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BANK FINANCIAL PROJECTION MODEL

EXPLANATORY GUIDE

Murat Arslaner, Joon Soo Lee, and Joaquín Gutiérrez

Financial Systems Department

Financial & Private Sector Development Vice Presidency of the World Bank

May, 2010. Version 1.0 The FPM® and this Guide are provided for informational purposes only and its use is not endorsed for any person other than trained staff of the World Bank. This version contains explicit reference to protection arrangements and formulas used in selected areas. For confidentiality purposes and to protect the intellectual property of the developers these arrangements may not be always available in a public version. We have taken care to ensure that the instructions of this Guide are consistent with the mechanics coded in the version the FPM® that we have shared with you. If you detect any issues please let us know to update this guide and to provide additional guidance as needed.

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Table of Contents

ACRONYMS

I. Introduction ......................................................................................................................... 4 A. Background .......................................................................................................................... 4 B. Bank Financial Simulation: Conceptual Issues ..................................................................... 5 C. Protection and Licensing of the Model .............................................................................. 11 D. Recalculation and Governor Switches ............................................................................... 11 II. Objectives and Uses of the Model ..................................................................................... 12 A. Initial thoughts ................................................................................................................... 12 B. Overall Goal ........................................................................................................................ 13 C. Rationale of Using a Simulation to Monitor Conditions .................................................... 14 III. How to Use the FPM® and Perform a Projection ............................................................... 16 A. Overview of Steps .............................................................................................................. 16 B. Mapping Data to the FPM® ................................................................................................ 17 C. Entering Data ..................................................................................................................... 18 D. Stabilizing a Projection ....................................................................................................... 20 E. Sensitivity Analysis & Simulating Alternative Scenarios .................................................... 21 F. Simulating Stress ................................................................................................................ 23 G. Quantifying Value .............................................................................................................. 25 H. Estimating Resolution Costs ............................................................................................... 25 I. Simulation Structures ......................................................................................................... 27 IV. Overall Structure of the FPM® ........................................................................................... 29 A. Main Features of the Model .............................................................................................. 29 B. Structure of the Spreadsheet ............................................................................................. 32 C. Growth Dynamics of the Model ......................................................................................... 34 D. Model Balancing and Allocation of Funds Flow ................................................................. 45 E. Liquidity constraint mechanics in the Model ..................................................................... 49 V. Main Formulas of the Financial Projection Model ............................................................. 51 A. Available-for-Sale Securities (AFS) in the Model ............................................................... 51 B. The Loan Portfolio in the Model ........................................................................................ 54 C. Multi-purpose Assets (MPA) and Multi-purpose Liabilities (MPL) .................................... 61 D. Preferred Stocks in the Model ........................................................................................... 70 E. Income Tax in the Model ................................................................................................... 75 F. Operational Expenses and Other Operational Expenses in the Model ............................. 76 G. Estimation of Capital Adequacy Ratio in the Model .......................................................... 77 H. Financial Derivatives (Forwards and Swaps) ...................................................................... 79 I. Net Foreign Exchange Position .......................................................................................... 86 J. Setting Reference Rates for Interest-Earning Assets and Interest-Bearing Liabilities ....... 86 K. Repricing of Assets and Liabilities ...................................................................................... 87 L. Bank Resolution ................................................................................................................. 87

Annexes

1. Topics to Learn about the Bank 2. Mapping Spreadsheet 3. Subrogate PDs and LGDs 4. Governor Levers and Other Issues

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ACRONYMS:

AFS: Available-for-Sale Securities ACT: Actions BFF: Balance Sheet Funds Flow B/S: Balance Sheet CAMEL(S): Composite Rating System using as proxies of condition Capital adequacy, Asset

quality, Management effectiveness, recurrence and Earnings level, and Liquidity (plus Sensitivity to Market Risk)

CB: Central Bank DFF: Discretionary Funds Flow ELA: Emergency Liquidity Assistance FF: Funds Flow FG.CY.: Foreign Currency FPM: Financial Projection Model FVA: Fair-Value Adjustment FX: Foreign Exchange HTM: Held-to-Maturity Securities IAP: Interest Accrued Payable IAR: Interest Accrued Receivable IBL: Interest-Bearing Liability (ies) IEA: Interest-Earning Asset(s) IFF: Initial Funds Flow IRB: Internal Ratings-Based approach to capital (Basel II) LC.CY.: Local Currency LGD: Loss Given Default LOR: Lender of Last Resort MPA: Multipurpose Asset NPL: Non-Performing Loans OBS: Off-Balance Sheet OCF: Operational Cash Flow OFI: Other Financial Intermediaries P&A: Purchase and Assumption PD: Probability of Default P/L: Profit and Loss Account PV: Present Value RWA: Risk Weighted Assets

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I. Introduction

A. Background

The FPM® is a system of simultaneous equations which returns by iteration the balance sheet (B/S) and the profit and loss account (P/L) projected for a bank or a banking system. The FPM® follows the “Gauss-Seidel” recursive method, subject to the behavior of a set of internal and external variables, including a limited number of simplified management and regulatory constraints. The authors have conceived and developed the FPM® to assist in integrating work and outputs of other disciplines and sources. The FPM® can assist in producing examination reports, risk assessments from supervisors, well-implemented stress testing, as well as key outputs from risk management and financial control activities at institutions.

The FPM® is the intellectual property of the Financial Systems Unit (Oversight Group) of the Financial and Private Sector Development Vice Presidency of the World Bank. The Model is the intellectual domain of its developers: Murat Arslaner, Joon Soo Lee, and Joaquin Gutierrez, who conceived, designed, and developed the FPM® in its totality. It was inspired in different degrees by previous work and models developed and used since 1982 by Joaquin Gutierrez, Alfredo Bello, and Sophie Sirtaine in their respective works and engagements, but the current version does not replicate any solutions implemented by these other individuals.

The FPM® is a tool that simulates the effect of internal and external events upon bank solvency and profitability. Systematic use of the FPM® can help to answer crucial questions such as how solvency and sustainability of operations would evolve under certain stress scenarios, and whether pre-provision profits under normal and stressed conditions would be able to absorb operating costs and ongoing credit risk losses.

The FPM® is also helpful in evaluating the least cost solution of a problem bank by comparing

different alternatives in present value terms. Using the FPM®, supervisors can evaluate the implicit subsidy of government and central bank support to banks experiencing liquidity and solvency tensions, as well as to test bank rehabilitation and recapitalization plans.

In addition, by estimating the net present value of discretionary net income, the FPM® is central to determining the technical value of a bank under the income approach. This is an essential input for evaluating and negotiating a merger or acquisition, or the effect and support required to structure a purchase and assumption. Successful use of these techniques requires reliable data at entry and an accurate diagnosis (due diligence or inspection) of the target bank’s conditions.

The following section provides an overview of financial simulation in the context of banking and banking supervision, including a few rules of thumb and a summary list of essential parameters. Chapter II explains the objectives and uses of the FPM®. Chapter III guides the user through the

“The universe stands continual open to our gaze, but it cannot be

understood unless one first learns to comprehend the language and

interpret the characters in which it is written.” Galileo Galilei

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basic steps in performing a projection and evaluating alternative scenarios. Chapter IV documents the structure of the Model’s spreadsheets. Finally, Chapter V provides the set of equations used for the primary functions of the FPM®.

Note that this guide is deliberately written in an informal tone, and in a way that is meant to be accessible to readers. The term “we” is used throughout the guide to indicate the authors of the FPM®; “you” (used interchangeably with “users”) is utilized to indicate FPM® users who will be using the Model to build, run and analyze projections.

B. Bank Financial Simulation: Conceptual Issues

Overview

Financial forecasting is crucial for developing the realistic financial plans that are the basis of strategic decision-making. Bank profits that are achieved without effective forecasting and effort to detect, control, and manage risks border on speculation. Simulating bank performance under different forecast scenarios can underline the critical role played by key variables to which financial performance is sensitive. In this way, financial forecasting and simulation support the financial planning process, which itself ties together a bank’s strategic and operational planning and assures that current management decisions consider the future operating environment.

A financial projection extends into the future the trends that are observed today, and emphasizes the importance of tracking and managing controllable factors. For an insolvent or a problem bank, a projection is a passive representation of a situation that requires resolution. In addition, for both solvent and insolvent institutions, a financial simulation considers the effect of alternative management and regulatory actions, and integrates observed trends with changes forecasted in non-controllable factors. A simulation generates a set of expected outcomes (and indicators) which can be used to monitor financial and operational performance.

Simulation focuses on the impact of possible plans of action, which are usually designed to correct a negative event or trend. Banking functions that promote a sound and orthodox quest for profit, like capital budgeting, balance sheet management, and annual budgeting, always rely on conservative financial forecasts. Adequate planning, forecasting, and simulation are thus of high interest to bankers and bank supervisors, who monitor the health of financial institutions and the economy as a whole.

Financial simulation aims to ascertain how a bank will perform in the future under a particular set of endogenous and exogenous variables that we can select as representative of a given business and/or economic scenario. The conceptual issue at the core of financial simulation is institutional strength: whether, under the circumstances used in the simulation, a particular bank will be able to generate sufficient internal funds to maintain a cushion of profits to absorb any latent (structural) and current (operating) losses, as well as to preserve or regenerate its economic capital (accounting and regulatory capital measures are also considered).

Because of the pertinence of dividend policies, a second-tier issue in a simulation is to ascertain whether the profits, after due provisioning and allocation to reserves, will allow a bank to remunerate capital with an acceptable real rate of return without draining the bank's financial strength or compromising its medium-term stability.

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Simulation has a special purpose when major financial restructuring is involved. In such cases, simulation can help to reassure policymakers and supervisors that bank rehabilitation or restructuring is worth its costs. Simulating a bank’s financial statements can confirm that, at the very least, the estimated necessary resources are sufficient to turn negative trends around and reasonably assure the bank’s future survival. In addition, since in many cases privatization will follow rehabilitation, the use of a financial simulation that uses conservative estimates will help to value potential cash flows for pricing considerations.

When a sale is contemplated, comparative testing by means of alternative simulations permits an analysis of the feasibility of the potential acquirer’s business plans, and can corroborate whether the new independent entity will be able to sustain itself through shareholder support and new management. Trying to find the answers to these questions brings to the forefront the core issues of any financial simulation:

The starting point of any simulation should be based on a realistic assessment of a bank's financial condition;

Prudence given experience requires a conservative view of the asset quality and potential performance of the bank's interest-earning assets;

The exogenous variables (rates of growth and interest) that drive its operational environment must be identified;

A pragmatic estimation of the foreseeable evolution of those exogenous variables is needed; and

The sensitivity of performance to changes in key exogenous and controllable variables should be tested under different scenarios.

Assessment of Condition

We do not recommend undertaking a projection/simulation without good quality information regarding the target bank and the contribution of each of its business divisions (trading, credit, investment and funding, other fee-based services) to risks and revenues. At a minimum, this information should include a good level of understanding of the bank’s operating environment and of the drivers of the overall banking system and economy. Limited access to information or poor-quality information means reduced credibility and quality of the projected results. Preparing the necessary information requires access to certain sources and reports, as well as a detailed analysis of the essential information that these reports should contain.

There are external public sources which can help, like the reports of rating agencies and other market analysts, but these are almost invariably insufficient. The reports from bank-paid external auditors and statutory accountants can be useful sources of information, especially if they are subject to adequate quality assurance, and provided such reports followed reasonable asset valuation criteria and contain adequate coverage of risk assets. For example, many recently-audited reports prepared under International Financial Reporting Standards (IFRS) contain some level of granular information in terms of segment analysis, average rates of interest and level of impaired loans by credit portfolios (households, consumer, and corporate). However, these are not always sufficient and/or consistent.

To design a good projection/simulation for a bank, one would normally need to combine the information from the external sources described above with the internal reports of examination

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and risk assessments from bank supervisors, as well as risk assets reviews and profitability analyses done by the bank itself. In general, these two internal sources should have a higher degree of granularity regarding asset risk and income performance, as well as for costs and funding, than the external sources listed above.

However, several possible situations can distort the transparency of the information gathered from all sources described above. First, rating agencies and external auditors can be influenced by the interests of the managers who pay them for their opinions. Second, bank examiners almost invariably work under pressure, sometimes political, and often lack the necessary resources and training that would allow them to carry out a robust examination of a bank. Many times examiners are required to review and attest to compliance with regulation, rather than having the time and full access necessary to evaluate a bank’s financial condition, or the effectiveness and integrity of systems and controls. And third, internal bank governance can fail to ensure the effectiveness and integrity of internal risk asset reviews, and risk management in general, resulting in possible situations like the financial fiasco that exploded in 2008 in many developed countries.

For particular cases where information sources are clearly insufficient or inadequate -- for example, for a very large, complex, or deeply problematic bank -- the best approach for establishing the real conditions of a bank is to perform special diagnostics using third parties, such as expert bankers and supervisors, including truly independent auditors. Under well-designed and properly controlled terms of reference, these special diagnostics can be the most effective tool to determine the real condition of a particular bank, as well as to provide the information necessary to ascertain its financial viability.

The FPM® would come into play after such special diagnostics. Alternatively, it can be used, albeit with a lesser degree of confidence, together with a mix of the information sources discussed above. In this latter case, the user of the Model needs to be aware of those essential inputs and parameters that are most important to making the projection/simulation accurate and realistic. Using poor quality information is likely to result in a projection that is not credible (“garbage in, garbage out”). The user is advised to select conservative assumptions of essential inputs and parameters from the list that follows.

Essential Inputs and Parameters

This guide explains in Chapter III how to conduct all the preparatory work that will lead to a well-grounded projection/simulation, or what we call a “stabilized” projection. That chapter contains multiple references and detailed discussions regarding the essential inputs and parameters that have a higher level of influence on the results of a projection. For those users with less experience, a general summary of inputs and parameters is presented here. For more detailed notes, please see Chapter III.

Growth and spread can “cure” all problems, especially if credit losses are kept below historic and/or expected losses, given the stage of the economic cycle and the relative values of the factors that can affect that loss (i.e., judiciary process and work-out of debt affect the severity of the loss, or LGD). Thus, one could project a bank, insolvent in reality, to grow at the speed of sound, tripling its spreads, and perfectly capitalized in less than five years, all shown on the Model’s spreadsheets.

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Users of the FPM® should keep in mind several reasonable rules of thumb based on experience, a list of which appears below. These assumptions apply to normal cases unless one is presented with compelling quantitative evidence to the contrary that is based on indisputable information:

A bank cannot exceed the pace of growth in the local economy without taking market share from its competitors (who in turn should be expected to react and adopt alternative strategies to retain and increase their market shares as well).

If all banks project growth that is faster than the rate of growth of the economy, in a few years their combined market shares would exceed several times the total existing market (which is highly unlikely).

If there are three to five years of fast growth in credit (for example, more than twice the real GDP growth), especially in speculative and weak cash-generating sectors, it is very likely that credit losses will appear (sooner rather than later, as loans mature - unless rolled-over).

To grow consistently above trends and competitors, a bank needs to tackle underserved segments, introduce new products, and/or compete in pricing (which are all risky and costly strategies, which should not be hidden in any projection).

More competition means lower spreads, cost-income tensions, and a shift to lower credit quality segments for those banks with weaker risk management processes (especially in risky segments such as credit cards, real estate, etc.).

As competition increases, banks’ bids for funds should lead to an increase in deposit rates and more costly funding sources (or banks will keep deposit rates negative in real terms, causing further dis-intermediation).

A bank cannot finance the growth of its loans and investments above the rate of growth of its core deposits without access to alternative funding (and possible alternative funding sources are currently scarce and many are relatively unstable).

A bank cannot widen the spread between its interest-earning assets and interest-bearing liabilities without assuming additional credit and liquidity risks (which works only if local competitors do not follow the same strategy).

Taking on the additional risks described in the point above may be fruitful if these risks are priced via provisioning and reasonable retained earnings; otherwise losses will reappear (except during a long credit cycle like that of the last decade).

If there is a plan to widen interest spreads, one or both of the following two possibilities might happen: a) borrowers see an increase in the cost of credit; and/or b) depositors see their remuneration rate fall.

If one or both of the above happens, deposit growth might falter, or fail to materialize as expected, leaving the repayment capacity of the borrowers to deteriorate further (increasing credit losses, unless problem loans are re-aged and refinanced).

If all the banks in a given country follow the same strategy, spreads normally will tend to narrow rather than widen, which puts pressure on costs and reduces the capacity to provide for normal credit losses.

Loans in a foreign currency (FG.CY.) to borrowers who do not generate repayment cash flow in that currency are more risky and should normally exhibit large default probabilities and loan losses.

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Significant discrepancies between credit risk pricing and provisioning (accounting vs. economic full cost allocation of credit and liquidity risks) lead to easy volume growth, high dividends, big bonuses, and later, to bigger losses.

Any other “magical” source of growth and net earnings must be carefully examined before including it in a projection (unless it is a credible blanket guarantee provided by the government so that taxpayers end up covering losses)

In the end, the user of the FPM® needs to exert careful due diligence (and lots of good analysis) regarding the data which supports the core assumptions and parameters listed below as a simple check list. Users should ask supervisors and technical staff in central banks, as well as management of the target bank, about the evidence that support the assumptions and the consistency of each in relation to the other assumptions.

As discussed above, data for assumptions and other parameters for the projection/simulation can be obtained from several sources for both the local banking industry and the target bank. You should obtain the uniform bank performance reports and functional cost analysis that bank supervisors customarily use as part of their offsite surveillance systems. These reports should include information on asset quality, arrears, and provisioning by credit segment (consumers, mortgages, large corporate, etc.), depending on the granularity of the regulatory reporting systems in place. Otherwise, as a substitute or as a complement, notes to the reported financial statements can provide valuable information (although not always complete) to quantify assumptions, as well as to evaluate consistency and reasonability, for the following essential parameters:

1) Volume Growth: trends, plans and outlook for significant activities.

