The financial crisis: what is happening, why did it happen, and what are the implications for the banking industry?

1. CONFIDENTIAL CONFIDENTIAL The financial crisis: what is happening, why did it happen, and what are the implications for the banking industry? Jungkiu Choi / Brendon Hopkins

2. Market Turmoil Source: Financial Times

3. Agenda • What is happening? • Why has this happened? • Analysis of past financial crises • What are the implications for the banking industry?

4. 600 The crisis intensified in September 2008 with many large scale bank failures and collapse of Lehman Brothers • H2 08 • LIBOR 3-Month Spread to T-Bills* (bps) in FDIC receivership in US conservatorship files for bankruptcy acquired by BoA rescued by Fed acquired by Lloyds TSB sold to JPM nationalised and acquired by BNP-P • H1 08 nationalised and acquired by Santander US$7bn trading loss acquired by Wells Fargo • H2 07 acquired by BoA government bail out freezes three funds • H1 07 acquired by JPM with US$29bn Fed backing US$700bn bailout passed by Senate Several European governments guarantee deposits • H2 06 files for bankruptcy House prices begin to fall after loose credit and massive growth in MBS lead to record increases draws US$12bn on credit lines Discount window opened to primary dealers US$3bn loan to rescue internal fund with subprime losses government bail out run on the bank; BoE rescues Icelandic banks collapse UK and European governments construct bail out funds • Jan • Feb • Mar • Apr • May • Jun • Jul • Aug • Sep • Oct • Nov • Dec • Jan • Feb • Mar • Apr • May • Jun • Jul • Aug • Sep • Oct • 2007 • 2008 * Through 06-Oct-08; over U.S. 3 month T-billsSource: Datastream; Company reports; NY Times; Wall Street Journal; Group Strategy analysis

5. Assets Liabilities Loans to customers Deposits Loans to banks Wholesale funding Securities Debt / Prefs Other assets Equity Cash A Traditional Bank A normal company - Nike Assets Liabilities Trade payables Accounts Receivable Debt Stock Equity Other assets Cash Nike

6. The Traditional Bank Assets Liabilities Key Ratios Optimal levels < 100% Loan / Deposits Ratio [Total loans / total deposits] Loans to customers Deposits > 20% Liquid Assets Ratio [Cash+T.Bills+Net Interbank+Securities) / Total Assets] Loans to banks < 20x Leverage ratio [Equity / Total Assets] Wholesale funding Securities Capital Ratios (BoE guidance) - Core capital - Tier 1 - Total capital Debt / Prefs 4% 8% 10% Other assets Equity Cash

7. Northern Rock Assets Liabilities Key Ratios Actual levels Deposits > 300% Loan / Deposits Ratio [Total loans / total deposits] < 10% Liquid Assets Ratio [Cash+T.Bills+Net Interbank+Securities) / Total Assets] Loans to customers Wholesale funding 14x Leverage ratio [Equity / Total Assets] Debt / Prefs Loans to banks Equity Securities Cash

8. Standard Chartered Assets Liabilities Key Ratios Actual levels 85% Loan / Deposits Ratio [Total loans / total deposits] Loans to customers Deposits > 20% Liquid Assets Ratio [Cash+T.Bills+Net Interbank+Securities) / Total Assets] Loans to banks 14x Leverage ratio [Equity / Total Assets] Wholesale funding Securities Derivatives Derivatives Capital Ratios - Core capital - Tier 1 - Total capital Other assets 6.1% 8.5% 14.9% Debt / Prefs Cash Equity

9. How banks suffer from a crisis Assets Liabilities Ailment Impact  securities  Equity Subprime write-off Loans to customers Deposits Loan losses  Loans  Equity  ratio falls Deposits Force liquidation of assets Inability to fund = collapse Run on the bank Loans to banks Wholesale funding Securities  Liquidity  Price of funding Inability to fund = collapse Interbank dries up Debt / Prefs Other assets Equity Cash Basel 2 Pro-cyclical RWAs  as credit quality  Capital ratios stressed

