonisation directive has been proposed, i.e. that there will be no opportunity for national options or deviations unless the directive specifically allows such. The Basel Committee has decided that pure core capital (common equity Tier 1) and core capital (Tier 1) shall comprise 4.5 per cent and 6 per cent of the assessment basis, respectively. Combined with the stricter qualitative requirements for core capital, in general, and pure core capital, in particular, this will entail stricter requirements compared with the current minimum requirements of 2 per cent and 4 per cent, respectively. The requirements for regulatory capital will remain unchanged at 8 per cent. To prevent the banks from experiencing any problems meeting the minimum requirements during periods of major losses in the banking sector, the banks shall maintain two different capital buffers. The requirement for a capital conservation buffer means that the banks shall maintain a pure core capital of 2.5 per cent of the assessment basis, in addition to the minimum requirement. In order to protect the banking system against the consequences of strong credit growth, the banks shall also maintain a countercyclical buffer during periods with very strong credit growth. This buffer will be percentage points, and it must also be satisfied by pure core capital. The sum total of the capital preservation buffer and the countercyclical buffer are referred to as the combined buffer 10

11 requirement. Banks that do not satisfy the combined buffer requirement will face restrictions on their dividend policy, bonus payments, distribution of bonus shares and buyback of shares. These restrictions will increase, the lesss the difference is between the capital and minimum requirements, including the necessary buffers. Banks that do not satisfy the combined buffer requirement must submit a plan to the authorities outlining how they will ensure compliance with the requirement. The figure below illustrates tes the changes in the requirements for the core capital in Basel III as described above: Figure 4: Structure of the core capital The proposed gradual introduction period will result in the following development for the capital requirements over time: Figure 5: Development of the capital requirements over time The Basel III / CRD IV proposal stipulates additional new requirements for hybrid capital that is to count as core capital. Based on this proposal, the hybrid tier 1 securities as they are normally defined in Norwegian banks today will not be considered as core capital. As a transitional arrangement it has 11

12 been proposed that such securities should be included with 90 per cent of their value in 2013 and then be reduced by 10 percentage points annually thereafter. The same will apply correspondingly to subordinated loan capital, which is currently included in supplementary capital, but does not satisfy the future quality requirements. The key difference with regard to both hybrid tier 1 securities and subordinated loan capital is the fact that repayment incentives in the form of a higher coupon rate after the call date, for example, will not be permitted in the future. In addition, it has been proposed that the regulatory deductions that are currently deducted 50 per cent from the core capital and 50 per cent from the supplementary capital, shall be set at a 100 per cent deduction from the core capital from the end of For SpareBank 1 SR-Bank this primarily applies to the deduction items for ownership risk in the SpareBank 1 Group and Bank 1 Oslo Akershus, and the difference between "expected losses IRB" less loss provisions. The regulatory deduction rules will also be amended upon the introduction of CRD IV. The deduction for assets in other financial institutions shall be made if the ownership interest exceeds 10 per cent. This limit is currently 2 per cent in the current Norwegian regulations. In addition, the bank can retain an amount corresponding to 10 per cent of its own regulatory capital before such deductions must be made, for a maximum, however, of 15 per cent of the regulatory capital in relation to the combined deductions for deferred tax assets and significant investments in other financial institutions. The current provisions for capital adequacy reserve deductions are stricter than the rules for deductions in accordance with CRD IV. It has therefore been proposed that the detailed provisions in Norwegian law on this point shall be replaced by a statutory authority for the Financial Supervisory Authority of Norway to order deductions for the capital adequacy reserve. In parallel with Basel III / CRD IV, proposals have been prepared internationally for additional capital requirements for the so-called global systemically important banks. It has been proposed that they be subjected to minimum capital requirements that are percentage points above the general minimum requirement. As part of the bill to introduce CRD IV in Norway, the Financial Supervisory Authority of Norway proposes a statutory authority to subject systemically important institutions to additional requirements, even if these regulations are not part of the CRD IV directive. The Basel Committee will also introduce requirements for the unweighted leverage ratio, which is a supplement to the risk-based capital requirements. This requirement will be finalised in 2017 and become effective in The transitional period will be used to test a requirement that the core capital shall amount to at least 3 per cent of the bank's exposure, where off-balance sheet items will be included to varying degrees. The proposal for the CRD IV Directive in the EU does not entail that the Leverage Ratio requirement will be introduced, but that the supervisory authorities will have an opportunity to apply the leverage ratio as a Pillar 2 tool from 2013, that is to order individual banks to comply with such a requirement. The banks will also be required to publish their Leverage Ratio from In the preamble to the directive, it is also stated that there is determination to introduce it as a regulatory minimum requirement from 1 January 2018, as is envisioned in Basel III. The Basel Committee will also introduce quantitative liquidity requirements and aims to introduce the short-term liquidity indicator, the Liquidity Coverage Ratio (LCR), in 2015, and the long-term indicator, the Net Stable Funding, in These two requirements will not be introduced through the CRD IV proposal either, but, in the same manner as the Leverage Ratio, the preamble to the draft directive points out that these requirements will be introduced on 1 January 2015 and 1 January 2018, respectively. CRD IV introduces, however, reporting requirements related to the funding structure and LCR. In addition, CRD IV introduces a general liquidity requirement for the banks from This means that the banks will be required to maintain minimum liquid assets that correspond to the net negative cash flow in a stressed situation with regard to the liquidity. In the event of a breach or expected breach of this requirement the bank shall submit a plan to the supervisory authority and report its liquidity situation daily. 12