▫ Rates of growth for major lines of the B/S (assets and liabilities) based on products and business segments targeted.

▫ Consistency between the target bank’s market shares in those segments and trends in the industry and the economy.

▫ Capacity of and steps taken by the bank to win a larger market share in certain segments and capitalize on economies of scale.

▫ Resources and products of the bank, including associated needs and costs, that would be required to achieve a larger market share in certain segments.

▫ Core segments of clientele in deposit-taking products and in relevant credit segments (i.e., related parties).

▫ Underlying economics of those segments: pricing and typical spreads and costs considering products/services sold.

2) Interest-Based Activity: trends and outlook for reference rates and spreads, including cross-currency and foreign currency activities.

▫ Recent average and marginal rates of interest for main segments of loans, securities, deposits, and funding sources.

▫ Reference rates in the industry to link them to the above rates and other rates of interest-earning assets and interest-bearing liabilities.

▫ Current level and trend of the spreads between the target bank’s relevant assets and liabilities, and the relevant reference rates in the industry.

▫ Trends and expected outlook for those reference rates to regional/international reference rates (i.e., LIBOR, EuroLIBOR).

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▫ Consistency among the above, considering expected evolution of monetary aggregates, Public Sector Borrowing Requirement (PSBR), and Consumer Price Index (CPI).

3) Lending Activities and Asset Quality: dynamics of asset quality and risk parameters (migration, work-outs, charge-offs).

▫ Loan quality reported by segment and available credit reviews, including level of adversely classified loans.

▫ Trends and practices by major segments to account for and to provision arrears, re-aged and restructured loans.

▫ Level of provisioning, restructured and non-accrual status loans, and low-provisioned loans supported in collateral.

▫ Income recognition trends, as well as the practice of reversals and accruals of interest, fees, and foreign exchange (FX) revaluation income.

4) Fee-Based Activities: trends and outlook in turnover regarding lending, payment, Asset Management (AMG) and other fee-generating services.

▫ Decomposition by main product or service and stability of recurrent and non-recurrent non-interest and fee income.

▫ Suite of fee income and commissions related to lending activities (basis, frequency, recurrence, and tenor).

▫ Structure and trends of the FX position and revaluation profits and practices (FG.CY. borrowing and lending).

5) Trading and Capital Market Activities: recurrence, sensitivity, and contribution.

▫ Effect of trading, sales and other transfers of securities and loans, including those to affiliated parties and other vehicles.

▫ Valuation practices for securities allocated to different portfolios (trading, AFS, HTM) and book allocation trends.

▫ Trends in off-balance sheet activities and their effect on earnings, including financial derivatives activity.

▫ Maturity profiles of large depositors, funding sources, bonds/securities issues, as well as potential roll-over issues.

6) Other Aspects: Dynamics of costs, contribution, and other distributions, including audit and control costs.

▫ Headcount and overheads: relationship/elasticity to growth, cost to revamp/deliver central functions and products.

▫ Additional operational capacity (Information Technology, Management Information Systems, processing), lags in systems and infrastructure leading to potential cost spikes.

▫ Taxation (average and marginal rates), and dividend pay-out practices and other statutory distributions.

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C. Protection and Licensing of the Model

The FPM® is the property of the Financial Systems Unit (Oversight Group) of the Financial and Private Sector Development Vice Presidency of the World Bank. In such cases, the Unit is happy to share a protected copy with them. To protect the intellectual property of its developers, the FPM® is delivered with electronic protection in place (compiled in binary form, using .exe file format) that is designed to avoid accidental destruction of formulas, as well as to protect sensitive areas of the Model from the view of third parties who could use the Model for their own benefit and/or commercial purposes. Areas such as the balancing of the fund flows and the formulas associated with certain parts of the Model related to the fund flow are protected, and formulas used are hidden from the viewer. In addition, to ensure that FPM® users are notified of all changes to the Model, and to give us an opportunity to renew our relationship with a particular country, the FPM® contains a mechanism to renew the license after a predetermined number of weeks. Once the expiration date is reached, a mechanism within the FPM® invalidates the user’s copy, notifying the user with a popup message.

D. Recalculation and Governor Switches

The worksheets in which we have coded the FPM® contain a measure of circularity, with some of its cells dependent on calculations in other parts of the worksheets. The FPM® works a projection by resolving the set of simultaneous equations representing the balance sheet and the profit and loss account through iterations. The worksheet must always be in manual recalculation mode (not automatic) and converges well with 100 to 300 iterations after hitting the <F9> key. Annex 4 provides a summary of governors and global variables that allow the user to easily control options that factor into the projections.

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II. Objectives and Uses of the Model

A. Initial thoughts

Milton Friedman, in his seminal article "The Methodology of Positive Economics" (1953), emphasized that a model can only be evaluated in terms of its predictive power. It cannot be evaluated in terms of the assumptions employed, or in terms of whether the Model seems to be sufficiently complicated to capture all the relevant details from "real life". In other words, a model can be simple, and yet judged successful, if it helps in predicting the future and in improving the efficiency of the decision-making process.

It can be argued that "real life" is more complicated in banking supervision and bank restructuring than in “normal” economics – to the extent that it is impacted in a very important way by a wide range of micro and macro variables as well as by politics. There are many details that models cannot, and maybe should not, accommodate. Instead, the role of a financial projection model such as the one presented here, is to simplify the interaction among a bank’s different business activities, present them in a common language (financial statements), and highlight the most important factors that impact solvency.

In that sense, the Model presented in this guide is a flexible tool that can assists the analyst, the banker and the supervisor to sort out the major explanatory variables from a noisy, and often also politically charged, environment (for example, like the public outcry following the current global financial crisis).

If used correctly, the Model can be a powerful analytical tool that provides a technically solid and clear perspective of the financial dynamics of a bank (or a banking system) in a reasonably rapid and efficient manner. In a situation of crisis or potential crisis, the FPM® also – most importantly – allows analysis, discussions, and negotiations to move on to the most critical issues impacting the bank or banking system. Thus, the projection/simulation made with the FPM® is often not an end in itself, but can be a powerful means to an end.

The following provides a list to typical questions which the FPM® can help to answer if the Model is used correctly:

• What are the weakest banks that could sink if and when the global storm reaches our financial system?

• Which banks are likely to sink faster (speed and trend of flow loss) and would need to be dealt with first?

• How and for how long should the sinking banks be kept afloat (does the bank continue to burn financial resources)?

• What is the capacity of the net operating margin to absorb current and potential losses?

• What are the trends and signs of future pre-provision profits (net of non-recurrent items)?

• Would a particular failing bank be viable and worth restructuring or recapitalizing?

• How should the cost-benefit analysis of alternative resolution options be done?

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• What would be the fair value of the ordinary and preferred shares bought by the government?

• When and at what technical value should the government sell its participation?

The FPM® has been designed at a medium complexity level to assist answering the above questions both as a standalone and as a tool for integrating the work of others. As a standalone, the Model has been tested in low information environments by running projections solely based on public information. In terms of integration, for those cases where there are richer outputs from other analyses, the FPM® has been developed to assist in incorporating the work of other disciplines and sources, including reports of examination, risk assessments from supervisors, well-implemented stress testing exercise anchored into macroeconomic models, as well as the results and analysis of risk management and financial control activities at the institutions themselves.

B. Overall Goal

The FPM® has central uses in financial stability and in banking supervision as an integrating tool to assess forward-looking risks to the stability and viability of a bank, a group, or a banking system. The FPM® can integrate the results of more complete and sophisticated macro and micro surveillance activities, without necessarily being fully dependent on the degree of sophistication and availability of the outputs of these activities. As a standalone and as an integrating tool, the FPM® can be used in a variety of situations:

• Identifying and monitoring problem banks, as well as assessing their risk profiles, and moving from the analysis of past historic ratios to evaluating alternative paths of future fund flows and trends in condition;

• Extrapolating the results of examinations and diagnostics regarding financial condition: assessing the sensitivity and the capacity of a bank’s pre-provision profits in regards to the bank’s ability to earn its way out of a crisis or delicate situation;

• Assessing the sustainability going forward of mergers and acquisitions and restructuring plans;

• Attesting/assessing the consistency and strength of business plans (a precondition for evolving towards a more risk-based approach to supervision [RBS]), by understanding the risk/reward economics and the contribution of significant functional activities to those economics;

• Evaluating least-cost alternatives in problem and failed bank resolution cases, through comparing the present value of resolution costs to liquidation and deposit payoff (provide support to rationalize and justify policy exceptions);

• Implementing dynamic stress-tests, simulating the impact of scenarios, as well as implementing sensitivity analysis;

• Valuation (present value of discounted cash flows) as a technical starting point for negotiating the price of a potential sale of the bank;

• Explicit analysis of cost and subsidies of official support programs;

• Comparative discussion of business plans and compensation linked to performance.

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C. Rationale of Using a Simulation to Monitor Conditions

The activities associated with answering the questions listed above are essential to integrating traditional ex-post CAMEL ratings with BASEL risk-assessments (in the diagram below), and for progressively evolving supervision from a compliance to a well understood risk-based approach, where the risks to insolvency and instability are placed at the center of the work of supervisors.

Traditionally, the implementation of CAMEL rating of many countries tends to focus on using a backward-looking ratio analysis, often without incorporating reclassification and adjustments made by onsite examiners, including an assessment of the integrity and effectiveness of management systems and controls in supporting adequate levels of internal governance.

The risks of the viability of a bank or banking system (insolvency/instability) depend on several factors which are difficult to measure with ratios. Given this fact, the approach to supervision should be changed to a more dynamic view of condition (qualitative and quantitative), moving away from the complacency brought about by certifying compliance with regulatory ratios toward understanding the economics of the businesses, not only of the bank’s accounts.

This broader approach requires understanding and assessing both management plans and the bank’s businesses and franchises; determining the reliability of management systems, processes and controls; and focusing on the dynamic of fund flows across the firm (operational and liquidity), rather than attempting to conceptualize and assess condition by using historic accounting stocks and ratios.

Financial simulation supports this necessary change toward forward-looking assessments of risk and rewards under foreseeable trends. Simulation complemented by reasonably well-supported stress tests and risk-focus onsite reviews can assist in operationalizing the assessment of solvency and of the sustainability of operations. Simulation can clarify the risk-reward economics of significant functional activities so as to answer the following questions, both at micro (firm) and macro (system) levels:

Current Condition and Viability:

• Do businesses generate sufficient pre-provision profits for a bank to earn its way out of current problems?

• Can management earn a reasonable rate of return, remunerate capital, and keep the bank aligned to its risk profile?

• Is risk pricing consistent with the risk-based neutral price or does management focus exclusively on volume?

• Does management retain, via provisioning, sufficient resources to compensate any gaps in pricing?

Banker

Management

Activities

Businesses

Leverage

Capital@Risk

Earnings

Risk-Adjusted

Systems

MIS-RMG

Economic

Viability

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Sensitivity Analysis:

• Where is the break-even frontier of a bank and of its banking system (and what will it take to knock them down)?

• How do crucial variables affect the viability of the bank, its businesses, and value? • Under which assumptions would the present or potential problems be overcome?

Under which assumptions would they be aggravated? • What is the fair technical value of the shares (ordinary/preferred) if the bank were to be

supported by the government?

Industry Structure:

• Is there excess of risk in the system, an excess of physical structure (network and firms/banks) or both?

• What would be the effect of deleveraging on the system and its borrowers (how will the system grow)?

• Will business volumes be enough to recover full economic costs at the individual bank and system level?

• Are assumptions realistic, i.e., do they result in a competitive banking system structure which intermediates efficiently?

• What drives spreads and are the projected spreads sufficient to recover the full economic costs involved? Are the projected spreads excessive?

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III. How to Use the FPM® and Perform a Projection

The following sections summarize the process and activities related to using the FPM® for preparing a projection and for simulating the behavior of a target bank (or banking system). Section A provides an overview of the steps involved. Section B explains how to map the financial statements available on the [Entry] worksheet of the FPM®. Section C guides entry of financial data and relevant assumptions into the FPM®. Section D explains what a stabilized projection is and how to complete one. Section E introduces simulation and sensitivity analysis, depending on the degree of sophistication of the techniques used, to generate the values of the parameters of external variables. Section F presents several approaches to simulating financial tensions. Section G introduces bank valuation. Section H explains how to use the FPM® to estimate the costs of alternative resolution transactions. Finally, Section I introduces the implementation of a set of common resolution structures.

A. Overview of Steps

There are ten basic steps for using the FPM®:

1. Determine the purpose of the projection and become familiar with the target bank, its operating environment, and economy.

2. Obtain and/or prepare the data necessary to make a projection and to map the data into the FPM®, securing alternatives to missing data.

3. Enter into the FPM® the relevant reclassifications/adjustments from examination to reflect the real condition of the bank.

4. Run a few trials until the projected financial performance becomes a stabilized trend (base case).

5. Identify and enter two additional scenarios, each of which contains a different variance in external macroeconomic factors (mild/extreme crisis or optimist/pessimistic cases).

6. Simulate performance under these additional scenarios and estimate the sensitivity to core variables.

7. Introduce stress conditions to asset quality and interest performance, funding and market liquidity or interest rate risk events.

8. Quantify the range of values of the bank under alternative conditions (approximate the value of the bank).

9. If the bank is a problem bank, estimate the present value of alternative resolution/rehabilitation actions.

10. Evaluate, report, and discuss the results of the above steps, design ongoing actions and fill residual gaps of information.

Before starting these steps, users of the Model must understand the purpose of the projection. All parties should agree to the terms of engagement and align your respective expectations regarding the outcomes and the quality of the exercise.

One way to use the FPM® is for offsite surveillance purposes. Another more delicate proposition is to use the FPM® to evaluate the costs of alternative restructuring options for a problem bank. The information required for each type of engagement, the time and associated

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work, as well as the respective responsibilities and deliveries should be well discussed and documented by all involved.

B. Mapping Data to the FPM®

Annex 1 summarizes a set of topics that may be relevant for users who need to become familiar with a bank, depending on the scope and purpose of the projection. Topics range from ownership and internal governance structures to the bank’s organization and group membership. In any case, the user’s focus in using the Model is to project the financials in which the risks and returns of the bank’s business activities materialize. Thus, the focus should be on contribution to earnings and costs, asset quality, income performance of loans and investments, as well as liquidity funding issues. Depending on the depth of the engagement, processing information on these topics could take from several days up to a couple of weeks.

After getting to know the bank, map the financial statements to the [Entry] sheet of the FPM®. The initial balance sheet (B/S), profit and loss account (P/L) and off-balance sheet (OBS) activity are the basis for the projection. Mapping requires experience in a variety of disciplines (accounting, banking, financial analysis, and supervision). However, mapping is the only way to learn fully about the target bank because it forces you to understand the bank in figures, to perform a decent level of analytics, and to find out what crucial information might be missing.

The mapping process will also help you to understand the scope of accounting, banking and regulatory practices in the country, and can also assist in developing a case study on the bank. The mapping process will provide you an informed view regarding the areas where risk assessment and analysis might benefit from further refinement.

A specially designed worksheet to assist you in mapping can be provided to you separately from the FPM®. Users can use different sources for mapping: a) a sample or the complete set of prudential reports; b) the full chart of accounts of the bank; c) the annual public financial reports, including detailed notes; d) other relevant information provided by bank management from its MIS or from third parties (i.e., auditors’ working papers); or e) any combination of these sources. Note that the base year [Entry] has to be annual figures, regardless of the frequencies of the 12 periods chosen.

“Mapping” is allocating each line of the reported or internal B/S and P/L to a predetermined line of the FPM® by means of assigning a code. The mapping worksheet (Mapping.xls) contains one numeric code for each line of the FPM®. Mapping can take from one day to one week, depending on the information available and the number of past periods entered in Mapping.xls.

Depending on the sources of information used, mapping can involve aggregating several lines of financial statements into one line of the FPM® (e.g., grouping all investment securities into, for example, the trading and the AFS portfolios). Or, in other cases, you must distribute a line of the financial statements (for example, loans) into several lines available in the FPM®, segregating the loan portfolio into segments relevant for projecting/simulating, such as household mortgages, consumer loans, credit cards, large corporations, or a particular problem sector (e.g., commercial real estate, related parties, mining, or manufacturing).

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A sample of the structure and some basic explanations of the mapping worksheet are included in Annex 2. It can be useful to map more than one year (or period) of financial statements to the FPM®. This will allow users to do some level of financial analysis of past trends using the aggregated structure of the FPM®. This structure has been designed to accommodate, in general, any set of reported financial statements. It does not reproduce any particular country or format (e.g. CEBS COREP, Fitch IBCA or Moody’s templates, etc.), because our experience tells us that it is more effective and efficient to adapt country data to the FPM® than to reconfigure the FPM® to fit particular country reporting templates. Constructing a new model can take three to four months.

If you enter more than one year (the base period of the projection) in the mapping worksheet, it is easy to automatically obtain historical average balances and trends, and (annual) average rates and margins with the format of the FPM®. These figures includes proxy percentages of interest-earning assets and interest-bearing liabilities, growth rates and other proxies in the same format utilized by the FPM®, which will help you to enter the assumptions of behavior for the B/S and the P/L in the projection. In addition, the mapping worksheet allows users to perform their own calculations and to document additional necessary computations, distributions, and interpolations.

C. Entering Data

Entering data into the FPM can be a boring task, but it is necessary in order to operate the FPM®. There are five sets of entries to the FPM® file (FPM.xls) that must be input. The initial analysis of the bank and its banking system, as well as the mapping process as per the previous step, should provide you with the necessary information to enter the data needed. Any essential gaps of information should be worked out (preferably prior to an on-site visit) in discussions with banking supervisors, and data requested from them or other counterparts in the FPM® engagement (i.e., bank management).