10. A global recessionary environment seems likely to ensue – the question is how bad will it be? • Moderate global recession • Credit losses at lower end of the range – up to US$1.5trn • US & UK economic slowdowns / recessions are short and mild; Asia remains insulated • Credit markets largely recover in 09; low prices attract sophisticated buyers; liquidity and confidence returns • Limited additional credit losses in Q1 2009 and beyond • Securitization volumes pick up in 2009; full recovery by 2010 • Investment bank earnings bounce back in 2009 / 10 • Long chill • Credit losses in middle of the range – US$1.5trn-US$2trn • US & UK experience recessions lasting 3-4 quarters; Asia slow but avoids recession • Credit markets remain depressed throughout recover later in 2009 • Securitization recovers later in 2009, but largely “vanilla” structures • Further capital raising by banks to repair balance sheets • More banks require rescue /bail-out • Most likely range • Credit losses in top end of range - US$2tn and possibly beyond • US and UK recession of 6 or more quarters; Europe and Asia slow significantly and more countries dip into recession • Unemployment increases over pre-2006 levels, peaking at 7%-8% in several quarters • Sustained stock market decline has strong negative effect on the wealthy • Banks consistently unable to meet capital raising targets; large corporate credit losses; several sizable bank failures; large further government interventions required • Strong social backlash to free market system and globalisation • Prolonged deep global • recession Source: McKinsey analysis

11. Regulatory change is also accelerating with many unprecedented steps • Long-term • impact Regulatory changes since September 7, 2008 • Fannie Mae, Freddie Mac Conservatorship • Treasury replaces management, gives FHFA control, explicitly guarantees GSE obligations, takes equity stake • NY State Insurance Dept Interventions • NY state allows AIG to borrow from its subsidiaries, before US$85bn Federal Reserve loan; announces regulation of CDS • Money Market Funds guaranteed • Treasury insures eligible mutual funds (TBD) to US$50bn total limit; no limit on amount per account-holder • UK and US Short-Sale Restrictions • FSA bans short selling on 32 financial stocks until January • SEC bans short selling on financial stocks through October 2008 • GS, MS Become Bank Holding Companies • Fed approves GS and MS to become BHCs; higher capital requirements reduce leverage by 50% • TARP (Paulson Plan) • Legislation proposed – debated, modified, and passed –authorizing Treasury to buy US$700bn in “troubled assets” to stabilize markets • Coordinated European Interventions • EU members coordinate on Fortis and Dexia bailouts • EU governments (e.g., Germany, Ireland, UK, Greece, Austria) guarantee deposits • Fed to Purchase Commercial Paper • Fed plans to purchase 3-month unsecured and asset-backed commercial paper from issuers

12. All countries to systemically support important institutions Undertake measures to get credit flowing Assist banks in raising capital Reassure savers Restart market for mortgage-backed securities Asian regulators are taking steps to address key issues and maintain stability Regulatory changes since Sept-Oct 2008 • ASEAN • Singapore central bank moving to zero-appreciation stance for trade-weighted Singapore dollar • Singapore government guarantees bank deposits • Asset maintenance ratio closely monitored (i.e. the money raised in SIN, is not deployed to toxic assets) • Australia • Government guarantees bank deposits for 2 years buys $8bn in non-bank mortgage securities • Official interest rate cut by 100 bps • Short-selling suspended • China • Taiwan government guarantees all deposits until December 2009; suspends short-selling until year end • China government cut 1-year interest rates by c. 81 bps and Cash Reserve Ratio (CRR) by c. 50 bps • Reduced major banks’ required reserve ratio • Increased credit to encourage SME loans • RBI reduces CRR by 150 bps • SEBI lifts ban on FII investment through the participatory note route • Foreign investment limit in domestic debt market increased • Government infusing capital in system to raise the state owned banks capital adequacy to 12%; dissuading banks from withdrawing investments in equity markets • India • Japan • Emergency funding mechanism to help smaller lenders’ balance sheets through direct injections of public funds • BOJ injects US$120bn into domestic money market to maintain liquidity and Yen stability • Launch tentative measures to stabilise stock prices-: ban on short selling, suspension of sale of public sector-owned stocks, relax restrictions on corporations' purchase of own stocks, resume purchase of stock held by banks, suspension of mark-to-market accounting rules, allow banks’s stock holdings to exceed its core capital • Korea • FX stabilisation fund for banks and exporters who need US$. Fund value ~$5b • Low-income mortgagees given an extended repayment period (extra 5 years) • Government guarantees on SME bank loans • G20 • 5 point plan