13 Importance should be attached, however, to the fact that Norges Bank and the Financial Supervisory Authority of Norway have previously stated that The Basel III regulations will be introduced earlier in Norway than otherwise in Europe. In a consultation memorandum related to the proposed legislative amendment for the implementation of CRD IV in Norway, which was presented on 10 October 2011, the Financial Supervisory Authority of Norway pointed out that it has not taken a stand on any early implementation. A staggered implementation plan in Europe would entail unfair competition. 2.3 Banking Law Commission's proposal In parallel with the development of Basel III / CRD IV, the Banking Law Commission has submitted a proposal for new combined framework legislation for the financial industry in Norway. A proposal that entails a significant change in relation to the current regulations is the introduction of provisions for so-called collaborating groups, which will encompass the SpareBank 1 Alliance, to implement socalled proportionate consolidation with respect to capital advocacy regardless of ownership interests. Under the current regulations, such consolidation does not take place for ownership interests from per cent. The introduction of such a consolidation requirement will normally entail stronger capital adequacy at the parent bank level, because deductions shall not be made from the regulatory capital for this investment. At the consolidated level the effects will also be influenced by the relationship between the capital adequacy of the consolidating bank and the consolidated institution. In connection with the bill to introduce CRD IV in Norway the Financial Supervisory Authority of Norway has questioned whether the Banking Law Commission's proposal is consistent with the consolidation provisions pursuant to CRD IV. Since national deviations from CRD IV will not be permitted unless specifically allowed in the directive, the Financial Supervisory Authority of Norway proposes that the Act be limited to establishing the legal authority to order such proportionate consolidation instead of introducing such a consolidation requirement. 2.4 EBA - requirement of a 9 per cent pure core capital adequacy ratio for systemically important banks The European Banking Authority (EBA) published the need for overcapitalisation of European banks on 26 October The reason for the new requirement is increased systemic risk as a result of the sovereign debt crisis in various European countries. The EBA has proposed the introduction of a requirement that systemically important banks have a minimum pure core capital adequacy ratio 3 of 9 per cent of the total risk-weighted assets by 30 June 2012 (including the IRB floor). The buffer shall be used to withstand stress/shock and subsequently be able to maintain acceptance capital adequacy. The EBA does not have the authority to impose such requirements on Norwegian institutions. The Financial Supervisory Authority of Norway has stated that it supports the EBA's plan to increase the capitalisation of the banks and will follow up these plans and Norway. The Financial Supervisory Authority of Norway adds that all banks and finance companies should have minimum pure core capital of 9 per cent by the end of June At the end of 2011 SpareBank 1 SR-Bank has a pure core capital adequacy ratio of 8.3 per cent. SpareBank 1 SR-Bank will strengthen its equity by a maximum of NOK 1.5 billion through a preemptive rights issue of ordinary shares. The issue is guaranteed by the company's largest shareholder and companies in the SpareBank 1 Alliance. 3 Pure core capital is defined as the core capital less hybrid Tier 1 bonds 13