I. Entries into the [FPM Cover] sheet: These include name of the target bank, the date of the base financial statements, the frequency selected for the projection, and the external scenario chosen from the three that the FPM® can accommodate. Notice that most cells requiring user input in the worksheet are filled in yellow (light, or dark for essential data) and the fonts are in blue. Areas in black font and medium orange filing are normally protected, because they contain a formula, which helps to avoid deleting one of them by accident.

II. Entries into the [Macro] sheet: These include the external parameters that are relevant to the economy and the banking system. These annual rates are entered in the same currency and units (millions of LC.CY. for instance). These parameters can be found in reports of financial stability from the Central Bank, the International Financial Statistics of the IMF, as well as other reports from country ratings. Section C of Chapter IV explains in more detail the dynamics of volume/business growth used in the FPM®. There are no complex regressions performed in the FPM® to predict the pace of growth, and you can integrate the results of more sophisticated extrapolations estimated outside of the FPM® if available.

III. Entries into the [Entry] sheet: These include the end of the period (eop) financial statements of the base year of the projection (B/S, P/L, and OBS). These annual rates

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are entered in the same currency and units (millions of LC.CY. for example). You should use the output of your analysis completed on the mapping worksheet for entry into the FPM.xls, or link these files directly. Among others, the [Entry] sheet has also space reserved to input: a) average balances for the base period for assets, net worth, deposits, and loans; b) relevant discounts to approximate recovery rates in case of liquidation, purchase, and other assumptions. These data points should normally be available to the country supervisors and deposit insurance agency, perhaps from previous resolution cases.

Notice that the labels of the lines are in blue font that appears in yellow highlighting. This color combination indicates that you can change the names of the lines to your national language or to a different concept (e.g., “Other Corporate Loans” to “Troubled or Restructured Loans”). Making such changes will only change the title of the line as it appears on the worksheet, and not its coded behavior.

IV. Entries into the [Assumptions-BS] sheet: These include the assumptions on how the different B/S and OBS lines will behave in the projection. These figures should be entered as annual rates, regardless of the frequencies of periods chosen. Section C.2 of Chapter IV provides more information on the growth factors of these parameters, and other parts of the guide include explanations of the following: a) target regulatory and liquidity ratio; b) switches that allow the user to turn on/off liquidity and capital constraints in the projection; d) allocation of discretionary funds flow between available for sale securities (AFS) and loans; e) compulsory reserve requirements; f) growth of all other assets and liability lines; and, among others, g) key risk parameters (i.e., Probability of Default (PD) and Loss Given Default (LGD)) to simulate the dynamics of the loan segments selected for projection.

An important aspect in entering the B/S assumptions is the specification of which product lines for deposits and for other funding liabilities are subject to reserve requirements and liquidity rules, as explained later in Chapter IV. Annex 3 provides hints on how to use the concepts of PD and LGD when there is no estimation available.

IV. Entries into the [Assumptions-PL] sheet: These include the assumptions of how the different lines of the P/L will behave in the projection. These figures should be entered as annual rates, regardless of the frequencies of periods chosen. Section C.3 in Chapter IV provides more information on the determinants of these parameters, and other parts of the guide include explanations of the following: a) the market reference rates to which the interest-earning assets and interest-bearing liabilities should be linked; b) the spreads that will be added or subtracted to the former reference rates to form the rates of interest at which the latter assets and liabilities will accrue interest in the projection; c) the behavior of fees and commissions; and, among others, d) the manner in which operational expenses and other items of the P/L account will behave.

An important aspect in entering the P/L assumptions is the specification of the market rates of reference to which other assets and liabilities will be linked, as explained later in Chapter IV. The rates are referenced to the line codes set in column D in [External]. This sheet takes the rates of both growth and interest of the scenario selected among the three made available in [Macro]. Each scenario provides for five years of assumptions about the future. In [External], the assumptions of the fifth year are extended linearly without more adjustments for years six through twelve.

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Besides the notes embedded in FPM.xls (in the far right columns of each sheet), the FPM® has in several columns (B, C, and D) input and comment areas that provide additional help and information on how a particular cell or line works. In addition, Chapters IV and V provide more detailed explanations on the mechanics of growth and performance of the FPM® and how the assumptions summarized above return a projection. Annex 3 provides hints on how to estimate alternative credit risk parameters when these are not available, working in a “zero-data” environment.

As explained in Chapter IV, the rest of the tabs or sheets of FPM.xls contain the calculation of the business volumes and associated P/L for the bank activities we have designated (Deposits, Loans, Money Market, etc.), as well as the outputs of the projection (B/S, P/L, Fund Flow, Summary, etc.).

D. Stabilizing a Projection

Stabilizing a projection means establishing a baseline scenario which reasonably replicates the current trends of a bank. A stabilized projection is a passive representation of what would be the evolution of a bank if nothing else happens (no external disturbances, management actions, or supervisory measures).

If a bank is doing well, the stabilized projection will seem to replicate the performance indicators of the entry period. In other words, you should expect margins and spreads, capital and liquidity proxy indicators, as well as earning and asset quality indicators (RoA, RoE, etc.) to be reasonably similar or close to the most recent trends.

Conversely, if a bank is doing poorly (failing or about to fail) then the negative trends will accelerate in a projection, starting to burn financial resources (or accelerating the burn rate). This latter scenario is most likely the one that would happen in real life, except for accounting tricks and actions like continual re-aging of non-performing loans which obscure the real situation. The clarity offered is one of the key purposes of projecting the P/L and its components: it allows a look into the future.

The operational losses due to negative pre-provision profits (net operating margin after operational costs free of non-recurrent and extraordinary items) will be financed with the net fund flow generated by the B/S (i.e., new deposits mobilized used to cover negative interest income or the operating costs of the bank). Furthermore, in cases where deposits dry out or run out, and if other funding sources are not accessible, a line of last resort in the FPM® lends funds at a specified rate to avoid collapse, once discretionary liquidity balances are exhausted (i.e., violate liquidity rule and sell AFS).

This line is automatically managed by the FPM®. The line of last resort is deemed to provide emergency liquidity assistance (ELA). Calculating two consecutive projections with zero cost and at the punitive rate required by the Central Bank can help you to quantify the amount of subsidy that any Central Bank is providing to a bank to keep it alive.

We urge you to evaluate the outputs of each projection that you run by examining the B/S, P/L, and indicators provided in [Summary]. The B/S should always balance, after allocating the

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discretionary funds flow, sometimes with a little help from ELA. An examination of the B/S might reveal one or more of the following conditions, which should be cause for concern: a) a sudden change, jump or drop in a concrete line or proxy indicator; b) a significant deviation in the spread between interest-earning assets and interest-bearing liabilities; c) a material change in the spread between the average interest on loans and deposits; and d) a change in the real rate of remuneration of deposits.

Any material changes need to be explained based on the consistency of assumptions used in that projection with the scenarios that they support. Otherwise, something is wrong in your data or in any other model supporting the FPM®.

Users may detect abnormal behavior and significant changes in the above indicators that the FPM® offers in the [Summary] sheet. This can be caused by distortions, errors, or miscalculations in the initial estimates of growth, interest rates or other assumptions. For example, you might have unintentionally used average rates for the previous year, when in reality the P/L is driven by the marginal rates at which assets and liabilities are contracted and served. Or, it might be that you forgot to delete some of the absolute actions that you implemented in [Actions].

Review the results in [Summary] and refine your assumptions until you arrive at a baseline projection that stabilizes closer to the recent performance trends of the target bank. Name the scenario as “Base-Trend” (or another name) and move to the next step (also, save FPM.xls as, say, Trend_FPM_dd_mm_yy.xls) and continue working to achieve your original purpose, i.e., value the bank under several scenarios and estimate the sensitivity of that value to changes in core assumptions.

E. Sensitivity Analysis & Simulating Alternative Scenarios

Once you have a stabilized projection, you can start testing performance under alternative scenarios and quantify the effects on performance (profitability, capital adequacy, and bank value) of discrete changes in core assumptions. In a sensitivity analysis, a single or small number of variables experience a change (of a given size or dimension), subject to the condition that the other system variables remain unchanged. In a scenario analysis, a broad group of variables changes simultaneously, defining what is called a scenario. There are different approaches to performing a simulation based on a scenario analysis, while a sensitivity analysis is much simpler. The following paragraphs introduce how the FPM® can assist you in implementing both, although this guide does not purport to be a compendium of these techniques.

The FPM® does not quantify the link between the scenarios and the external variables that drive performance. To do that you would like to develop satellite models adapted to the information available in your country. What the FPM® does do is to integrate in a common, simple language (balance sheet and profit and loss account) a variety of outputs, from top-notch sophisticated macroeconomic modeling to simpler rules of thumb that you can approximate in the projection without high sophistication.

Using the FPM® to implement a scenario/sensitivity analysis allows you to factor, in a rather transparent way, the second-round and feed-back effects which traditional stress test do not usually address. Besides integrating sophisticated modeling and traditional supervisory risk

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asset review, the FPM® can help to report the expected reactions from bankers and market agents, in hard numbers, by intuitively modulating the assumptions projected and superimposing the combined effect on incentives, fear, and crisis.

Practitioners and academic modelers follow different techniques to determine the size or dimension of the changes of the variables used in the FPM® as assumptions for the projection, such as hypothetical, historical, or probabilistic calibration, or a combination of these.

Sensitivity Analysis:

In a sensitivity analysis, the usual practice is to apply historical calibration. With this technique, the size of the change is chosen according to the largest change that the variable in question experienced over a certain period of time in the past. The selection of this time period is closely related to the type of risk being analyzed and to the circumstances prevailing in the target bank’s operating environment over that period. This is possible, of course, only if there are good time series data to estimate the change.

If you have time series data for the selected variable, you can also decide to use the distribution of the observed largest changes, to select a given percentile or a certain probability of occurrence (adverse tail of the distribution) and to determine what value the variable would have in an extreme situation. In other cases, especially when available data of the required quality is scarce, we prefer to use hypothetical calibration. In a hypothetical calibration, a change in the variable is input, based on assumptions that might not have been observed in the past. In such a case, the lack of this data should be documented.

Starting with the most simple sensitivity analysis, you can evaluate how the bank value, approximated by the FPM® in the [Valuation] sheet, varies with changes in each of the core variables. The core variables usually selected are growth, spreads, operational expenses, and provisioning for credit risk. However, you can perform the analysis for any other variable that has assumptions entered into the Model.

Typically, you will create a pivot table of changes to compile and report sensitivity. With one model run for each, you can develop a sensitivity table on the side in just ten minutes. Users can do this for bank valuation, or any proxy indicator of solvency (e.g., capital adequacy, RoE, etc.). If a simulation tool, such as Crystal Ball from Oracle®, is attached to the FPM® you can estimate the distribution of values based on Monte Carlo techniques.

A sensitivity test may consist of changing the assumptions regarding asset quality. Often, asset quality information is not transparent unless loan classification and provisioning are properly evaluated through an independent risk assets review. You can approximate the sensitivity of solvency to a range of assumptions regarding loan quality in segments such as credit cards or real estate companies, changing the pace of defaults or reclassifying a chunk of restructured loans.

You can also do so by changing the PD or LGD for a loan segment in [Assumptions-BS], lines 84 to 109 and 377 to 394, or implementing absolute changes in [Actions], lines 23 to 62. In addition, you can estimate how sensitive the recovery of a problem bank would be to any controllable factors or external variables, e.g., deferral of structural loan losses or changes in the

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interest performance level of all or a particular segment of impaired loans. The FPM® allows you to evaluate the sensitivity to any factor you choose.

Simulation of Scenarios:

Simulation is more complex than a sensitivity analysis, and relates to scenarios which determine simultaneous changes in several factors that affect the assumptions of the projection, such as a recession or a crisis in the economy. Changes are estimated by practitioners using econometric models to determine the relationships between the scenario and the external variables that drive the performance and the value of the target bank in the projection.

To run a simulation, you would need to estimate the effect of a scenario on the core assumptions which drive bank value, or solvency (for example, earnings and capital) outside of the FPM®. The estimation can then be integrated with the changes in core variables associated with that particular scenario. Section F explains how to implement stress tests with the FPM® without sophisticated quantitative modeling. The implementation of shocks chosen to stress a bank is applied to the B/S and P/L, incorporating the effect that these shocks have in asset quality and earnings, before the final impact on capital.

Since the FPM® allows you to enter and store up to three scenarios in [Macro], you can associate a projection with each scenario of external variables, and then change relevant internal variables (for example, spreads and PD for retail segments) of the bank. Then, you can follow those changes with a sensitivity analysis for particular factors in a given scenario.

F. Simulating Stress

The FPM® allows you to produce stress test scenarios. If your counterparts have a reliable stress test practice, you will be able to estimate the effect of certain changes. For example, stress tests should allow you to estimate the change of the growth in deposits and the quality of loan segments under a particular macroeconomic scenario. The staff from Research or Financial Stability of your country Central Bank can assist you in developing more sophisticated means to estimate loss statistics under alternative approaches, provided there is adequate data available to do so (i.e., covariance or actuarial models, Merton simulation, macroeconomic default, or cash-flow models).

The rest of this section explains how to use the FPM® to integrate estimates made “outside” the FPM®. Outside estimates can cover the financial condition (from examination) and the impact of events (from stress), and how these two factors affect performance of asset quality, funding liquidity, earnings and capital. These estimates could be made by bank management and by bank examiners, as well as by the Financial Stability Unit of the Central Bank or by our colleagues at the IMF. However, if these stakeholders do not have a realistic view of local financial conditions and stress parameters, what should FPM® users do? The answer depends on the purpose of the simulation and the environment in which it is to be completed.

At a minimum, stress testing allows reporting, with a reasonable level of assurance, that the objectives enunciated in Chapter II can be met: that the bank is viable, or that viability can be restored at an affordable cost. Otherwise, the bank should be liquidated and it is necessary to

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recommend a (politically) feasible, less costly economic alternative among possibilities, reporting related tradeoffs and approximate costs.

Since information about a bank’s conditions might be imperfect, or might be dynamically affected by the course of the business cycle and the economy, users can also run several consecutive projections on the FPM®, modulating various levers available that govern (hence the name “governors”) the simulation of different types of assumptions and stress. A few types of governors are discussed below. We hope you discover some other ways of using the FPM® to implement stress tests or perform sensitivity analyses.

First, you can run the FPM® modulating the growth levers. There are two basic growth governors: 1) lines 39 and 41 in [Macro] that allow you to scale the growth of deposits at the banking system level to the growth of the nominal GDP; and 2) lines 81 and 82 also in [Macro], which allows you to simulate the effect of changes in the deposits market share (transactional and savings) of the target bank. You can estimate outside the FPM® how much to scale and quantify the resulting impact.

Second, you can run the FPM® scaling (up, normally) the expected loss calculated by the Model. There is one basic loss governor in lines 169 and 170 in [Macro] to do this for loans denominated in both local (LC.CY.) and foreign currency (FG.CY.). These lines scale expected loss as a parallel shift in both PD and LGD for all the loan segments at the same and in the same amount. Each PD and LGD entered in [Assumptions-BS] is multiplied (scaled) by the square-root of the scaling factor entered in those lines. This can help you to simulate and quantify an external downturn event.

Third, you can selectively modulate the PD and LGD entered for each loan segment in [Assumptions-BS]. You may wish to increase by, for example, three standard deviations the PD of consumer loans and by only one standard deviation the PD of household mortgages. Once you have entered the PD, you know that the unexpected loss, which is the standard deviation of the expected loss, might approximate the square-root (of PD – PD^2). You can also calculate the effect of scaling the LGD alone, considering that the standard deviation of severity (LGD) is typically around 25 percent. These are approximations based on practitioner experience. To scale the PDs and LGDs properly to their risk drivers, you would first need to model their relationship to the relevant risk drivers. However, in order to do that you need data series of adequate richness and quality.

Fourth, you can create specific event scenarios by using the features built in to the [Actions] sheet. You may decide to provoke a deposit run between Period 3 and Period 4, entering for the lines of deposit products a negative absolute amount calculated as a percentage of the amount of deposits in those products in Period 2. You can also migrate in [Actions] loans from well-rated prime (A) loans and less well rated sub-prime (B) loans to default/impaired (C/D) loans.

Fifth, you can simulate market funding and interest rate risk episodes by increasing the fair value adjustments and provisions for trading, AFS, and HTM securities, or narrowing the spreads in the projection that link interest-earning assets and interest-bearing liabilities. You can also increase the retention of interest accrued receivable to bleed the cash flow from the P/L or provoke an ALM event in any period of the projection, simulating in [Actions] the

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reimbursement of bonds issued and failed roll-overs of market funding, considering the potential impact on performance, based on actual maturities.

There is a clear advantage to integrating external estimations for stress tests into the FPM®. Once this is done, the results are produced within the common language of financial statements, so that everyone can easily understand the outcomes of the impact and the assumptions in terms of solvency (asset quality, earnings, liquidity, and capital), even if the origins of the stress assumptions are not obvious.

Moreover, rather than restricting simulation (or stress testing) to an isolated, retrospective point in time modeled into a single equation, the FPM® enables you to play through time periods along the normal horizon of the banking business, letting the consequences of the changes, assumptions, and stresses crystallize in the economy. Results will be distinguishable to static assessment of impact from a point-in-time diagnostic, allowing further credit or liquidity events, the reactions of management and other economic agents (e.g., authorities and supervisors, or foreign creditors) and the propagation, decay, and interaction among them (feedback and second-order effects that amplify or mitigate an initial shock).

G. Quantifying Value

In a worksheet dedicated to [Valuation], the FPM® has a rudimentary but rather powerful calculation which approximates the value of the target bank. This estimation is as accurate as any other estimated valuation that could be made by the most cunning investment banker, and can be used both as the starting point to guide considerations (i.e., mergers and acquisitions, selling a problem bank taken over by authorities with or without a number of restructuring actions) or as an indicator of total performance.