13. Agenda • What is happening? • Why has this happened? • Analysis of past financial crises • What are the implications for the banking industry?

14. The genesis of the crisis lay in the largest US real estate bubble in the past forty years • Office of Federal Housing Enterprise Oversight HPI (all transactions) • 40% overvaluation relative to long-term trend • US$14.4 trillion of residential / commercial mortgages outstanding • Recent “bubble” • 44% increase in HPI from 2002-2007 • Late eighties “housing bubble” • Late seventies “housing bubble” • 1975 • 77 • 79 • 81 • 83 • 84 • 86 • 88 • 90 • 92 • 94 • 96 • 98 • 00 • 02 • 04 • 06 • 08 Source: Economy.com

15. 600 • 0.5%-1% of world GDP • 1%-5% of world GDP • 5%-10% of world GDP • 10%+ of world GDP • World GDP(2007) = US$55trn In a globalised world where cross-border investments have increased, linking financial markets • Lines show total value of cross-border investments between regions*, 2007 Figures in bubbles show size of total domestic financial assets, US$bn • Russia, Eastern Europe • 5,070 • UK • 11,055 • Emerging • Asia • 21,782 US 61,194 Western Europe 52,435 • Japan • 20,089 • Hong Kong, • Singapore, Taiwan • 4,379 • Middle East, rest of world • 5,524 • Australia, • New Zealand, Canada • 8,530 • Latin America • 5,939 * Includes total value of cross-border investments in equity and debt securities, lending and deposits, and foreign direct investment Source: Brookings Institution, McKinsey, Laura Tyson

16. Asia exports ? Sub prime and other lending Consumer spending Stock market Corporate earnings Real estate Commodity Other bubbles that drove the crisis are also consequently bursting due to deleveraging….

17. 1 • Weaknesses in basic risk infrastructure (e.g., data quality) • Limited understanding of liquidity, capital, and accounting implications (e.g., liquidity and capital position undermanaged) • Underestimation of structural risks and serial “bubbles”(e.g., no consideration of “bubble” indicators) • Transparency • 2 • Risks not sufficiently considered in strategies (e.g., hidden tail risks, growth ambitions not matched by institutional capabilities) • Risk appetite/risk taking capacity overestimated • Ownership • Processes • Governance • Culture • 3 • Overreliance on models with significant limitations(e.g., risk factors not fully captured, lack of proper stress testing) • In time of crisis, inadequate decision speed and quality (e.g., CRO/CFO debates on numbers, no contingency plans) • Accountability for risk evaporated (overreliance on CRO, committees improperly used to socialize accountability) • Dramatic skill deficiencies incl. ExCo and Board • 5 • Misaligned, short term, top-line oriented incentives(e.g., self interest of decision makers outweighing well-being of institutions) • Risk concerns pushed aside Banks have played their part with key failures in leadership, infrastructure, governance and risk management…. • 4

18. Agenda • What is happening? • Why has this happened? • Analysis of past financial crises • What are the implications for the banking industry?