14 2.5 Assessment of proposal for new regulations At a general level, SpareBank 1 SR-Bank supports the proposal to increase the capital requirements for banks to create a more robust financial system, and with this, to prevent economic and financial shocks. One of the primary weaknesses of the capital adequacy rules and regulations so far has been the fact that several significant risks have not been identified by the regulatory capital requirements. This applies to the concentration risk, business risk, reputation risk, strategic risk and a number of offbalance-sheet items. In addition, the regulatory capital tied up in equity investments has been significantly underestimated. The financial crisis has shown that the regulatory capital has not adequately managed to identify the inherent risk in international investment banks. The introduction of the unweighted leverage ratio requirement is an attempt to rectify some of these weaknesses, but the proposal in its current form will excessively impact the institutions that specialise in lending to the low risk segment. The unweighted leverage ratio requirement should be differentiated according to the banks' different business models. However, these are problems that have been recognised, and the Basel Committee has notified that it will consider this. SpareBank 1 SR-Bank finds that the operational risk is still not covered in a satisfactory manner in the Basel III proposal. This is primarily due to the fact that an international recognised method for identifying and quantifying the operational risk has not been established. The regulatory capital requirements for operational risk reflect therefore the organisation-specific risk of the individual bank to very little extent. In addition, the measurement methods are very computer-driven and the focus will therefore be retrospective rather than forward-looking. With regard to the proposal for the implementation of the countercyclical buffer, SpareBank 1 SR- Bank agrees that it is sensible that the banks create a capital buffer in good times in order to withstand losses during negative economic shifts in a better way. However, SpareBank 1 SR-Bank feels that the proposed solution has a number of weaknesses that the banks must consider when evaluating future capitalisation strategies. The calculation method used as a basis is theoretically complex, and provides a poor expression of at what point in time the countercyclical capital buffer should be introduced or phased out. The intention therefore is to give the supervisory authorities broad authority to use other indicators, such as the development of real estate prices, credit spreads, interest rate conditions or GDP growth as a criteria for introducing or phasing out the capital buffer. This can result in measures with inadequate consistency globally, since the supervisory authorities can rely of different assessments, independently of each other. In other words, a country can choose to introduce the measure while another country may choose not to implement the requirement, even though the indicator performance is the same. This may result in unfair competition across national borders. To give the banks a certain degree of predictability in capital planning, a notification deadline of 12 months has been proposed before the supervisory authorities can introduce a capital buffer. Such an announcement can be perceived negatively by the market and have a negative impact on the banks' rating. This may then have a negative effect on the price and access to capital in a situation in which it can be expected that many banks will try to increase their capitalisation during the same period of time. A joint European announcement on the introduction of a capital buffer will make the banks' access to capital even more difficult. In addition to the aforementioned weaknesses, the preservation buffer or the countercyclical capital buffer do not take into consideration the individual banks' different business models or risk management systems, and they are thus not motivation in themselves for better risk management. During the implementation of the Basel II regulations, one of the main objectives was to give an incentive for better risk management. 14