The FPM® calculates the present value of the stream of dividends available for discretionary distribution at the end of the first ten periods of the projection. After this period, the FPM® also adds the present value of the estimated perpetuity for Period 11 of the projection, which simulates the residual value of the target bank at that date. This calculation excludes from the discretionary dividends in each period any foreseen material capital investment and regulatory capital adequacy needs.

The discount rate for calculating the present value and the capitalization rate used to quantify the perpetuity are entered by the user in lines 134 to 142 of the [Macro] sheet, following customary bank valuation practices under the discounted cash flow method. You can select several different rates as the discount and capitalization rates for the valuation, such as a fully built discount rate or the cost of funds (externally entered or using the average interest expense of the bank in the projection).

H. Estimating Resolution Costs

A problem bank about to fail or one that already failed can be resolved using different methods, depending on the institutional and legal framework of a particular country. Resolving a bank

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involves procedures to allocate losses, liquidate assets, and satisfy creditors. In some jurisdictions, authorities are mandated to minimize the costs involved in resolving a problem bank. Minimizing costs can include a set of early and prompt corrective powers to require restoration of solvency, merger with or acquisition by a third party, or liquidation. Liquidation can happen under a set of alternative mechanisms, such as a purchase and assume (P&A) operation.

Liquidation of a bank, especially if large and complex, may be very costly. Sometimes banks are instead taken over and restructured rather than liquidated. Losses are allocated to former shareholders and any additional bad assets are carved out to clear the bank’s balance sheet and then re-privatize the institution. In other cases, banks are liquidated piece by piece and some depositors, if insured, are paid and the residual assets are used to pay other creditors. A third way to resolve a failed bank is to separate its good parts, branches, and clients, and transfer these to another bank which assumes part or all of the deposits, receiving a net compensation in exchange. This latter method is in essence a P&A operation, which might have other components attached.

In any situation regarding the resolution of a problem bank, the party responsible for implementing the resolution needs to understand the costs associated with the resolution in order to account for and report them. The FPM® can assist in estimating these costs and comparing alternative resolution alternatives, in some cases helping to choose the least costly or more politically feasible option.

The first step involved in a resolution is to obtain an estimate of actual past recovery costs from the country bank supervisors, deposit insurer, or accountants that might have been involved in previous resolutions. This information can be entered in the [Entry] sheet, columns AB and AC. In a similar manner, the transfer costs associated with P&A resolutions implemented in the past can be entered in columns AJ and AK. Such information is not always available for various reasons and we have suggested alternative discount and recovery rates in column AA based on our experience.

Based on that information, as well as additional data on specific assets which represent singular adjustments to book values, the FPM® approximates in the [Resolution] sheet an initial estimation of liquidation costs and transfer values in case of P&A or similar structures. In that sheet, you can compare these two values with the current book value and the PV of the income approach calculated in [Valuation]. In liquidations and P&As, there are additional costs related to overall deductions, administrative costs, as well as costs associated with asset/loss structures to provide acquirers incentives to assume deposits of a failing bank. The FPM® provides initial values for these in the yellow input cells.

Comparing the present value of the above estimations with all forms of support granted to a problem bank (i.e., forgone interest, loss income maintenance loans, problem assets carved out), including the cost of restructuring its operations (close branches, lay off employees etc.), can help you to analyze the least costly form of resolution among alternatives. This exercise will also assist in cost allocation among stakeholders.

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I. Simulation Structures

We have conceived and developed the FPM® to enable you to implement a broad variety of simulation structures by using, in a flexible manner, the two sets of books available, represented by the LC.CY. and the FG.CY. templates. These books allow you to try out different alternative resolution structures, project their behavior, and estimate their associated B/S and P/L effects, including an assessment of the flows associated with these alternatives in present value terms. You can implement the following simulation structures:

1. Good bank (bankable activities) and bad bank (heavy non-performing assets and uninsured liabilities) approach;

2. Acquiring bank and acquired bank (merged into the acquiring); 3. Acquiring bank and assets and liabilities acquired from a third institution via a P&A

transaction; 4. Local activities and foreign (branch) activities of a bank; 5. Parent bank and subsidiary activities; and 6. Any others that your imagination can conceive, such as projecting corporate and retail

activities separately in sub-segments.

As you can see, each structure has two entities and each entity can be projected in one of the two currency books available.

In the analysis, the assets and liabilities of each part should be quantified separately. You should allocate (or enter) the good bank in the LC.CY. column and the bad bank in the FG.CY. column and set and run the assumptions as you wish. Since each column has a liquidity rule and a B/S and P/L, you can visualize and quantify the contribution of each part to the whole and how the good bank subsidizes the bad bank, including the point at which the spin-off can be implemented.

You can segregate and allocate the two entities at the inception of the projection in [Entry] or during the projection using the [Actions]. In the latter, you should enter a negative amount to detract from one book (currency) and allocate (enter) the same amount in positive in the other book (currency). To have a B/S and P/L projected for each entity (currency) you will need to enter assumptions for the balance sheet and the profit and loss account for both entities (currencies). You must consider the drivers of activity growth, spreads, and credit risk of each entity, all of which may be different, and implement them in the assumptions. Naturally, this will require a good level of analysis, since the FPM® is only a worksheet whose output is only as good as the analysis used to identify and enter data.

Using [Actions] you can see the effect on value and performance with and without the acquired assets and the merged bank. The changes in the net present value of discretionary dividends available for distribution, as well as the changes in proxy indicators of the bank’s conditions, will quantify the effect of a P&A or an acquisition by a sound or less-sound bank.

Users also need to decide whether you wish to project a fully allocated P/L for the second entity or not. The switch placed in cell H13 of [FPM Cover+ has to be set at “1” for the projection to calculate operational costs (labor, overheads, IT, communication expenses). Otherwise, the second entity, or second (FG.CY.) currency book, will be allocated with interest income and

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expenses, fee revenues, and impairment/provisioning charges, but not with operating costs (which for a normal local bank are supposed to be incurred only in LC.CY.).

If you use the FG.CY. book to implement a second entity structure, you have to remember to set to “1” the foreign exchange rate, since in this case you are projecting all currencies in each book and the FX rate must be the same in both currencies.

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IV. Overall Structure of the FPM®

This Chapter describes the most relevant characteristics of the FPM®. Section A summarizes its general features. Section B presents a summary table of the [sheets] of the Model. Section C describes its general growth dynamics as well as how the lines of the balance sheet and the profit and loss account behave in a projection. Section D expands the process and mechanics used to allocate and balance the flow of funds during the projection. Section E explains how the liquidity and liquidity constraints work. Chapter V details the mechanics and main formulas of some important lines in the worksheets.

A. Main Features of the Model

As discussed earlier, the FPM® is a system of simultaneous equations that produces the balance sheet (B/S) and the profit and loss account (P/L) of a bank by iteration (Gauss-Seidel method). The Model’s Excel workbook shows circularity, and recalculation needs to be set on manual mode (hit the <F9> key to recalculate). In its current version, FPM® iterations are limited to 300. The Model has been tested at zeros and converges with zeros without reporting errors. You may still find some residual design features which do not work as intended. In such case, please contact the authors to let us know where corrections need to be made.

Below is a list of the Model’s main features:

Flexible projection periods:

Projects 12 periods with a choice among six frequencies that can be changed for each period. The frequencies for each period controlled on the [FPM Cover] sheet, in cells H5 through S5. In each cell, the user can choose one of the following: “1” for annual; “2” for semiannual; “4” for quarterly; “12” for monthly; “52” for weekly; and “365” for daily projections. This allows differentiated projections in each period; however, the user needs to keep in mind that the figures projected would be in these chosen frequencies when comparing one period to the next. In most simulation cases, it will make sense for user to keep the frequency the same for each period. For example, choosing “1” for all 12 periods to give 12 years for bank valuation purposes, or “2” for all periods to give six semesters for assessing medium-term viability and effects of restructuring and other management actions, and so on.

Multiple macroeconomic scenarios:

Allows a choice of up to three macroeconomic scenarios for use in the projections, which could, for example, represent the base, best, and adverse case scenarios. The Model projects the B/S and the P/L for two books or currency-based activities (local and foreign). You can also use both books to segregate a good bank and a bad bank, to quantify the effect of acquiring another bank, to assess the implications of a purchase and assumption (P&A) transaction, or to differentiate local and foreign operations.

Loan portfolio segments:

Allows up to eight credit segments per currency. Each segment has high grade A loans, less well-rated grade B loans, and a default/impaired grade C/D loans. This differentiation allows simulation of a broad range of situations with sufficient granularity to emphasize specific

30

concentrations of the loan portfolio (i.e., restructured loans, sectors at risk, contribution of new lines, etc.).

Has scaling factors to scale the PD/LGD as well as the interest performance of C/D loans (income suspended or cashed) to simulate asset quality problems across the periods, including stress events which, in combination with ad-hoc changes in the PD/LGD and using the absolute [Actions], lets users try out a variety of combinations, carve-outs, and buy-ins.

Deposit products:

Allows up to seven types of deposit products with the ability to separately distinguish reserve requirements and interest expenses for each currency. For transactional and savings products, this ability allows users to specify different stability, cost and price sensitivities of core and non-core clientele, including re-intermediation/disintermediation patterns associated with different financial policy frameworks.

Growth rates:

Uses nominal GDP as the growth driver for deposits at the system level, and uses market share to allocate deposit growth to a particular bank. Additionally, the Model allows the user to scale this growth above or below the nominal GDP, to adjust growth rates in light of any other information, e.g. trends towards financial deepening, shift of deposits towards higher remunerated products or more liquid instruments, etc.

Funds flow:

Offers separate views of the two crucial components of discretionary funds flow in each currency – the operational cash flow earned in cash from the P/L items and the residual net fund flows from B/S activities. The Model shows these figures both before and after allocating discretionary cash flow to loans and to Available for Sale Securities (AFS) (see below), subject to any constraints selected regarding liquidity and emergency liquidity assistance (ELA).

Allows user to allocate the discretionary fund flow between loans and AFS, considering past trends and capabilities of the bank and the feasibility of management plans. If allocating funds to loans, the user can decide the distribution of funds into each of the loan segments in the portfolio, rendering explicit both growth policy and pricing decisions, as well as their strategic/economic implications.

Uses a designated balancing item to finance deficits of cash funds flow (surpluses are allocated to loans and AFS) which is the ELA line for the projection. The conditional repayment of this ELA line can be accelerated or postponed after settlement between discretionary fund flows in each currency portfolio.

Other projection capabilities:

Provides for user-defined regulatory or management constraints for liquidity and capital which then affect the allocation of discretionary funds flow, the repayment of ELA, and the distribution of dividends, including proxy regulatory capital adequacy, both under a standard Basel I regime and approximating a simplified Basel II implementation.

Has two multi-purpose lines (one asset and one liability) to simulate a zero-coupon or cash accrual/payment loan or security suitable to project a variety of bank restructuring

31

instruments, including swaps. The model also has lines to project non-cumulative preferred shares.

Allows the user to simulate the effect of a broad range of B/S asset and liability management and P/L account restructuring actions (including line-per-line carve-out/swap measures, as well as loan migration, recapitalization, and reorganization procedures related to mergers and acquisitions) by means of absolute amount entries in [Actions].

If statistics on market multiples and recovery ratios in liquidation and P&A transactions are available, the FPM® provides an initial estimation to visualize core technical values (book, liquidation, P&A, NPV of DCF) to inform decision-making based on present value terms.

Finally, among other prime features, the FPM® has a rich number of essential user’s notes directly included in the Model worksheet.

Ability to customize line items

The MS Excel row labels (line item titles) used in all the B/S and P/L lines that appear in blue font in yellow-filled cells can be changed by the user to fit a particular local instrument. For example, “Other Corporate Loans” can be renamed as “Loans to Trouble Restructured Corporations” or “Loans to Troubled Manufacturing Firms”, to segregate from corporate loans a particular segment or sector of interest to the projection/simulation. Labels can be also changed to a different language. However, the behavior of the line is pre-coded and cannot be changed easily; thus, the change in names should still reflect the characteristics of the section to which it belongs.

The next section offers a summary of the areas, [sheets] of the FPM® followed by Section C that explains in more detail how growth is handled in a projection.

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B. Structure of the Spreadsheet

The following table describes the [sheets] available in the current version of the Model. (A new sheet [IRB] is being developed to implement a proxy of the Basel II internal ratings-based approach to capital (IRB) and should be available in the future.

[Sheets] of the FPM®:

[FPM Cover] Introduces the overall structure of the FPM®, its areas and labels used for certain variables – user input sheet

Var

iab

les

[Macro]

Historic data for key external variables (GDP, interest rates, banking system, and others); Assumptions for these external variables make up three possible scenarios for fives projection periods – user input sheet

[External]

External variables used for the projection periods, according to results of user entry in [Macro], including market rates of growth, interest, and FX

[Entry]

Where the lines of the base financial statements are entered, including reclassifications and adjustments – user input sheet

[Assumptions-BS]

Assumptions (annual rates) regarding the manner in which assets and liabilities behave for each period; core component of the projection, linked to the scenarios – user input sheet

[Assumptions-PLA]

Assumptions (annual rates) regarding the manner in which revenues and costs for each period; core component of the projection, linked to the B/S – user input sheet

[Rates]

Displays the rates used by the projection as result of user input in other sheets, such as the [Assumptions] and [External]

Ban

k A

ctiv

itie

s

[Deposits, Cash, &CB] B/S evolution of Deposit Products which drive the projection, including Cash & Central Bank (CB)

[Money Market] Activities B/S and income-expense P/L for interbank lent and borrowed funds, including CB ELA

[Capital Market] Activities B/S and income-expense P/L for all securities investments (AFS and HTM) as well as borrowed funds

[Loans] B/S and income-expense P/L for all eight segments of lending activities in corporate and retail

[Other A&L and OBS] B/S and income-expense P/L for all non-interest-earning (NIE) assets and non-interest-bearing (NIB) liabilities

[Operations] Non-interest income and expense elements of the P/L

[Capital] Capital accounts and eligible capital instruments (ECI)

[Derivatives] Long and short foreign exchange forward contracts

[IRB] Alternative approximation to the capital adequacy calculations under Basel II (under construction)

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[Actions]

Set of absolute amounts added or subtracted to each selected projected items to simulate restructuring – user input sheet

Mo

del

[Funds Flow] The tie-up of all the projection parts generating the discretionary fund flow available for reinvestment

[Projected BS] Projected balance sheet and initial balance sheet fund flow (BFF) used to balance the Model

[Projected PL] Projected P/L and initial operational cash flow (OCF) used to balance the Model

Ou

tpu

t [Summary] Summary for presentation of the projected B/S and P/L

[Valuation] Provides an approximation to the value of the bank in PV terms and the cost/benefit of restructuring

[Resolution] Provides a tool to approximate liquidation value for the bank

[Executive Summary] A short set of proxy indicators from the projection

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C. Growth Dynamics of the Model

This section provides a summary of the dynamics of the projection and how the financial statements are driven by the external variables (such as nominal GDP growth rate) and deposits growth. The next section provides actual formulas used to balance growth in the Model. First, the funds flow (FF) provided by the change in deposits is allocated to comply with the reserve requirement and liquidity rules. The remaining resources are combined with the net funds available from the Money and Capital Market activities. The residual net surplus of B/S funds flow is combined with the cash flow from operations, and both are balanced in the [Funds Flow] area based on allocation rules of discretionary funds flow among loans and securities selected by the user. A full detailed description of this process (growth, balancing and allocation of discretionary fund flows) is included below in Chapter V. Part 1 below describes growth. Part 2 describes the behavior of balance sheet lines and Part 3 describes the behavior of the profit and loss account lines. 1. Key Drivers of Growth in the Model

▫ Growth in the Model is driven by the path of nominal GDP (real growth plus inflation) which

determines the evolution of deposits at the system level modulated up or down by a scaling factor K located in [Macro] lines 39 and 41.

▫ The Model allows you to fill in and operate three scenarios (① Base, ② Best, and ③ Adverse) entered in [Macro] columns AE to AU, based on your expert analysis of both past and foreseen trends.

▫ Once the scenario data are filled in, select the scenario you would like the projection to

apply by selecting its associated number (1, 2, or 3 in cell H6 in [FPM Cover]). ▫ Based on the inflation differential (line 13) with the international inflation level chosen (i.e.,

Euro or US areas in line 12) the Model projects the nominal depreciation of the local currency (LC.CY.) and builds the FX rate in [Macro] lines 8 and 9.

▫ The total size of the banking industry is projected in Sections D and E in [Macro] giving the

total market of deposits and loans in the banking system in local currency (LC.CY.), and in foreign currency (FG.CY.), respectively, linking both variables to nominal GDP.

▫ Based on the initial market share of the bank, [Macro] Sections F and H project its share in

the system’s total deposits and credits, modulating market share with an add-on placed in lines 81 and 82 in LC.CY. and 113 and 114 in FG.CY. to simulated gains and loss of business.

▫ If you wish to project the full banking system, rather than a specific bank or group of banks,

the market share is set at 100 percent by entering the systems’ deposits and loans in sections F and I (lines 71 to 74 in LC.CY. and 103 to 106 in FG.CY.).

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▫ As indicated above, an Add-on factor in [Macro] (lines 81, 82 and 113, 114) allows you to modify the market share by adding or subtracting points to those lines, so that a particular bank earns or loses market share along the projection period.

▫ As indicated above, growth of local deposits is linked to the nominal growth of GDP scaled

by a factor K in [Macro] lines 39 and 41, which allows you to modulate financial deepening along the hypothetical economic cycle.

▫ The local markets for transactional deposits and savings and time deposit products are

differentiated in [Macro] Section D, simulating the limit of the total “pie” of deposits in the system for which all the banks are competing.