19. Types of financial crisis: more than 100 financial crises since 1980 can be classified into 6 types – with the largest being shown below. This crisis is more severe than them all… • Type 1 • Current crisis looks likely to be deep and long across many sophisticated financial markets with major impact in real economy • US S&L • UK (1991- averted) • H • Has impacted US election and is beginning to lead to political changes e.g. resignation of government in Belgium over Fortis • Type 4 • UK (1973) • Sweden (1991) • Denmark (1990) • Japan (1990s) • M • Development of financial systems • Government intervention and external support • Market resolution • Type 2 • Type 3 • Korea (1997) • Thailand (1997) • Chile (1982) • US Depression (1929) • Argentina (1981, 1995) • Brazil (1995, 1999) • Mexico(1995) • L • Type 5 • Type 6 • Indonesia (1997) • Russia (1997) • Financial sector • Financial sector and macro economy (trade deficit) • Financial sector and real economy (companiesROIC < WACC) • Financial, real economy and politics • Financial, real economy, macro economy and politics • Root causes and depth of crisis

20. Most severe credit crisis since 1987 Every financial crisis is unique, but the flight to quality repeats 87 Stock Market Crash Russian Ruble Crisis Bursting of Tech Bubble & 9/11 S&L Crisis Sources : Bloomberg, SCB Global Research

21. A U-shaped recession is not helping either It is not just a financial crisis: A battered housing market will make the recovery process a slow and painful one for households Source: Bloomberg, SCB Global Research

22. US housing to keep on falling • Case Shiller, 2000=100 No recovery before 2010 Source: Bloomberg

23. UK: Another housing market in trouble Institute of Chartered Surveyors Survey % expecting prices to rise minus % expecting prices to fall Source: Bloomberg

24. Barclays’ recent share price

25. Japan (1992) Philippines (1997) Hong Kong (1997) Korea (1907) Malaysia (1997) (9.3) 1.9 Average Thailand (1997) Indonesia (1997) US (1929) Experience on the systematic banking crises suggests that downturn conditions persist for a long time… Tracking of GDP and real house price trends before, during and after respective banking crises Economists identify these systematic banking crises… ‘Big 5’ post WW2 • Peak to Trough GDP Decline (left, %) against Duration of Downturn (right, years) • The first energy crisis • 52% of Spanish banks in serious financial problems Spain (1977) Norway (1987) • Commodity-shock-driven recession • loan losses and insolvency in banks • three largest banks nationalised Finland (1991) • Soviet Union recession preceded by financial market liberalisation and the collapse of exports • Finnish government spent over €10b to support Finnish banks Sweden (1991) • Restructuring of the tax system caused financial bubble that formed during 1980s to burst • Central bank unsuccessful in defending the currency’s fixed exchange rate • Peak to Trough Real House Prices Decline (left, %) against Duration of Downturn (right, years)(scales not comparable, purple denotes current crisis) Hong Kong (1997) Japan (1992) • Rating agencies lowering of Japanese banks evaluations due to non-disclosure and a lack of transparency • 13 Japanese financial institutions effectively went bankrupt during 1995 UK (2007) US (2007) Spain (2008) (55.9) 3.4 Average Philippines (1997) Emerging market crises Japan (1992) Asian Crisis (1997) Hong Kong, Indonesia, Malaysia, Philippines, Thailand Colombia (1998) and Argentina (2001)Interest rate actions in defence of currency regimes spread knock on effects to banking sector Dataset also includes US 1929 US (1929) Malaysia (1997) Indonesia (1997) Korea (1997) Thailand (1997) Source: ‘Is the 2007 U S Subprime Financial Crisis So Different? An International Historical Comparison’, C. Reinhart & K. Rogoff; Feb-08

26. 5,033 Financial crisis evolves in a typical path but timeframes for each stage can vary significantly…. • Liquidity • Defaults, asset price crash • Fear, lost of confidence • Liquidity Crisis • Crisis Breakout • 2 - 6 months • Liquidity problem continues • Financial institutions closed • Big defaults • Credit Crisis • Oversupply and easy credit conditions • Asset prices rising fast • "As long as the music is playing, you've got to get up and dance” • 6 - 18 months • Industry consolidation • Regulatory changes • LT capital base grows • Increased M&A • Restructuring • 2 - 5 years • GDP recovers • Recovery • 5 - 15 years

27. 5,033 Severity and duration of crisis is uncertain – but some lessons have been learned from past experience…. Restructuring/ Recovery Liquidity Crisis Credit Crisis