15 In addition to the counter cyclical buffer, a new regulation for losses will most likely be introduced. The proposed principle will build on the recognition of losses based on the expected losses. During periods of very insignificant losses, the difference between the actual losses and expected losses will be set aside as an additional reserve, while during periods when the losses are higher than expected, the provisions will be reduced. This approach will give a lower volatility for the banks' earnings throughout an economic cycle, and the approach may also dampen credit growth during economic expansion. SpareBank 1 SR-Bank supports this approach. It should be borne in mind, however, that the countercyclical economic buffer and the proposed change in the method for the recognition of losses point in the same direction. Both methods result in stricter requirements during economic expansion and more lenient requirements during economic downturns, but it is important that the combined effect of the two approaches is not too severe. 2.6 Consequences of Basel III for SpareBank 1 SR-Bank For SpareBank 1 SR-Bank, the Basel III regulations will result in a net increase in the core (Tier 1) capital ratio of 1 percentage point, while the capital adequacy ratio will be strengthened by 2.4 percentage points. This is attributed to the following: The fact that Basel III requires that the IRB floor be phased out. In connection with the introduction of Basel II in Europe in 2007, a transitional arrangement was introduced that entailed that the new minimum regulatory capital calculated in accordance with Basel II (including IRB) could not be lower than 80 per cent of the minimum regulatory capital in accordance with the old capital calculation regulations (Basel I). New deduction rules for the regulatory capital, in which a new method was introduced to calculate the deduction from the regulatory capital for the ownership risk in the Sparebank 1 Group and Bank 1 Oslo Akershus. The fact that the difference between the expected losses in the IRB system and the loss provisions from 2013 will be deducted in full from the core capital, while there is a 50 per cent reduction from the core capital and 50 per cent reduction in the supplementary capital in the current regulations. The Basel III regulations will also have consequences for the composition of the liquidity buffer in the future. The Basel Committee will introduce quantitative liquidity requirements and aims to introduce the short-term liquidity indicator, the Liquidity Coverage Ratio (LCR), in 2015 and the long-term indicator, Net Stable Funding Ratio (NSFR) in SpareBank 1 SR-Bank will reduce its funding risk in 2012 through building up a greater share of liquid assets with high quality and thus strengthening the short-term liquidity indicator, Liquidity Coverage Ratio (LCR). The hybrid tier 1 securities issued and subordinated loans from Norwegian banks do not satisfy the new Basel III requirements for valid hybrid tier 1 securities and regulatory capital. A transitional arrangement will therefore be introduced from 2013 with a haircut of 10 per cent per year for this capital until After 2019 the capital will no longer qualify as core capital. SpareBank 1 SR-Bank will adapt to the new requirements by replacing subordinated loans and hybrid tier 1 securities with qualifying capital. 15

16 3. PILLAR 1 M MINIMUM REQUIREMENTS FOR SUBORDINATED LOAN CAPITAL In Pillar 1 different methods the banks can choose from when calculating capital requirement are described. The different methods are illustrated in table 1. Table 1: Alternative methods for calculating the minimum regulatory capital requirement Credit risk Standard method Basic IRB method * Advanced IRB method * Market risk Standard method Internal ratings method * Operational risk Basic method Standardised method * AMA method * The minimum requirements for regulatory capital amounts to 8 per cent of the weighted balance (calculation basis). In principle, there are two different approaches to the calculation of the minimum regulatory capital requirement according to the capital adequacy regulations. One approach is based on template rules while the other is based on the application of internal ratings. In the internal ratings based (IRB) approach, the minimum regulatory capital requirements will be based on the banks internal risk assessments. Consequently, the statutory minimum capital adequacy requirement is more risk sensitive, so that the capital requirement corresponds more closely to the risk in the underlying portfolios or activities. Use of internal models must be approved in advance by the supervisory authorities. 3.1 Choice of methods at SpareBank 1 SR-Bank Table 2 shows the methods that SpareBank 1 SR-Bank uses for calculation of its capital requirements for credit, market and operational risk, respectively. Table 2: SpareBank 1 SR-Bank's methods for calculating the minimum regulatory capital requirement Type of risk Credit risk Portfolio States - parent bank Regulatory method Standard method Institutions - parent bank Standard method Housing cooperatives, clubs and associations - Standard method parent bank Businesses - parent bank IRB - Basic Mass market - parent bank IRB - mass market (advanced) SpareBank 1 SR-Finans AS - subsidiary Standard method SpareBank 1 SR-Investering AS - subsidiary Standard method SpareBank 1 SR-Forvaltning AS subsidiary Standard method 16