▫ Growth of local credit is linked to the nominal growth of GDP scaled by a factor K in [Macro]

lines 43 and 45, which allows you to modulate financial intermediation along the hypothetical economic cycle.

▫ The corporate and retail credit segments are differentiated as well, producing the total “pie”

of the credit business in the system for which banks compete, which is only used to monitor credit growth, rather than as a constraint in the projection.

▫ The same process is followed for the market of FG.CY. deposits and loans at system level.

Subsequently, the Model offers a few key indicators to control financial deepening and intermediation proxies (to be coded at this stage).

▫ Section F in [Macro] invites to you enter the market share of the target bank for LC.CY.

operations (deposits and credits) under simulation, including an annual allowance in line 81 and 82 for changing market share.

Summary Growth Mechanics

36

▫ Section G in [Macro] invites you to distribute the market share of deposits of the target

bank among seven different products (3 transactional and 4 savings) with different interest expense structures entered in [Assumptions-PLA].

▫ Section H recalculates the expected absolute growth in the deposit products for the target

bank based on the assumptions entered above, along with the balance sheet figures in [Entry].

▫ The same process is repeated in Sections I to K in [Macro] for the market share of deposits

and credits of the target bank’s FG.CY. activities. ▫ Sections B and C store reference rates of the system in FG.CY. and LC.CY. which are used as

base rates in the projection, and which also provide pre-calculated spreads to monitor the plausibility of scenarios.

▫ Additional reference rates are enabled in sections L and M to enter scenarios for discount

and risk premia, central bank and interbank money market rates, as well as other rates for FG.CY. activities.

▫ These latter rates and those in sections B to C are transformed in [External] into a panel of

reference annual rates available for the user to link in column D through entering codes “1” to “19”.

▫ The scenarios in [Macro] cover up to five years going forward and in [External] the fifth

year’s rates are extended to years 6 through 12 without further adjustment, to cover the 12 periods available in the model.

▫ The code in column D of [External] is the link to select the reference rate for all interest-

earning assets and interest-bearing liabilities which you designate in column D of [Assumptions-PLA] as those that form the rates of interest.

▫ Again, that selection is done by choosing in [Assumptions-PLA], column D lines 7 to 22 and

40 to 57, the digit(s) that corresponds to the base reference rate in [External] which will add to the reference rate the desired spread.

▫ No such addition will take place if you select “0” as code, and that particular interest-

earning asset or interest-bearing liability will not be assigned an interest rate in the projection (hence, will yield a zero P/L interest income or cost).

▫ All rates of growth, interest and PD are supposed to be annual rates and later adjusted, as coded, in [External], [Rates], and each [Activity] sheet to the relevant frequency selected by the user in [FPM Cover] cells H5 through S5 before calculations start.

▫ For periods more frequent than annual, the allocation of growth and interest rates to each period follows the frequency selected by dividing the annual rates corresponding to the period into the number of periods of that frequency.

37

▫ To allow flexibility in using the absolute [Actions], the changes to be effected here do not follow the frequency rule indicated above and are applied directly to the period in which they are entered in [Actions]. You may think of the [Actions] as a versatile governor to control the exercise (or projection).

▫ You can include or exclude the absolute actions discussed above by selecting the value of the switch placed in H12 in the [FPM Cover], which allows you to easily quantify the corresponding effect on a scenario of Actions shown in [Value].

▫ With this Actions governor, you can reasonably quantify the effect on the PV of any management or official support or restructuring [Actions] or scenario of loan portfolio migration.

▫ Also, you can think of [Actions] as the governing asset and liability management (ALM) toolkit. In [Actions], you can play out your ALM maturity plots, like failure to roll-over market funding, or a deposit run scenario.

▫ The FPM® simplifies the maturity of assets and liabilities assuming a roll-over scenario where maturing assets and liabilities are renewed. The [Actions] sheet allows you to alter that roll-over behavior by adding new assets and liabilities, or including the repayment of bonds and borrowing owed to creditors.

▫ Moreover, [Actions] allows asset-to-asset, liability-to-liability, and liability-to-equity swaps, as well as carving-out of assets and liabilities.

▫ You can balance an action (square the books) (for example, increase an asset and a liability by a given amount), or just implement an asset change. The FPM® will balance itself and invest or finance the surplus or deficit affecting liquidity. In the same manner, you can affect net worth. For example, if you carve out problem loans by an amount and pay them to the bank with a security, then the loan provisions relieved will flow via the P/L account.

▫ With time and access to appropriate data series, or with help of local counterparts, you can try to develop a simple regression model to project deposits based on GDP and other relevant local and external drivers.

This guide’s Section D below provides a complete account of the formulas used to balance growth in the Model. The next two Parts document in full detail the dynamics of growth and behavior of each B/S and P/L line item in the FPM®.

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2. Growth Factors of the Balance Sheet Items

There are four different components of a Balance Sheet item’s growth in the projection:

1) Percentage of growth of that item during the period as specified in [Assumptions-BS]; 2) Percentage of another balance sheet or profit and loss account item as of the end

period as specified in [Assumptions-BS] or [Assumptions-PLA]; 3) Absolute change during the period as specified in [Actions]; and 4) Allocation from funds flow during the period as specified in [Assumptions-BS].

The specific values of the above growth factors for the projection period are set by the user. In this regard, you have a great deal of flexibility in setting growth factors based on either scenarios or analysis of behavior of each balance sheet item. The table below lists each B/S line item and the factor by which it will grow in the projection after it has been entered in the referenced lines in [Assumptions-BS]. Table 1. Growth Factors of the Projected Balance Sheet Note: Cells in colored shade represent key lines in the Model.

Balance Sheet Items Growth Factors

I. ASSETS Lines refer to those in [Assumptions-BS],

unless otherwise stated

Cash & Balance with Central Bank

Cash in Vault and ATMs % of the sum of transactional deposits accounts (line 21)

CB Reserve Requirements % of all deposits accounts (lines 23 to 29)

Other CB Deposits % of the sum of transactional deposits accounts (line 33)

Money Market Activities (Assets)

Correspondent & Settlement Accounts % of Customer Deposit Accounts + % of Net Loan Portfolio Segment (lines 36 and 37)

Due from Banks/OFI in Interbank Liquidity adjustment line (see Chapter IV, Section E)

Securities Held for Trading % Growth (line 40)

(+/-) Fair Value Adjustments % of Securities Held for Trading (line 42)

Repo Money Market Operations % Growth (line 44)

Capital Market Activities (Assets)

AFS (Available for Sale Securities) Discretionary funds allocation (see Chapter V, Section A)

(+/-) Fair Value Adjustments % of AFS Securities (line 48)

Less: Impairment Adjustments % of Net AFS Securities (line 50)

HTM Securities % Growth (line 52)

Less: Impairment Adjustments % of HTM Securities (line 54)

Multipurpose Asset (MPA) Absolute changes from [Actions] (see

39

Balance Sheet Items Growth Factors

Chapter V, Section C)

IAR on MPA (+) (or Discounted AR on MPA (-))

Periods of Interest Accrual on Recapitalization Bond (line 57)

Investments in Associates/ Subsidiaries % Growth (line 59)

(+/-) Carrying Value Adjustments % of Investments in Associates/Subsidiaries (line 61)

Less: Impairment Adjustments % of Net Investments in Associates/ Subsidiaries (line 63)

Loans Discretionary funds allocation (see Chapter V, Section A)

A-grade loans Funds flow allocation

B-grade loans Funds flow allocation

C/D-grade loans (impaired loans) Loans migration (PD, scaling factor)

Less: Loans loss reserves Expected LGD for impaired loans

Other Assets

Property, Plant and Equipment % Growth (line 133)

Less: Accumulated Depreciation % of Net Property, Plant/Equipment (line 135)

Interest Accrued Receivable % of TOTAL INTEREST INCOME (line 137)

Goodwill Absolute change

Less: Amortization & Impairments % of Net Goodwill (line 140)

Foreclosed Assets (OREO) % of total retail & corporate impaired loans (C/D) (line 142)

Less: Provisions for OREO % of Foreclosed Assets (line 144)

Other Assets % of Total Assets (line 146)

II. LIABILITIES & EQUITY

LIABILITIES

Customer Deposit Accounts Nominal GDP times Market share (Key driver of model growth)

Money Market Activities

Due to Banks/OFI in Interbank % Growth (line 157)

Money Market Repo Operations % Growth (line 159)

ELA from Central Bank Model balancing line

Institutional Money Market Deposits % Growth (line 162)

Capital Market Activities

Syndicate Loans & Similar Borrowing % Growth (line 165)

MLT Lines of Credit (Parent or EBRD) % Growth (line 167)

Bonds Issued % Growth (line 169)

Subordinated Bonds % Growth (line 171)

Multipurpose Liability (MPL) Absolute change from policy actions

Discounted A/P on MPL (-) (or Interest Periods of Interest Accrual on Zero Coupon

40

Balance Sheet Items Growth Factors

Accrued on MPL (+)) Debt (line 174)

Other Liabilities

General Loan Loss Provision Expected PD, LGD for loans

Provisions for Employee Benefits % of Personnel Expenses (line 178)

Provisions for OBS Guarantees % of Doubtful Guarantees ([Assumptions-PLA] line 158)

Tax Liabilities % of Income Tax Expense (line 182)

Interest Accrued Payable % of Interest Expense (line 184)

Other Liabilities “ % of TOTAL LIABILITIES” (line 186)

Financial Derivative Liabilities (FVA) % of Total Derivatives (line 188)

SHAREHOLDER`S EQUITY

Common Stock (Private) Absolute change

Common Stock (Official) Absolute change from policy actions

Preferred Stock (Private) Absolute change

Preferred Stock (Official) Absolute change from policy actions

Retained Earnings Performance of operations (same as Retained Earnings in the P/L)

Gains/Losses on AFS Securities Same as fair value adjustment for AFS securities in the B/S

Revaluation Reserves % of Property, Plant and Equipment (line 200)

All Other Reserves Absolute change

III.OFF-BALANCE SHEET ACTIVITY

Contingent Liabilities

Financial Guarantees % Growth (line 208)

Doubtful Guarantees % of Financial Guarantees (line 210)

Contingent Commitments

Retail and Credit Card Lines % of Net Retail Loan Portfolio (line 213)

Corporate Loans Lines % of Net Corporate Loan Portfolio (line 215)

Assets Under Management

Pension Funds under Management % Growth (line 218)

Mutual Funds under Management % Growth (line 220)

Trusts and Other Funds under Management

% Growth (line 222)

Derivatives

Forwards Long Absolute change

Forwards Short Absolute change

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3. Determinants of the Income Statement Items

Determinants of the Profit and Loss Account line items in the projection are the following:

1) Reference interest rate plus designated spreads (interest-earning assets and interest-bearing liabilities);

2) Percentage of a related B/S or P/L item or business volumes (i.e., for fee income and expenses);

3) Nominal GDP growth rate (i.e., operational expenses); and 4) Expected PD and LGD for loans (impairment charges for loans, etc).

You can set the specific values of each of the above factors over the projection period. As in the case of balance sheet items, users have a great deal of flexibility in setting growth factors based on either scenarios or analysis of behavior of each income statement item. The table below lists each P/L line item and its determinants in the projection once entered in the referred lines in [Assumptions-PLA]. Table2. Determinants of the Projected Income Statement

Income Statement Items Determinants of Income/Expense

TOTAL INTEREST INCOME Lines refer to those in [Assumptions-PLA], unless otherwise stated

Remunerated Reserve Requirements Reference interest rate + spread for each item (The user is allowed to choose an appropriate reference rate for each item among 19 rates) (lines 7 to 22); Balances of interest- earning assets

Other CB Deposits (Interest earning)

Due from Banks/OFI in Interbank

Debt Securities Held for Trading

Repo Money Market Operations

AFS Debt Securities

HTM Debt Securities

Multipurpose Asset (MPA)

Residential Mortgages (RM)

Consumer Loans (CL)

Other Retail Loans (ORL)

SME Loans Managed as Retail

Loans to Large Local Corporate (LLC)

Loans to RE Construction Companies (REC)

Loans to Local Trading Companies (LTC)

Loans to Other Local Corporate (OLC)

TOTAL INTEREST EXPENSE

Retail Transactional Accounts Reference interest rate + spread for each item (The user chooses an appropriate reference rate for each item among 19 rates)

Corporate Transactional Accounts

Demand Retail Accounts IBL

42

Income Statement Items Determinants of Income/Expense

Saving Accounts & Similar IBL (lines 40 to 57); Balances of interest-bearing liabilities Time Deposits and IBL CDs.

Corporate IBL Wholesale Deposits

Money Market IBL Deposits

Due to Banks/OFI in Interbank

Money Market Repo Operations

ELA from Central Bank (LOLR line)

Institutional Money Market Deposits

Syndicate Loans & Similar

MLT Lines of Credit (Parent or EBRD)

Bonds Issued

Subordinated Bonds

Multipurpose Liability (MPL)

NET INTEREST MARGIN

Fee and Commission Income

Asset Management Fees % of pension/mutual/other funds under management (lines 72 to 74)

Loan Commitment Fees % of retail and credit card lines & corporate loans lines (lines 76 and 77)

Financial Guarantee Fees % of financial guarantee (line 79)

Payment Service Fees % of volume of payment service transactions (line 81)

Clearing and Settlement System Fees % of volume of clearing & settlement service (line 83)

Lending Fees % of net loans (line 85)

FX Transaction Fees % of net FX spot position (line 87)

Other Fee and Commission Income % of total assets (line 89)

Fee and Commission Expense (-)

Brokerage Fees % of trading securities held for trading & assets under management (line 92)

Available Credit Line Fees % of MLT lines of credits (parent/EBRD) (line 94)

Servicing Fees for Syndication Activities % of syndicated loans or similar borrowing (line 96)

Other Fees and Commission Expenses % of total liabilities (line 98)

Net Fee and Commission Income

Net Trading Income

Gains (Losses) on Trading Securities % of trading securities (line 102)

FX Translation Gains (or, Losses) % of FX spot position (line 104)

Other Trading Gains or Losses % of Trading Book Exposure (line 106)

Gain (Loss) on Securities

43

Income Statement Items Determinants of Income/Expense

Gains (Losses) on AFS Securities % of AFS securities (line 109)

Gains (Losses) on HTM Securities % of HTM securities (line 111)

Dividend Income

% of equity securities held for trading, equity AFS securities & investments in associates/subsidiaries (line 113 to 115)

Other Operating Income % of total interest income (line 117)

GROSS OPERATING MARGIN

Operational Expenses (-)

Personnel Expenses

Salaries Either i) Nominal GDP growth rate or ii) % of total assets or iii) average expenses *total headcount (based on the user’s choice) (lines 120 to 126) – see governors in [Entry] C208

Social Security Benefits

Other Personnel Expenses

Other Administrative Expenses

IT and Communication Either i) Nominal GDP growth rate or ii) % of total assets or iii) assumed % growth (based on the user’s choice) (lines 127 to 135) – see governors in [Entry] C212

Property, fixtures, supplies

Marketing expenses

Other Expenses

Depreciation and Amortization

Depreciation of Fixed Assets % of net fixed assets ([Assumptions – BS] (line 135)

Amortization of Goodwill % of net Goodwill ([Assumptions – BS] line 140)

Other Operating Expense (-) % of (operating expense – depreciation & amortization cost) (line 140)

NET OPERATING MARGIN

Gain (Loss) in Foreclosed Asset % of net foreclosed assets (line 143)

Net Provisioning (-)

Impairment Charges for Loans Balance of impaired loans and expected LGD for impaired loans

Impairment Charges for Securities

AFS Securities % of net balance of AFS and HTM securities ([Assumptions BS] lines 50 and 54) HTM Securities

Prov.: Investments in Associates/Subs. % of net balance of Investments ([Assumptions BS] line 63)

Provision for Foreclosed Assets % of Foreclosed Assets ([Assumptions BS] line 144)

Provisions for Doubtful Guarantees % of Doubtful Guarantees (line 158)

Charge for General Provision Balance of A/B grade loans and expected PDs and LGDs for each loan

Provisions for Employee Benefit % of Personnel Expenses ([Assumptions BS] line 178)

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Income Statement Items Determinants of Income/Expense

Recoveries from Charged-off Loans % of Charged-off loans (line 162)

Other Income (Loss) % of Net Operating Income (Losses) (line 164)

Extraordinary Income (Loss) Absolute change

NET INCOME BEFORE TAX Income Tax Expense Income tax rate, balance of available tax

credit (line 168)

NET INCOME AFTER TAX Dividends on Preferred Stocks Fixed dividend rate, Dividend in accrual(in

case of cumulative stocks), Regulatory capital ratio(in case of capital adequacy ratio constraint)

NET PROFIT AFTER DISTRIBUTIONS

Dividends on Common Stock % of Net Profit (line 174)

RETAINED EARNINGS

The following sections explains how the FPM® balances itself through the iteration process and the mechanisms for allocating the overall discretionary funds flow, including the role played by some important lines such as the Available for Sale Securities (AFS) and the Emergency Liquidity Assistance (ELA) lines. Chapter V details the mechanics of the most relevant lines of the FPM®, including a step-by-step walk-through of the formulas used to implement them.

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D. Model Balancing and Allocation of Funds Flow

The following paragraphs describe how the FPM® allocates – in each period of the projection – the discretionary funds flow available for reinvestment, including the balancing process through iterations in two parts: Part I, Funds Flow Calculation; and Part II: Key Lines used to balance the Model. The detailed mechanics of important lines are documented in the next Chapter.

Balancing the Model is the result of the interplay among all its lines through reinvesting surplus into AFS, loans or both, and closing the financing gap via the ELA line (emergency liquidity assistance acting as lender of last resort in a projection, perhaps your CB).