28. Current macro environment –Multiple deleverage Basel 2 IFRS accounting Macro economic slow down Regulatory pressure Rising losses in Rising losses in Rising losses in Banks Banks Banks US subprime market and US subprime market and US subprime market and realise realise realise contagion as prices fall in contagion as prices fall in contagion as prices fall in losses and losses and losses and other asset classes other asset classes other asset classes provisions provisions provisions rise rise rise Sustainable Sustainable Sustainable banking sector banking sector banking sector Banks lose Banks lose Banks lose Multiple deleverage in a RoEs fall, RoEs fall, RoEs fall, confidence in confidence in confidence in down-turn from: leading to leading to leading to each other each other each other – – – share price share price share price Negative profitability gearing n wholesale wholesale wholesale freefall freefall freefall fundings dries fundings dries fundings dries • Falling profitability • Lower capital regeneration • Higher bad debt charge up and funding up and funding up and funding costs rise costs rise costs rise Basel II pro-cyclicality Triple Triple Multiple n Falling profits Falling profits Falling profits deleverage deleverage deleverage Regulatory pressure n result in job result in job result in job accelerates accelerates accelerates cuts, capital cuts, capital cuts, capital Slowing distribution n raisings and raisings and raisings and Liquidity / funding issues n asset sales asset sales asset sales Economic activity falls Economic activity falls Economic activity falls Lending slows to Lending slows to Lending slows to and asset prices fall and asset prices fall and asset prices fall retail and wholesale retail and wholesale retail and wholesale further further further customers customers customers

29. Agenda • What is happening? • Why has this happened? • Analysis of past financial crisis? • What are the implications for the banking industry?

30. Over the medium term, further regulatory overhaul is highly likely … • Basic • reforms 1 • Higher capital requirements in particular for securitization (as amendment of Basel II) 2 • Introduction of stricter liquidity management including liquidity buffers 3 • Improvement of capabilities and effectiveness of risk management practices 4 • Fixing flaws in supervisory structure, e.g., gaps in supervision of US investment banks, unregulated US mortgage originators 5 • Mitigation of pro-cyclical elements in Basel II 6 • Mitigation of pro-cyclical elements in fair value accounting 7 • Increased scrutiny applied to business model – more intensive process for entering new business lines / products • Broader • regulatory • expansion 8 • Align incentives to incorporate risk elements, e.g., stronger long-term incentives, deduct capital and funding costs from bonus pools, keep slice of risk on balance sheet, deposit safety fund

31. 43 Significant industry consolidation is advancing fast in Western markets… Top 5 players* (%) • Germany** • UK • US • 55 • 2007 • 2008E • 2007 • 2008E • 2007 • 2008E Top 5 Players M&A * By assets ** Analysis without savings and cooperative banks *** Total banking assets of deposit taking institutions and investment banking assets of Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, State Street and GE Commercial Finance Source: Central banks, McKinsey analysis

32. . • Additional Credit Losses • Shrinking Volumes • Pressure on Margins from Liquidity Costs • Deleveraging • Increasing Equity Requirements The challenge on profitability could be severe over the next few years… • Crisis impact • Global banking revenues (% GDP) • Goldman Sachs estimates losses to peak in Q1 / Q2 2009 • 7 • Moderate • Long chill • 6 • 5 • Prolonged deep recession • 4 • 0 • 2000 • 05 • 10 • 2015 • 25% cost reduction required to compensate revenue loss

33. In the long term, a new banking model will almost certainly emerge… • Winning Business Models • Efficient universal banks with strong, effective risk management and strong performance culture • Highest Growth Regions • Emerging markets, but with some major bubbles and failures • Winning Products • Relationship banking • Transactional banking • Easy to understand investment products • Reshaped mortgage and consumer finance • Low-cost liability gathering products • Most Important CEO Issues • Risk management • Re-regulation • Consolidation • Biggest Opportunity • Reinventing residential mortgage markets • Innovation in business models • Cutting complexity and cost structures • Acquire and turnaround underperforming players • Prospects • Very tough short term • More attractive long term as crisis forces consolidation, better risk management and efficiency

34. Questions?