17 Mass market - SpareBank 1 Boligkreditt AS Businesses - SpareBank 1 Næringskreditt AS Businesses - BN Bank AS Mass market - BN Bank AS IRB - mass market (advanced) Standard method Standard method Standard method Market risk Equity risk - parent bank Standard method Debt risk - parent bank Currency risk - parent bank Subsidiaries and part-owned companies Standard method Standard method Standard method Operational risk SpareBank 1 SR-Bank including subsidiaries Template method Other part-owned companies Standard method For the subsidiary SpareBank 1 SR-Finans AS, plans have been prepared for a subsequent transition to the IRB method and the portfolio reports are therefore based on the standard method for the time being. The company s principal activities are lease funding and secured car loans. The calculation basis for SR-Finans AS is approximately 4.5 per cent of the overall calculation basis. SpareBank 1 SR-Bank owns 34.4 per cent of SpareBank 1 Boligkreditt AS, 30.7 per cent of SpareBank 1 Næringskreditt AS and 23.5 per cent of BN Bank ASA as of 31 December SpareBank 1 SR-Bank's share of the capital requirement for these companies are consolidated in SpareBank 1 SR-Bank's reporting capital adequacy based on the group's ownership interest. SpareBank 1 SR-Bank owns 19.5 per cent of the SpareBank 1 Group and Bank 1 Oslo Akershus AS. The part of the investment in the SpareBank 1 Group's book value that exceeds 2 per cent of the SpareBank 1 Group's regulatory capital is deducted from the regulatory capital and calculation basis in SpareBank 1 SR-Bank. SpareBank 1 SR-Bank has received approval from the Financial Supervisory Authority of Norway to make use of internal ratings based (IRB) measurement methods for credit risk. The bank has been approved for the use of the Basic IRB for businesses (hereinafter referred to as the corporate market) and IRB (Retail IRB) for the mass market (hereinafter referred to as the retail market). This means that the statutory minimum capital adequacy requirement for credit risk will be based on the group s internal risk models. When calculating the capital requirement according to the Basic IRB method for the corporate market, the probability of default (PD) risk parameter is estimated on the basis of internal ratings. The risk parameters conversion factor (CF) used in determining the exposure at default (EAD) and the loss given default (LGD) are determined based on the template rules in the Capital Requirements Regulations. When calculating the capital requirement according to the IRB method for the private market, internal models are used for calculation of the risk parameters probability of default (PD), conversion factor (CF) used in determining the exposure at default and loss given default (LGD). 17

18 3.2 Financial strength targets SpareBank 1 SR-Bank's capital situation is assessed based on two different criteria, regulatory capital and risk-adjusted capital. SpareBank 1 SR-Bank's minimum target is 9 per cent for its core (Tier 1) capital ratio and 11 per cent for its capital adequacy ratio. The group has, however, adopted new minimum targets for its regulatory ry capital effective from the end of the second quarter of 2012 The new minimum targets are a core (Tier 1) capital ratio of 10 per cent and a capital adequacy ratio of 12 per cent. In addition, a minimum m target figure will be introduced for the pure core capital adequacy ratio (excluding hybrid tier 1 secu urities) of 9 per cent in accordance with the new requirements from the Financial Supervisory Authority of Norway. The other criterion is risk-adjusted capital, in which the group's equity shall cover the risk-adjusted capital (unexpected losses) from all the group's risks calculated based on a confidence level of per cent Regulatory capital At end of the fourth quarter of 2011, the group had a capital adequacy ratio of 11.4 per cent and a core (Tier 1) capital ratio of 10.6 per cent. This capital adequacy is in line with SpareBank 1 SR-Bank's goals for the Figure 6: Development of capital adequacy as of the fourth quarter of The Board of Directors has decided that the ownership risk in the SpareBank 1 Group shall be calculated based on a confidence level of 99.5 per cent due to the fact that the risk in the SpareBank 1 Group is insurance risk to a significant extent. Insurance risk has a different loss distribution than traditional banking risk, and a confidence level of 99.5 per cent is in line with the Solvency II regulations. 18