Within the FPM® there are two basic types of Funds Flows (FF): 1) "Balance Sheet Funds Flow" (BFF) from balance sheet activities; and 2) "Operational Cash Flow" (OCF) from operations, earned in cash through the profit and loss account. In addition, you can affect these two types of Funds Flows through absolute changes that you can implement via the [Actions] sheet (management and official restructuring actions). These [Actions] act as a flexible asset and liability management (ALM) governor (i.e., you can repay liabilities, carve out assets, recapitalize, etc.).

Part I: Funds flow calculation

The Funds Flow calculation process of the FPM® can be summarized in eight basic steps as described below.

Step 1: Calculation of "Balance Sheet Funds Flow" (BFF) for each currency

Formula: BFF = (change in Liabilities and Net Worth items) - (change in Assets items), excluding AFS securities, loans, ELA, and retained earnings (given their special role in balancing a projection)

i) AFS securities is one of the two asset classes into which discretionary FF is allocated; ii) [Loans] are the other asset class into which discretionary FF is allocated (invest in new

securities or new loans); iii) ELA (for example, from the CB) is the Model-balancing line of last resort when there is a

financing need to close a FF gap; and iv) Retained earnings that are captured in the calculation of the OCF as explained below.

Step 2: Calculation of "Operational Cash Flow" (OCF) for each currency

Formula: OCF = (Profits after Tax and Dividends) + (Non-cash Expenses) - (Non-cash Incomes) ± (Operational Expense adjustments)

i) Non-cash expense items are depreciation of fixed assets, goodwill amortization, impairment charges, provisions for assets and liabilities, interest accrued receivable (IAR) increase, etc.

ii) Non-cash income items are FX revaluation gains/losses, the increase in IAR, etc. iii) Operational expense adjustments (in case that these are projected only in LC.CY., i.e., a

“local cost” based bank). Operational expenses are distributed into LC.CY. and FG.CY. activities in proportion to the relative asset size in each currency.

Step 3: Calculation of "Initial Funds Flow" (IFF) for each currency

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Formula: IFF = (BFF + OCF)

Step 4: Calculation of "Funds Flow after Actions to sell/buy AFS securities or Loans" (FFA) for each currency

Formula: FF after selling/buying AFS or Loans = (IFF) + (changes in FF from selling/buying AFS securities and/or Loans)

i) You can force selling/buying AFS and/or Loans by implementing absolute change(s) in [Actions].

ii) FF changes from these actions must be included because they are excluded from calculation of IFF.

Step 5: Calculation of "Funds Flow after forced sale of AFS securities to repay ELA" (FFE) for each currency

Formula: FF after using available AFS securities to repay ELA = (FFA) + (Necessary AFS securities to be sold to repay ELA balance in case FFA is less than the previous ELA)

i) If AFS are not sufficient to repay the period’s beginning balance of ELA, the balance of AFS securities are assumed to be sold to pay the previous ELA.

ii) The model allows a choice to sell or not to sell AFS securities when the existing ELA balance cannot be fully repaid by available Funds Flow (FFA). This feature is governed through user input in [Assumptions-BS] cell D15, one of the FPM®’s many governors explained later in Annex 4.

Step 6: Calculation of "Funds Flow after Cross-Currency Transfer to repay ELA” for each currency

Formula: Funds Flow after Cross-currency Transfer = (FFE) ± (Cross-currency Transfer), where the cross-currency transfer is made so that positive FF in one currency covers the negative FF in the other currency until that negative becomes zero

* Cross-currency transfer does not occur when FF in both currencies are all positive or negative. Step 7: Calculation of "Discretionary Funds Flow after Cross-Currency Allocation" for each currency

Formula: Discretionary Funds Flow (DFF) = (Funds Flow after Cross-currency Transfer) - (Cross-currency outflow) + (Cross-currency inflow)

i) Notice that the FPM® assumes that cross-currency allocation is carried at the prevailing spot FX rate.

ii) You can set the proportion of cross-currency outflow to total funds flow for each currency in [Funds Flow] sheet lines 33 and 34.

As currently coded, the FPM® does not incorporate an explicit mechanism to correct interest rate differentials across the two currencies, such as an OBS forward or alternative hedge to cost, as part of the gross operating margin, the differential from FX depreciation or appreciation. This might be essential in those cases where a bank borrows at lower rates in FG.CY. and sells the funds at the spot FX rate to then lend at a higher rate in LC.CY. As a customary sound practice,

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management will buy forward the necessary FG.CY. to cover the short spot position created, and the differential FX rate points will be debited in the P/L to correct the interest spread. The user can implement the P/L effect of this strategy by using line 179 “Gains/Losses in Trading Securities” in the *Action] sheet, manually quantifying its effect. Step 8: Calculation of "Discretionary Funds Flow" (DFF) for each currency

Formula: Discretionary Funds Flow (DFF) = Max (Funds Flow after Cross-currency Transfer - Funds flow that are used to pay ELA balance, 0)

i) When DFF is positive, it is allocated into either AFS or Loans, based on the allocation rule (Note that DFF cannot be a negative value, so it is capped at zero).

ii) The above FF is determined simultaneously along with the balance of AFS securities, Loans, ELA balance, and retained earnings (or OCF) in such a way that model balancing is achieved through DFF allocation and ELA adjustment.

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Part II: Key lines to balance the Model

1. Emergency Lending Assistance (ELA) from CB, lender of last resort (LOR) in [Money Market]

line 15

Formula: ELA = Max (initial ELA balance - FF after cross-currency transfer, 0)

i) It is assumed that FF is first used to comply with the liquidity rule (unless exempted as designated in cell H9 of [Assumptions-BS]; See Section E below.).

ii) It is assumed that any FF after satisfying the liquidity rule is then used to repay the initial ELA balance (unless otherwise designated in governor placed in cell D15 in [Assumptions-BS])and then allocated into AFS securities and Loans.

iii) The ELA line shows how much financing is needed to balance the Model. It is assumed that the CB provides the funds.

iv) The PV of any differential between the market interest rate and that charged by the CB is a subsidy provided by the CB.

2. AFS Securities in [Capital Markets] line 6

Formula: AFS securities = Initial AFS + Absolute change in AFS from Actions + DFF allocation into AFS (when FF available after sell/buy AFS and Loans (FFA) > the initial ELA, or when no forced sale of AFS to repay ELA is selected by the user),

or:

AFS securities = Initial AFS + Absolute change in AFS from Actions - Amount of AFS that FPM needs to sell for repaying any outstanding balances of ELA (when FFA < the initial ELA and forced sale of AFS to repay ELA is selected by the user)

3. Loans

Formula: Loans = Initial balance of Loans + Absolute change in Loans from Actions + DFF allocation into Loans

This is the general behavior subject to the dynamics documented in much more detail in Section B of Chapter V.

4. Due from Banks/OFI in [Money Market] Line 7

Formula: Due from Banks/OFI = When liquidity constraint is active: MAX(required liquid assets – current stock of liquid assets, excluding due from banks/OFI), where required liquid assets are calculated by applying target ratio of liquid assets to liquid liabilities. If there are more liquid assets (excluding due from banks/OFI) than required, this line is 0 (because this line cannot be negative).

When liquidity constraint is deactivated: balance of line at end of last period * growth factors+ any actions.

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E. Liquidity constraint mechanics in the Model

The FPM® allows you to activate or deactivate a liquidity constraint rule. When activated, the rule forces the bank to comply, keeping a certain level of liquid assets to satisfy the target ratio of liquid assets to liquid liabilities. The model provides users with a suite of governors to control the target ratio of eligible liquid assets to liquid liabilities as well as the concrete lines of liquid assets and liquid liabilities available in the projection.

If activated, the Model calculates the required liquid assets. In case of a deficit of liquid assets against this required amount, the Model supplies the Due from Banks/OFI line in the [Money Market] with the amount needed forcing the projection to comply with the target liquidity ratio selected. If there are enough liquid assets to satisfy the liquidity constraint, the balance of Due from Banks/OFI is set and kept at zero.

If deactivated, the Model the line Due from Banks/OFI line is projected according to its growth factors, including actions.

1. How to activate or deactivate the liquidity constraint

You can activate or deactivate the liquidity constraint by choosing “Y” (yes) or “N” (no) in [Assumptions-BS] cells H9 (in local currency) and X9 (in foreign currency).

2. How to set a target liquidity ratio and the scope of liquid assets/liabilities

A target liquidity ratio can be set by users in [Assumptions-BS] line 8.

The scope of liquid assets and applicable liabilities can be set by users in the [Entry] sheet, cells C6 to C20 and C85 to C100. Where cell value is set to ”1”, the asset or liability line is regarded as “liquid” and subject to the constraint; where cell value is set to “0”, that particular item is excluded from the scope of liquid assets or liabilities.

In addition, you can set what percentage of a particular liquid asset or liability line item is counted as “liquid assets or liquid liabilities” in column D of the [Entry] sheet. For example, when the value is 50 percent, a half of the nominal value of the item is regarded as a liquid asset or liquid liability.

3. How the Model forces a projection to meet the liquidity constraint

Calculation of the required amount of liquid assets: The amount of required liquid assets is calculated implicitly by summing up the product of a) the target liquidity ratio; b) the value of column C of the [Entry] sheet; c) the value of column D of the [Entry] sheet; and d) the balance of a liquid liability, for all liquid liability items.

Calculation of the current level of eligible liquid assets: The amount of eligible liquid assets is calculated by summing up the multiplication of a) the value of column C of the [Entry] sheet; b) the value of column C of the [Entry] sheet; and c) the balance of a liquid asset, for all liquid assets items, except Due from Banks/OFI.

Determination of “Due from Banks/OFI”:

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If the current level of eligible liquid assets is less than the required amount, the balance of “Due from Banks/OFI” will be the difference;

Otherwise, the balance will be zero (since this means no further liquid assets are needed).

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V. Main Formulas of the Financial Projection Model

The following sections document the mechanics of the important lines of the Model. Section A explains the mechanics of AFS. Section B details the mechanics of Loans. Section C reports the functioning of two multipurpose lines for an asset and a liability. Section D explains the mechanics of preferred stocks. Section E details how income taxes are calculated. Section F explains how operational and other operational expenses work. Section G presents the mechanics of approximating a capital adequacy ratio under a standard risk weight approach. Section H clarifies how the Model provisionally implements derivatives. Section I reviews the calculation of net foreign exchange position. Section J explains how to select reference rates for each interest-earning asset and interest-bearing liability to which entered spreads are added to form the projected rates of interest. And finally, Section K discusses the repricing options and mechanisms of interest-earning assets and interest-bearing liabilities in the Mode.

A. Available-for-Sale Securities (AFS) in the Model

1. AFS Securities in the [Capital Market] activity sheet

Formula: IF($D$6=0, H6+ (Actions!I7*ACT)+ 'Funds Flow'!I9, IF('Funds Flow'!I25< 'Money Market'!H14,H6+ (Actions!I7*ACT)- MIN(('Money Market'!H14- 'Funds Flow'!I25), H6+ (Actions!I7*ACT)), H6+ (Actions!I7*ACT)+ 'Funds Flow'!I9))

First, look at the text of the formula (without cell references) proposed in the previous Chapter IV, Part II, where we said that AFS securities are equal to a) or b) below:

a) The initial AFS, + Absolute change in AFS from Actions + DFF allocation into AFS (when FF available after sell/buy AFS and Loans (FFA) is > than the initial ELA or when no forced sale of AFS to repay ELA is selected by the user); or

b) The initial AFS, + Absolute change in AFS from Actions - Amount of AFS that FPM needs to sell for repaying any outstanding balances of ELA (when FFA < than the initial ELA and if forced sale of AFS to repay ELA is selected by the user)

Let us look again at the formula below, but this time with cells, formulas, and colors so that it is easier to follow the formula:

Formula: =IF($D$6=0, H6 + (Actions!I7 *ACT) + 'Funds Flow'!I9, IF('Funds Flow'!I25 < 'Money Market'!H14, H6 + (Actions!I7*ACT) – MIN (('Money Market'!H14 - 'Funds Flow'!I25), H6 + (Actions!I7*ACT)), H6 + (Actions!I7*ACT) + 'Funds Flow'!I9).

1) When $D$6=0, the option for forced sale of AFS securities is not activated. $D$6 is the governor placed in cell D15 of [Assumptions-BS] which allows you to force (“1”) or not (“0”) the sale of AFS to repay ELA. The balance of AFS for the current period (I6) will be equal to the blue underlined part of the formula:

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I6 = H6 (previous balance of AFS) + Actions!I7*ACT (change in AFS from Actions) + 'Funds Flow'!I9 (the portion of FF allocated to AFS).

2) When $D$6=1, the option for forced sale of AFS is activated with two alternatives documented below as 2.1 and 2.2. The green, red and magenta parts of the formula apply.

2.1) When funds flow is negative or positive, but less than ELA,…

i.e. IF('Funds Flow'!I25 (amount of FF from all activities) <'Money Market'!I14 (balance of ELA from CB at the end of previous period) (hence, the FPM® needs to sell AFS to repay ELA, to cover a negative FF or to complement a FF that it is not enough to repay ELA),

…there will not be any FF allocation to ELA. The FPM® needs to sell AFS to repay ELA or to cover the negative FF.

Then:

I6 = H6 (previous balance of AFS) + (Actions!I7*ACT) (change in AFS from Actions) – MIN (('Money Market'!H14 (ELA) - 'Funds Flow'!I25 (amount of funds flow from all activities)), H6 + (Actions!I7*ACT)) Which means that the FPM® will sell AFS (previous balance of AFS + change in AFS from Actions) to pay: or the net amount of ELA less the existing FF (if positive, it reduces ELA; if negative, it is added to ELA) as much as there is enough AFS to sell: MIN (('Money Market'!H14 (ELA) -'Funds Flow'!I25)). Otherwise, the FPM® only will sell what it has available at that moment which is H6 + (Actions!I7*ACT)

2.2) Otherwise, when funds flow is greater than ELA,…

i.e. IF('Funds Flow'!I25 (amount of FF from all activities) =>'Money Market'!I14 (balance of ELA from CB at the end of previous period) (hence, it will not be necessary to sell AFS to repay ELA or to cover a negative FF, since in this case, FF will be positive and enough to repay ELA),

…there is no need to sell ELA and available FF is allocated into AFS. Then: I6 = H6 (previous balance of AFS) + (Actions!I7*ACT) (change in AFS from Actions) +'Funds Flow'!I9 (the portion of Funds Flow allocated to AFS)

2.3) Fair-value adjustments for AFS Securities Formula: I6*I72 Fair value adjustments: I7 = I6 (balance of AFS securities) *I72 (fair value adjustments rate) * Note that the amount of fair value adjustments appears as Gains (Losses) on AFS securities in the [Capital] activities sheet (not in the P/L), according to IFRS accounting practice.

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2. Impairment for AFS Securities in the [Capital Market] activity sheet

Formula: (I6+I7)*I74 Impairment reserves: I8 = I6 (balance of AFS securities) + I7 (fair value adjustments) *I74 (expected loss rate for AFS securities) Points to keep in mind:

In addition to being an asset allocation class, ELA acts a secondary liquidity buffer.

The primary liquidity buffer is enabled with the liquidity governor discussed above.

The growth of AFS securities depends on discretionary funds flow allocation, since available funds are allocated into either AFS securities or loans.

However, you can change the absolute amount of AFS using [Actions] by “selling” or “buying” them.

One very important feature of this model is that it can force the bank to sell any available AFS securities to repay the balance of ELA from Central Bank and cover negative funds flow (set cell D15 in [Assumptions-BS+ equal to “1”).

You can control the level of fair value adjustment and expected loss (impairment) for AFS securities using lines 48 and 50 in the [Assumption-BS] sheet, selecting the rates that fit expected valuation or market scenarios envisioned for the AFS.

Note that the amount of FF changes from buying or selling AFS securities implicitly includes the related changes in both fair value adjustment and impairment reserves which are not captured in the BFF and OCF.

In other words, the amount of absolute change in AFS from the [Actions] is in FF units. Therefore, when selling AFS securities, the bank may not receive this full amount in cash as it would receive the remaining funds flow after the respective fair value adjustments and impairment reserves have been subtracted.

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B. The Loan Portfolio in the Model

There are 16 loan segments, eight in each currency, available in the FPM®. Every loan segment has three grades or classes: A - well/best-rated (prime); B - less well-rated (sub-prime); and C/D - (impaired/defaulted), each with its own dynamics.

You can run a projection with only one segment of generic loans, or with all segments. Ideally, based on your analysis, the segments of loans that affect value and performance significantly would be identified and singled out in the projection. You can change the name of the segments and the three grades of the loan classification in [Entry] (e.g., call them performing, semi-performing, and classified).

You may wish to separate those segments that are the drivers of growth and revenues of the bank, those more at-risk, or those for which there is information available in the IFRS reports or internally in the bank. For example, you can concentrate all problem restructured corporate loans in a particular segment or single out the loans granted to a particular sector or industry which shows excessive concentration, poor outlook, high probability of failure, or any combination of these features.

The paragraphs that follow describe the mechanics of the formulas coded in the FPM®.

These mechanics follow the same pattern for each segment. Loan segments grow only if there is discretionary FF available to finance them. Provided this funding is available, loans are allocated to each segment using the governor levers referred to in different parts of this Guide. New loans are allocated to best/well-rated A loans and to lesser/lower-rated B loans in the proportions that you decide, based on the trends and outlook of the industry and the business plan of bank management.

Each grade has its own credit risk dynamics and pricing. Loans allocated to A and B grades are supposed to be repaid, and their repayment funds reinvested into new loans. In addition, these loans deteriorate each period and the unpaid loans migrate to the C/D grade of impaired/defaulted loans, which can be made non-performing. The rate at which A and B loans falls into default or becomes impaired is governed by the probability of default (PD) entered in [Assumptions-BS] for each grade. Annex 3 provides “hints” on how to produce the rate of migration (the PD).

Thus, A and B loans grow by their allocation from discretionary FF and decrease by migration to C/D loans. Additionally, these loans can change by the absolute amounts entered in [Actions]. There is also a feedback process: impaired/defaulted loans can be recovered or “worked-out”, moving from C/D back to A or B grades. In most cases, these once impaired loans will be worked out to B grade only; however, the user can decide what percentage of the worked-out loans becomes A loans in [Assumptions-BS] line 111. This is discussed more in detail below.

You can modulate the interest income performance status of the segments in one of three ways: 1) changing the spreads applied to A and B class loans; 2) controlling the level of performance of C/D loans in [Assumptions-PLA] lines 60 to 67; or 3) increasing the level of accruals for all interest income set in [Assumptions-BS] line 137.

The factors discussed above are the core determinants of your projection’s reliability. Accordingly, the lower the quality and availability of the data used to prepare assumptions about these factors, the more time you should dedicate to discussions with the banking supervisors, market analysts and other experts who know the market and, more specifically, the

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managers of the target bank. A properly designed risk assets review or examination can be the best tool to obtain this necessary information.

The analysis that goes before the projection is crucial to the results and the implications of any limitations to be reported. You can compensate for the limitations by reporting the results of your projection under a set of alternative scenarios that test the sensitivity of the results (valuation and performance).

This caveat (the “garbage-in garbage-out” saying) applies to all other lines of the Model. You need to know more about the underlying business and banking practices in major contributing activities than about the historical statistics of the reported lines of a balance sheet. The FPM® is not an accounting or statistical tool, but a process through which to look forward to future value and performance. Applying a good level of analysis is a must. Below are explanations of the formulas for the Retail Residential Mortgage segment, as an example ([Loans] sheet, lines 8 to 11).

1. Prime (A grade) Loans in the [Loans] activity sheet

Formula: I8 = H8+I199 +'Funds Flow'!I$10 * I104 * I113 - (H8+I199)) * I122 * (I$150)^0.5) - 'Funds Flow'!I$10*I104*I113*0.5*I122*(I$150)^0.5+((H10+((H8+I199)* I122*(I$150)^0.5 + ’Funds Flow’!I$10*I104*I113*0.5*I122*(I$150)^0.5 +(H9+I200)*(I$150)^(0.5)+’Funds Flow’!I$10*I104*(1-I113)*0.5*I131*(I$150)^0.5) +I201)*I152)*’Assumptions-BS’!I111

The formula for the A class of loans has the components explained below:

i. H8 (balance of A loans at the end of the previous period) +I199 (changes through Actions in the current period)

ii. Plus the allocation to new A loans from FF: +’Funds Flow'!I$10 (discretionary FF allocation to loans) *I104 (percentage of total portfolio to be allocated to this segment (Mortgages)) *I113 (grade allocation to A loans)

iii. Less the migration of the previous balance of A loans and its changes through [Actions] in the current period to impaired C/D loans: - (H8+I199) * I122 (expected PD) * (I$150)^0.5 (the scaling factor for a downturn cycle)

iv. Less the migration of newly allocated loans to impaired loans: -'Funds Flow'!I$10 (discretionary FF allocation to loans) *I104 (percentage of total portfolio to be allocated to this segment (Mortgages)) * I113 (grade allocation to A loans) * 0.5 (in-period migration scaling factor) * I122 (expected PD) * (I$150)^0.5 (scaling factor for downturn cycle)

v. Plus the migration of C/D loans in the period worked out to A grade instead of B: +((H10 (C/D loans from previous period)+((H8+I199)*I122*(I$150)^0.5+’Funds Flow’!I$10*I104*I113*0.5*I122*(I$150)^0.5 +(H9+I200)*(I$150)^(0.5)+’Funds Flow’!I$10*I104*(1-I113)*0.5*I131*(I$150)^0.5) (portion of A and B loans new during the current period which became C/D loans in the same period)+I201) (all new C/D loans from Actions ) (*I152) (work-out ratio of impaired loans) *’Assumptions-BS’!I111) (all new C/D loans from Actions ) (*I152) (percentage allocation of worked out loans to A loans).

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In other words, the migration of new loans granted in the period, which is the same amount allocated above in (ii), times 0.5 for half a period since the FPM® assumes that FF is generated during the period, not at the end nor the beginning, multiplied by the PD in I122, times the square root of the scaling factor I$150.

2. Sub-Prime (B grade) Loans in the [Loans] activity sheet

Formula: I9 = H9+I200+'Funds Flow'!I$10*I104*(1-I113) - (H9+I200)*I131*(I$150)^(0.5) - 'Funds Flow'!I$10*I104*(1-I113)*0.5*I131*(I$150)^(0.5) + (H10+I201)*I152

The formula for the B class of loans has the components explained below:

i. H9 (balance of B graded loans at the end of the previous period) +I200 (changes through [Actions] in the current period)

ii. Plus the allocation of new B loans from FF: 'Funds Flow'!I$10 (discretionary FF allocation to loans) * I104 (percentage of total portfolio to be allocated to this segment (Mortgages)) * (1-I113) (grade allocation to B, which is “1” less I113 (the percentage of loans allocated to A class))

iii. Less the migration of the previous balance of B loans and its changes through [Actions] in the current period to impaired loans C/D: (H9+I200) * I131 (expected PD) * (I$150)^0.5 (scaling factor for downturn cycle)

iv. Less the migration of newly allocated loans to impaired loans: 'Funds Flow'!I$10 (discretionary FF allocation to loans) * I104 ((percentage of total portfolio to be allocated to this segment (Mortgages)) * (1-I113) (grade allocation to B or 1 less allocation to A) * 0.5 (in-period migration scaling factor) * I131 (expected PD) * (I$150)^0.5 (scaling factor for downturn cycle)

v. Plus the C/D loans “cured” or “worked-out” to B grade in the period: (H10+I201)*I152

vi. Plus the migration of C/D loans in the period worked out to B grade: +((H10 (C/D loans from previous period)+((H8+I199)*I122*(I$150)^0.5+ ’Funds Flow’!I$10*I104*I113*0.5* I122*(I$150)^0.5 +(H9+I200)*(I$150)^(0.5)+’Funds Flow’!I$10*I104*(1-I113)*0.5* I131*(I$150)^0.5) (portion of A and B loans new during the current period which became C/D loans in the same period)+I201) (all new C/D loans from Actions ) (*I152) (work-out ratio of impaired loans) *’Assumptions-BS’!I111) (all new C/D loans from Actions ) (*1-I152) (percentage allocation of worked out loans to B loans).

3. Impaired or Loans in Default (“C/D” grade) in the [Loans] activity sheet

Formula: I10 =+H10 +(H8+I199) * I122 *(I$150)^0.5+'Funds Flow'!I$10 * I104 *I113*0.5 * I122 *(I$150)^0.5 + (H9+I200) *I131 *(I$150)^(0.5) +'Funds Flow'!I$10*I104*(1-I113) *0.5 *I131 *(I$150)^(0.5) -(H10+((H8+I199)*I122*(I$150)^0.5+'Funds Flow'!I$10*I104*I113*0.5* I122*(I$150)^0.5+(H9+I200)*I131*(I$150)^(0.5)+'Funds Flow'!I$10*I104*(1-I113)*0.5* I131*(I$150)^0.5) +I201) *I152 - (H10+ ((H8+I199)* I122* (I$150)^0.5 +'Funds Flow'!I$10 *I104* I113*0.5*I122*(I$150)^0.5+(H9+I200)* I131* (I$150)^(0.5)+'Funds Flow'!I$10*I104*(1-I113)*0.5*I131*(I$150)^0.5)+I201)*I161+I201

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The formula for the C/D class of loans in default or impaired has several components explained below:

i. Where I119 = Actions!I23*ACT (changes to A loans through [Actions] if activated by ACT =1) and I200 = Actions!I24*ACT, (changes to B loans through [Actions] if activated by ACT =1),

ii. H10 (balance of C/D grade loans at the end of the previous period)

iii. Plus the A loans from the previous period and its changes through [Actions] in the current period that become impaired or default in this period: +(H8+I199) * I122 (expected PD for A grade loans) * ($150)^0.5 (scaling factor for downturn)

iv. Plus the impairment of new A loans granted in this period: 'Funds Flow'!I$10 (discretionary FF allocation to loans) * I104 (percentage of total portfolio to be allocated to this segment (Mortgages)) * I113 (the percentage of loans allocated to A class)* 0.5 (in-

v. Plus the impairment or the default of B loans from the previous period and the changes through [Actions] in the current period: +(H9 +I200) * I131 (expected PD for B grade loans) *(I$150)^(0.5) (scaling factor for downturn)

vi. Plus the migration due to impairment or default of newly allocated B grade loans: 'Funds

Flow'!I$10 (discretionary FF allocation to loans) * I104 (percentage of total portfolio to be

allocated to this segment (Mortgages)) * (1-I113) (B grade allocation)* 0.5 (in-period

migration scaling factor) * I131 (expected PD) * (I$150)^0.5 (scaling factor)

vii. Less the loans “cured” through “work-out” or “re-aging” and “restructuring”: this is the

rehabilitation back into B loans of the C/D loans. H10 (C/D loans balance from the previous

period) +((H8+I199)*I122*(I$150)^0.5+'Funds Flow'!I$10 *I104*I113*0.5

*I122*(I$150)^0.5+(H9+I200)*I131*(I$150)^(0.5)+'Funds Flow'!I$10*I104*(1-I113)*0.5

*I131* (I$150)^0.5) (amount of A and B loans from previous period, [Actions], and from new

funds flow loan allocation that became C/D in the current period) and + I201 (amount of

“C/D” loans from *Actions+) * I152 (at the rate of workout indicated for the period)

viii. Less the loans declared lost and amortized in the period: +(H10 +((H8+I199)* I122*

(I$150)^0.5+'Funds Flow'!I$10*I104 *I113*0.5 *I122 *(I$150)^0.5+ (H9+I200)*I131*

(I$150)^0.5+'Funds Flow'!I$10*I104*(1-I113)*0.5 *I131 *(I$150)^0.5) (amount of A and B

loans from previous period, [Actions], and from new funds flow loan allocation that became

C/D in the current period) +I201) (balance of C/D loans from previous period plus its changes

through [Actions] in the current period) * I161 (at charge-off ratio of impaired loans)

ix. Plus the effect of any absolute change in C/D loans via [Actions]: +I201 (the absolute action = Action!J25 * ACT).

4. Impairment reserves for impaired loans (-) in the [Loans] activity sheet

Formula: I11 = I10 * I319 * (I$150)^0.5

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- Expected loss from impaired loans: I10 (impaired loans at the end of current period ) *I319 (expected LGD for impaired loans at the end of current period) *(I$150)^0.5 (scaling factor)

5. Impairment charges for loans (Specific loan loss provisioning) in the [Loans] activity sheet

Formula: I65 = (I11-H11+ …. +I47-H47) + ((H10+((H8+I199)*I122*(I$150)^0.5+'Funds Flow'!I$10 *I104*I113*0.5*I122*(I$150)^0.5+(H9+I200)*I131*(I$150)^(0.5)+'Funds Flow'!I$10*I104*(1-I113)*0.5*I131*(I$150)^0.5) +I201) *I161 + ….+(H46+ ((H44+I235) *I129 *(I$150)^0.5 +'Funds Flow'!I$10 *I111 *I120 *0.5 *I129 *(I$150)^0.5+ (H45+I236)* I138 *(I$150)^0.5 +'Funds Flow'!I$10 *I111*(1-I120) *0.5 *I138 *(I$150)^0.5) +I237)*I168) +I196 - Increase in impaired loans reserves: (I11-H11+ …. +I47-H47) (sum of increases in impaired

loans reserves for all 8 segments of loans) - Plus loan charge-offs:

- Multiplying the charge off ratio (I161) by the sum of below - all the impaired (C/D) loan parts for all 8 segments of loans:

i. H10 (previous period’s C/D loans); ii. (H8+I199)*I122*(I$150)^0.5+ 'Funds Flow'!I$10*I104*I113*0.5*I122

*(I$150)^0.5 (amount of A loans from previous period, [Actions], and from new funds flow loan allocation that became impaired in the current period);

iii. (H9+I200)*I131*(I$150)^(0.5)+'Funds Flow'!I$10*I104*(1-I113)*0.5 *I131 *(I$150)^0.5 (amount of B loans from previous period, [Actions], and from new funds flow loan allocation that became impaired in the current period);

iv. I201 (amount of C/D loans from [Actions]) - Plus all absolute changes to impairment reserves from [Actions]: I196

6. General loan loss reserves in the [Loans] activity sheet

Formula: I68 = I348 = SUM(I329:I336)+SUM(I339:I346) …where the SUM(I329:I336) is the sum of all 8 loan segments’ Generic Provisions for A loans, and SUM(I339:I346) is the sum of all 8 loan segments’ Generic Provisions for B loans. Formulas for these Generic Provisions are as follows: - For A loans: I329 =(I8*I246*I140)*I263

- Expected losses on A-grade loans: (I8 (A loans) *I246 (annualized expected PD) *I140 (expected LGD for A loans)

- Multiplied by the scaling factor: *I263 (annualized scaling factor) - For B loans: I339 = (I9*I255*I309)*I263

- Expected losses on B-grade loans: I9(B loans) *I255(annualized expected PD) *I309 (expected LGD for B loans)

- Multiplied by the scaling factor: *I263 (annualized scaling factor)

7. General loan loss charges for the period in the [Loans] activity sheet

Formula: I69 = (I68-H68)

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- Increase in the period of general loan loss reserves: (I68-H68)

8. Actions for Loan Segments and Classes

The user can change the balance of each class under each loan segment by placing amounts in the [Actions] tab. For example, the user may reclassify loans between segments or between classes in one segment, or even to another asset.

It is important to note that the amounts put in the specific reserves line of C/D loans in the [Actions] tab are accounted for under Impairment Charges in [Loans] – these amounts will not show up on the specific reserves line, as one may expect. In other words, specific reserves (a Balance Sheet item) cannot be changed through adding or subtracting amounts on the specific reserves line in [Actions] (line 26, for example). The Model will take any increase or decrease to this line as an impact to impairment charges (Profit and Loss account item). Therefore, to increase the impairment charges of C/D loans (because some C/D loans are charged off, for example), enter a positive amount into the relevant loan segment’s specific reserves line in [Actions]. To decrease impairment charges of C/D loans (because some loans have been recovered, for example), enter a negative amount. Changes to the specific reserves amount on the B/S can be made through changing the LGD for the loan segment in [Assumptions-BS].

LOAN WORK-OUTS, CHARGE-OFFS, AND RECOVERIES

The FPM captures the dynamic migration in a loan portfolio through enabling “work-outs”, charge-offs, and recoveries.

The feedback process by which the “curing” arrears and impaired/defaulted loans is controlled is through a work-out governor placed in [Assumptions-BS] lines 114 to 121. Of course, this can be used to “re-age” or to “roll-over” problem loans so that no one notices them. For example, if you set the work-out ratio to 100 percent, the problem loans will disappear. This mimics the “ever-greening” practices of bad bankers.

Also, impaired/defaulted loans are charged-off at a rate specified in [Assumptions-BS] lines 123 to 130. The recoveries of these loans that are amortized, charged off, or written off are specified in [Assumptions-PLA] line 162. The formulas for the results of these two loan dynamics are covered in detail here:

1. Volume of Charged-Off loans in [Operations] activities sheet

Formula: I59 = (H59 + IF(Loans!I201>0, Loans!H10,(Loans!H10+Loans!201))* Loans!I161+ IF(Loans!I206>0, Loans!H15,(Loans!H15+Loans!206))*Loans!I162+ IF(Loans!I211>0, Loans!H20,(Loans!H20+Loans!211))*Loans!I163+ … for each of the “8” loan segments (each being in one color … + IF(Loans!I237>0, Loans!H41,(Loans!H41+Loans!237))*Loans!I168) – I34 - The volume of amortized (charged-off) loans of the previous period (H59 from Period 0,

transferred from [Entry] input) - Plus, the following for each segment of loans (both in local and foreign currency books):

IF(Loans!I201>0, Loans!H10, (Loans!H10+Loans!201))*Loans!I161

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- Loans!201 are the Actions on C/D Impaired loans of the Period. Loans!201 = Actions!I25*ACT, thus are only active when the governor ACT=1 and the Action is in play. The Action is only considered when it is not a positive value. If it is positive the increased of amortized charged-off loans is only calculated at the rate *Loans!I161 on the balance of C/D impaired/defaulted loans of the Period located in Loans!H10, which are amortized at the later rate (as always, adjusted to frequency).

- In other words, when a bank being projected buys in new portfolios (e.g., in a M&A or P&A) and the Action > 0 is positive, the acquired C/D impaired/defaulted loans in that Period are not used to calculate new additional amortization of loss loans.

- When Loans!201 are negative <0, then FPM calculates the amortized charged-off loans using only the existing balance of C/D impaired/defaulted loans in that Period less the Actions implemented, at that moment a negative number and the double underlined green part of the IF is at play. Thus, when the user asks FPM to sell, swap or carve–out C/D impaired/defaulted loans, FPM does not use them to calculate the amortize balance of the period.

- The total of above minus I34, which is the recovered loans, covered in the explanation directly below.