19 Transitional rules in the IRB system In connection with the introduction of the Basel II regulations in 2007, a temporary transitional arrangement still applies for the IRB banks. According to the Capital Adequacy Regulations the IRB calculation basis in 2011 shall not be lower than 80 per cent of the minimum requirement calculated using the old capital adequacy rules and regulations (Basel I). The transitional arrangement was initially supposed to be terminated in 2009, but it is still in effect until further notice. Based on the portfolio as of the fourth quarter of 2011, the current capital requirement would have been NOK 861 million lower and the core (Tier 1) capital ratio would have been 1.2 percentage points higher without the transitional rule IRB ambitions for SpareBank 1 SR-Bank SpareBank 1 SR-Bank has received approval from the Financial Supervisory Authority of Norway to make use of internal ratings based (IRB) measurement methods for credit risk. The bank has been granted approval for the application of Foundation IRB Foundation for the corporate market and Retail IRB for the retail market. This means that the statutory minimum capital adequacy requirement for credit risk will be based in full or in part on the group s internal risk models. When calculating the capital requirement according to the IRB method for the retail market, internal models are used for calculation of the risk parameters probability of default (PD), conversion factor (CF) used in determining the exposure at default and loss given default (LGD). When estimating the capital requirements based on the fundamental IRB approach for the corporate market, the probability of default (PD) risk parameter is estimated on the basis of internal models. The risk parameters conversion factor (CF) used in determining the exposure at default and loss given default (LGD) are established according to the template rules in the Capital Requirements Regulations. The loss given default has been set on a regulatory basis at 45 per cent. The validation results for SpareBank 1 SR-Bank show that the loss given default for non-performing commitments in the corporate market is most likely in the vicinity of per cent if they had been realised during an economic downturn 5. SpareBank 1 SR-Bank has begun work qualifying for IRB Advanced the application to the Financial Supervisory Authority of Norway for approval to use an internal ratings based approach for calculation of the risk parameters conversion factor (CF) for use in determining the exposure at default (EAD) and the loss given default (LGD). It is expected that an approval will have a significant positive effect on the core capital adequacy. 5 So-called downturn estimate in accordance with the Capital Adequacy Regulations 19

20 4. PILLAR 2: GROUP'S INTERNAL RISK AND CAPITAL ADEQUACY ASSESSMENT 4.1 Objective of risk and capital management in SpareBank 1 SR-Bank The core business of the banking industry is to create value by assuming deliberate and acceptable risk. The group therefore invests significant resources in the further development of risk management systems and processes in line with leading international practice. Risk and capital management in SpareBank 1 SR-Bank shall support the group s strategic development and achievement of goals while ensuring financial stability and sound management of assets. This is to be achieved by: A strong organisational structure characterised by high awareness of risk management A good understanding of what risks drive earnings. Striving towards an optimal application of capital within the adopted business strategy Preventing unexpected single events from damaging the group s financial position to a serious extent. Making the most of synergy and diversification effects 4.2 Risk exposure at SpareBank 1 SR-Bank Trade and industry structure of the Group's market areas SpareBank 1 SR-Bank's market area is in Southern and Western Norway. The bank is currently located in the Agder, Hordaland and Rogaland counties. Even though the group has shown relatively good growth in Agder and Hordaland in the past years, the group's main activity is still in Rogaland. The description and analysis below is therefore mainly based on Rogaland. The "Economic Barometer for Rogaland Autumn 2011" concludes that there is a great deal of optimism in Rogaland due to the high level of investment in oil and gas in combination with the large oil discoveries in the North Sea. This has also had positive ripple effects on other industries. The situation in Europe is serious at the same time with a great deal of uncertainty and outlook for weak growth. Internationally, competitive enterprises dependent on growth in the world economy, may be facing major challenges. The high cost level in Rogaland in combination with a strong Norwegian krone makes the situation even more difficult. Below is a short description of the largest industries in Rogaland, measured by the number of employees. The description is based on the "Economic Barometer for Rogaland - Autumn 2011". The figure below shows employment distributed by sector in Rogaland. 20

21 Figure 7: Employment by sector Energy sector The energy sector is comprised of oil and gas production, power and water supply. The energy sector employs around 22,000 people, which accounts fewer than 10 per cent of the work force in the county. Employment has increased by around 10 per cent over the last year, and it is expected that employment will continue to increase as a result of the higher level of investment in connection with new developments in combination with a higher level of activity in operations, maintenance and modifications. New discoveries such as the Avaldsnes/Aldous field in the North Sea will create significant positive ripple effects for business, and it will represent major opportunities for the local business community in Rogaland. The sector's main challenges in the future will be the competition with other emerging global oil and gas markets, technology and access to qualified expertise. Industry Industry in Rogaland mainly consists of three areas, mechanical and metal goods, food and other industry. The combined employment ment in industry is around 25,000, which amounts to around 11 per cent of employment in the county. Almost half of the employees work in the mechanical and metal goods sector, which is closely linked to the oil and gas activities. Employment in industry has declined significantly, and there is a great deal of uncertainty concerning the future development of the exportoriented sector that is not related to the petroleum industry. Pressure on costs and greater competition from international companies in the home market and the need for product development are some of the challenges industry faces. Building and construction Building and construction employs around 18,000 people, which account for 8 per cent of employment in the county. This sector is very vulnerable to competition. Numbers from Statistics Norway show that while the growth in employment ment flattened out in connection with the financial crisis, companies in this sector are hiring again. Rogaland has a great need for new houses due to the strong population 21

22 growth. Growth is also expected for commercial buildings and construction as a result of several major road projects that are expected to start in the coming years. Distributive trades This sector employs just over 30,000 people, which accounts for around 13 per cent of overall employment in the county. The entire sector experienced lower revenues in connection with the financial crisis. Sale revenue has recovered and is at around the same level now as before the crisis, and it is expected that the distributive trades will increase in step with the increase in demand driven by the high level of activity in the oil and gas sector. Public sector There are around 66,000 employees in the public sector in Rogaland, which is almost 30 per cent of the overall employment in the county. During the financial crisis this sector showed the most growth in employment. To a great extent the public sector has been a buffer for increased unemployment during economic downturns. Growth in the public sector has continued after the financial crisis, even through the rate is somewhat lower than before. In the long term the sector will have a significant need for labour, and the county's population growth will give rise to a greater demand for public services. The development of the municipal economy will be decisive for how strong the growth in the public sector is in the coming years. 22

23 4.2.2 Macroeconomic outlook General Statistics Norway's economic barometer for the fourth quarter of 2011 shows a clear division in the Norwegian economy, in which the traditional export companies, such as companies in the timber industry, chemical raw materials industry, metallurgy industry, etc., have reported declining employment as a result of declining orders and falling prices in the export market, while the oil supplier industry is reporting increased production and strong growth in employment. Here it is the lack of qualified manpower that has contributed to limiting the production. When all the sectors are viewed as a whole, the development is somewhat better in the fourth quarter of 2011 than the third quarter of 2011 according to Statistics Norway's economic barometer, but there are, however, great differences from sector to sector. The economic cycle in Rogaland shows that growth is approaching the same level as the peak year of 2008 before the financial crisis, and continued strong growth is expected in SpareBank 1 SR-Bank's market area in The high rate of growth does, however, present challenges in the form of a lack of qualified manpower, transportation challenges and the lack of housing. A lasting imbalance between supply and demand will result in higher costs and negative competitiveness. In addition, it is very uncertain how a euro crisis and sovereign debt crisis in certain countries will affect the Norwegian economy. For companies in Rogaland as whole, the EU countries represent the most important export market. There is thus a risk that a further weakening in the European market may result in problems for export companies that are dependent on Europe. In addition to the fact that the purchasing power in Europe may be reduced, a strong Norwegian krone is also challenging for Norwegian export companies. The Norwegian krone has been strong and stable in 2011, and it is expected that the krone will remain strong. Rogaland Unemployment Unemployment is relatively stable in Norway. The LFS figures show that unemployment in Norway at the end of 2011 was 3.4 per cent and has hovered around 3.3 per cent throughout The labour market in Rogaland is good. Unemployment is at 2.5 per cent as of the fourth quarter of There has, however, been an increase of 0.4 percentage points compared with the previous quarter. Elsewhere in the bank's market area, unemployment increased somewhat in Vest-Agder as of the fourth quarter of 2011, while there has been a reduction in unemployment in Hordaland, compared with the previous quarter. The labour market outlook is somewhat weaker for Norway at the start of 2012, compared with the start of After good growth for most of our trading partners at the start of 2011, the rate of growth has lessened. Lower growth in production means that the companies do not need to increase their workforce as much. Export-oriented industry may experience lay-offs and reduced employment as a result of lower demand in Europe. New major oil discoveries in the North Sea will contribute at the same time to increasing the level of activity and employment in the market area of SpareBank 1 SR-Bank, however, the challenge here is to obtain enough qualified manpower. 6 Economic Barometer for Rogaland, fourth quarter of