2. Recoveries from Charged-Off Loans in the [Operations] activities sheet

Formula: [Operations] I34 = (H59+IF(Loans!I201>0, Loans!H10, (Loans!H10+Loans!201)) *Loans!I161+ IF(Loans!I206>0, Loans!H15, (Loans!H15+Loans!206))*Loans!I162+ IF(Loans!I211>0, Loans!H20,(Loans!H20+Loans!211))*Loans!I163+ … for each of the “8” loan segments (each being in one color … + IF(Loans!I237>0, Loans!H41, (Loans!H41+Loans!237))*Loans!I168) * I140 - The volume of amortized (charged-off) loans of the previous Period (H59 from Period 0,

taken from [Entry] input);

- Plus, the following for each segment of loans (both in local and foreign currency books: IF(Loans!I201>0, Loans!H10, (Loans!H10+Loans!201)) *Loans!I161, which is just the amount of impaired, C/D loans plus any negative Actions on impaired, C/D loans (see explanations on this Action portion in the formula for #1 above), multiplied by the percentage of charge-off’s, set in [Assumptions-BS] lines 123 to 130;

- The total of the above is multiplied by the percentage of recoveries from charged-off loans set in [Assumptions-PLA] line 162, which the FPM has transferred to I140.

Points to keep in mind:

- Note that new loan growth depends on discretionary FF allocation into each segment and each grade (A or B only; no allocation of new loans to C/D grade loans).

∙ It is assumed that funds from repayment of loans that matured are rolled over into new loans. (You can use absolute changes in [Actions] to reflect situations where loans are not rolled over for any reason.)

- In [Actions] you can sell, buy, carve-out, amortize, swap, and migrate loans among grades, classes, and with other assets.

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- Expected PDs and LGDs play a key role in determining Impaired Loans, Specific Provisioning, and General Provisioning.

- PDs and LGDs are used in a broad sense: they represent the migration that is expected to occur among grades.

- The amount of Loan Charge-off is included in Specific Loan Loss Provisioning.

- It should be noted that Expected PDs that are used to calculate General Provisions are annualized PDs.

C. Multi-purpose Assets (MPA) and Multi-purpose Liabilities (MPL)

MPA and MPL are two lines provided within the FPM® to simulate any particular type of asset or liability, or a portfolio of assets and liabilities with special valuation and interest payment features as described below. You can change the names of these lines in [Entry]; for example, zero coupon bond or interest-accrual only loans for MPA, and discount bond or interest-accrual only notes for MPL. You can use the lines through [Actions] or through entering initial balances in [Entry] as implementing reclassifications.

Alone or in combination with [Actions], these multipurpose lines allow you to simulate diverse carve-out and bank restructuring alternatives. Quantifying the present value of the cost or income revenue generated with these two lines means you can isolate and report the contribution (subsidy or public/private cost) to value and performance of a particular restructuring action or set of actions.

The MPA line can be any security or credit instrument. It can be used to segregate from the security or loan portfolios a specific asset or a specific portfolio of assets with homogeneous features. For example, you may wish to project a material number of problematic loans segregated for the corporate loan book, calling them problem restructured industrial loans. This portfolio can be characterized by its income performance status. You can also use MPA to simulate the performance of significant loan-to-equity swaps. Alternatively, the bank might be capitalized with a zero coupon bond asset which can be implemented by the MPA line.

The MPL line can be used for similar purposes, but applied to liabilities. For example, you can use it to consolidate a bundle of liabilities that are restructured into a new bond which could be a zero, an accruing or an interest cash payment bond. Through using the [Actions] sheet, you can simulate in any period a debt-to-debt swap, or consolidate official liquidity support, like borrowings from ELA accumulated after a stress situation. You can also rename the MLA line as debt to be capitalized and simulate a swap of the MPL for capital in [Actions].

1. Multi-purpose Assets (MPA) in the [Capital Market] activity sheet

The features of the MPA line are controlled by two governors placed in [Entry] cells C22 and D22 which can take values 0 or 1 with the following meaning:

If Entry!C22 = 0, MPA is an asset accounted for at “discount” (a zero coupon asset); If Entry!C22 = 1,MPA is a standard interest accrual asset.

In the second case, when MPA is a standard interest accrual asset, the manner in which interest is recognized depends from the value of the second governor placed in cell D22:

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If Entry!D22 = 0, interest payment on MPA are assumed to be made in cash; If Entry!D22 = 1, interest is accrued on accounting terms, but not earned in cash. This second option allows you to place in MPA a significant portfolio of trouble restructured loans which might be valuable in the future (for example, because of their attached collateral) but which are currently non-interest performing loans given the manner in which they have been restructured.

It is important to always enter the maturity along which the accrued interest and interest income will be recognized in B/S and P/L, respectively. This entry done in line 57 in [Assumptions-BS]. The user can enter more than one maturity for each action recognized in [Actions] sheet. However, all notional amounts are to be paid in and accrued interests are to be recognized based on the latest entry of maturity in the maturity band. The user does not need to set maturity for all actions in [Action] sheet. If the user doesn’t enter any maturity for an action, the notional amounts and remaining balance of accrued interests will be paid out based on the maturity of the previous action.

Formulas that the FPM® uses to implement the MPA lines are explained below, followed by a simple example to clarify its features. The versatility of MPA is only limited by the proficient user’s imagination.

1.1) Balance of the MPA in the [Capital Market] activity sheet Formula: I11 = IF (I85>1, +H11+Actions!I115*ACT, 0)

Note that the MPA only grows via [Actions] and the accrual of income.

Case 1: If I85>1, the period of interest accrual of the MPA is more than one, then the balance of MPA will be equal to +H11 (previous balance of the MPA) + Actions!I115*ACT (absolute change of MPA through [Actions]). If the user set an Action, but forgets to enter the accrual period in Assumptions-BS'!I57, the [Action] will not take place.

Case 2: If I85<=1, the period for interest accrual is equal to or less than one, which means that there is nothing to accrue and the balance of MPA will be = 0 since all principal and interest on the MPA have been fully paid. 1.2) Balance of Interest Accrued Receivable (IAR) on the discounted Zero-Coupon MPA (-) or

the Interest-Bearing MPA (+) in the [Capital Market] activity sheet Formula: I12 = IF(Entry!$C$22=1, IF(I85>1, +(H12+I28)* Entry!$D$22,0) IF(I85>1, +(H12 +(Actions!I116*ACT))- (H12 +(Actions!I116*ACT))*(1-Entry!$D$22)/I85),0)

Case 1: If Entry!$C$22=1, the MPA is a coupon-bearing asset, and…

I12 = (H12 (previous balance of IAR on MPA) + I28 (interest income in the actual period)) * Entry!$D$22 (if D22= 1, non-cash coupon payments), given that the remaining maturity is bigger than one, I85>1. In this case, the MPA is a coupon-bearing asset that accrues interest paid only at maturity. The FPM® will accrue the non-cash interest income to the IAR located in line I12.

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On the other hand, if the MPA makes cash payments on coupons, Entry!$D$22=0, I12 will be equal to zero.

Case 2: If Entry!$C$22=0, the MPA is a discounted zero-coupon asset, and…

I12 = (H12 (previous balance of IAR on MPA) + Actions!I116*ACT (change in the IAR on MPA through [Actions])) - (H12 +Actions!I116*ACT)*(1-Entry!$D$22) (if D22 = 1, non-cash interest payments)/I85 (the accrual period), given that the remaining maturity is bigger than one, I85>1. In this case the MPA is a discounted zero-coupon asset that accrues interest and only pays it at maturity. In other words, the IAR will not be recognized until maturity.

On the other hand, if the MPA makes cash payments on coupons, Entry!$D$22=0, I12 will be equal to (H12 + Actions!I116*ACT)-(H12 +Actions!I116*ACT)*(1-Entry!$D$22)/I85. The discount placed in IAR will be recognized based on the remaining accrual period.

1.3) Interest Income on MPA in the [Capital Market] activity sheet Formula I28 = IF (Entry!$C$22=1, IF(I85=0, 0, +(+H11+I11)/2 * I120), IF(I85=0, 0, (H12+(Actions!I116*ACT)) *(1-Entry!$D$22)/(MAX(I85,1))) Case 1: If Entry!$C$22=1, the MPA is a coupon-bearing asset, and the interest income will be… I28= (H11 (previous balance of coupon-bearing MPA) +I11 (current balance of coupon-bearing MPA)/2*I120 (Interest rate), given that the remaining maturity is not zero, I85≠0. When MPA is a coupon-bearing asset and the accrual period is more than one, then the interest income is calculated on the average of current and previous amounts of MPA. Case 2: If Entry!$C$22=0, the MPA is a zero-coupon asset, and the interest income will be I28 = (H12 (beginning balance of IAR on discounted MPA) +(Actions!I116*ACT) (changes in IAR through actions)) )/(MAX (I85 (the accrual period),1)), given that the remaining maturity is not zero, I85≠0. The MPA is a zero-coupon asset and the accrual period is bigger than zero, so the previous amount of IAR will be amortized and recognized as interest income. On the other hand, if the payments are not in cash, then the interest income will be zero, I28= 0, since all IAR will be paid fully at maturity. An example: You identify a number of corporate loans which need to be restructured and whose current value and performance is difficult to ascertain. In Period 2, you migrate USD 40,000 million from corporate loans to the MPA line relabeled as Restructured loans. You expect that these loans will be amortized in the next 12 years. Interest income is expected to be half the current market spread for similar loans. You do not wish to recognize any potential loss today, but you will affect the projection with a semi-performing asset. The following steps describe the implementation of this scenario. 1. Set cell governors in [Entry] C22 =1 (standard interest accrual asset) and D22 = 0 (cash

payment); 2. Set the maturity in [Assumptions-BS] line 57;

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3. Select reference rate (from the 19 reference rates listed in [External]) for MPA in [Assumptions-PLA] cell D14, 9 for example, to link to the average market rate on loans;

4. Enter in the same line 14 a negative spread to reflect the expectation of interest income reduction by half the reference market rate on these problem loans;

5. Enter in line 44 of [Actions] -40,000 to swap corporate loans for the MPA 6. Enter in line 115 of [Actions] 40,000 to reflect the new portfolio of troubled restructured

loans. 7. Change the name of the MPA line to Restructured Corporate Loans in E22 of [Entry]; 8. Activate the [Actions] by setting the governor in cell H12 in [FPM Cover] equal to 1; 9. Before hitting the <F9> key to recalculate, go to [Summary]. Note the estimated value and

performance indicator of your choice; 10. Hit the <F9> key and see the effect on value and performance of the swap; 11. See in [Capital Market] the projected line of Restructured Corporate Loans and its interest

income contribution; 12. You can further test sensitivity: change to zero the spread and see the impact; 13. You can now simulate additional principal repayments entering say -5,000 per Period in line

115 of [Actions]; 14. These amount will be added to the Funds Flow of the Period and reinvested; 15. Alternatively, you can also simulate additional losses: enter the same -5,000 in line 165 of

[Actions]; 16. You can also simulate that the restructured MPA line accrues interest but does not pay it in

cash; 17. To do that, set the governor cell in [Entry] D22 = 1. You will see interest to accrue (but no

earned in cash).

Below are several more examples of how to implement a “game at play” (restructuring alternative) through use of MPA in the FPM®. Remember to run plays with and without [Actions] activated, so that you can quantify and report the sensitivity of value and performance to alternative scenarios that use their drivers.

When you do this, keep in mind that some actions can improve the proxy of capital adequacy but have little impact on earnings, or that even if capital adequacy does improve, earnings might not enhance value. All will depend on whether the present value of free cash flows available for distribution (discretionary dividends) improves thanks to improved risk or return contribution of the business. The rest of the financial engineering might be merely accounting cosmetics.

Game at Play [Entry]

C22 [Entry]

D22

[Assumptions-BS]

Line 57 Comments

[Assumptions-PLA] D14

Swap of zero coupon assets with IAR assets. At any time, you can buy in cash all or part of the MPA and its accrued discount entering a

0 1

Set maturity to recognize IAR as non-cash earnings.

Enter in [Actions] line 57 as “+” the discount on the zero coupon asset, say 8,000. The interest accrual will not be amortized, since there is no cash payment.

No value needed (will not take effect given the formula)

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negative [Action] with or without another asset or letting FPM® to balance.

Swap of coupon bearing assets with cash payments assets.

1 0

Set maturity to recognize the coupons as cash earnings.

At any time you can control the maturity or swap principal by another asset entering a negative [Action] or let FPM® to balance itself through interaction.

Link spread to reference rate and use it to modulate level of income performance

Swap of zero coupon assets with cash payment assets.

0 0

Set maturity to amortize IAR as cash earnings.

You will see the discount to decrease as it is recognized in the P/L.

No value needed (will not take effect given the formula)

Swap of coupon bearing assets with no cash recognition assets: income accrued does not count as operational cash flow (but you can cash it with an [Action]).

1 1

Set maturity to recognize coupons as non-cash earnings.

Control maturity with [Assumptions-BS] Line 57 or force maturity entering a negative [Action] to amortize or swap the MPA for another asset (or to pay a given liability!).

D14 must be activated for income to be accrued while not paid until maturity.

Final note: In [Actions] you can capitalize the bank (lines 151 to 156) by entering the disbursement as any of the assets available for absolute [Actions], including the MPA. Thus, you can see the effect in value and performance of different instruments for implementing capital restoration programs. However, using MPA allows you to isolate the effect on the P/L which then allows you to estimate the PV of any solvency support granted to the bank.

2. Multi-purpose Liabilities (MPL) in the [Capital Market] activity sheet

The features of the MPL line are very similar to those explained before for the MPA. They are controlled by two governors placed in [Entry] cells C103 and D103 which can take values 0 and 1 with the following meaning:

If ‘Entry’!C103 = 0, MPL is a discounted or zero-coupon liability; If ‘Entry’!C103 = 1, MPL is a standard coupon-bearing liability.

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In this second case, when the governor C103 is set at 1, the manner in which interest is recognized (cash or accrued) depends on the value of the second governor placed in D103

If ‘Entry’!D103 = 0 interest service of MPL is made in cash in every period; If ‘Entry’!D103 = 1 interest service of MPL is accrued and paid at maturity.

In all cases you must always enter the maturity along which the accrued interest and interest income will be recognized in B/S and P/L, respectively. This is done in line 174 in [Assumptions-BS]. The user can enter more than one maturity for each amount in Actions sheet. However, all notional amounts are to be paid in and remaining accrued interests are to be recognized based on the latest entry of maturity in the maturity band. The user does not need to set maturity for all actions in Action sheet. If the user doesn’t enter a maturity for any action, the notional amounts and remaining balance of accrued interests will be paid out based on the maturity of the previous action.

Formulas that the FPM® uses to implement the MPL lines are explained below, followed by a simple example to clarify its features. The versatility of MPL is only limited by the proficient user’s imagination.

2.1) Balance of MPL in the [Capital Market] activity sheet Formula: I22 = IF(I111>1,+H22+Actions!I144*ACT,0) Case 1: If I111>1, the accrual period of MPL is more than one, and the balance of MPL will be +H22 (previous balance of MPL) + Actions!I144*ACT (change in MPL through [Actions]) Case 2: If I111<=1, the accrual period of MPL is equal to or less than one, and the balance of MPL will be zero since all principal have been fully paid. 2.2) Balance of Interest Accrued Payable on Discounted Zero-Coupon MPL (-) or Coupon-Bearing MPL (+) in the [Capital Market] activity sheet Formula: I23 = IF (Entry!$C$103=1, IF(I111>1 , +(H23+I34) * Entry!$D$103, 0), IF(I111>1, +(H23+ (Actions!I145*ACT))-(H23+ (Actions!I145*ACT)) *(1-Entry!$D$103)/I111,0)) Case 1: If Entry!$C$103=1, the MPL is a coupon-bearing liability, and the balance of accrued interest on the MPL will be… I23= (+H23 (previous balance of accrued interest on MPL)+ I34 (current non-cash interest expense) ) * Entry!$D$103 (if =1, non-cash interest payments)), given that the remaining maturity is more than one, I111>1. In this case, the MPL is a coupon-bearing liability and the coupon payments are not in cash, so the balance of accrual interest payments on MPL will be previous balance plus non-cash interest expense. On the other hand, if the MPL is a coupon-bearing liability, and the coupon payments are in cash, I23 will be zero.

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Case 2: If Entry!$C$103=0, the MPL is a zero-coupon liability, and the balance of accrued interests on the zero-coupon bond will be… I23= (H23 (previous balance of accrual interest payments on MPL)+ (Actions!I145*ACT)(changes in accrual interest payments through action))-(H23+ (Actions!I145*ACT)) *(1-Entry!$D$103(if it is 1, non-cash interest payments))/I111 (the accrual period)) given that the remaining maturity is bigger than one, I111>1. In this case, the MPL is a zero-coupon liability and the coupon payments are not in cash, so the balance of accrual interest payments on the zero-coupon liability will not change. On the other hand, if the MPL is a zero-coupon liability and the coupon payments are cash, the accrued interests will be amortized based on the remaining accrual period. 2.3) Interest Expense on MPL in the [Capital Market] activity sheet Formula: IF(Entry!$C$103=1, IF(I111=0, 0, +(H22+I22)/2 * I113), IF(I111=0, 0, (H23+ (Actions!I145*ACT)) * (1-Entry!$D$103)/MAX(I111,1)))

Case 1: If Entry!$C$103=1, the MPL is a coupon-bearing liability, and the interest expense will be…

I34= (H22 (the previous balance of MPL) +I22 (Current balance of MPL))/2 * I113 (Interest rate on MPL)). On the other hand, if it is a coupon-bearing liability without cash payment, the interest expense will be zero.

Case 2: If Entry!$C$103=0, the MPL is a zero-coupon liability, and the interest expense will be…

I34= (H23 (previous balance of accrual interest payments)+ (Actions!I145 (change in accrual interest payments through action)*ACT)) * (1-Entry!$D$103) (if it is 1, non-cash interest payments)/MAX(I111(the accrual period), 1)). On the other hand, if it is a zero-coupon liability without cash payment, the interest expense will be zero.

An example: You identify a number of uninsured creditors who will lose their investments in the bank if that bank is liquidated. For obvious reasons, the bank cannot recover its viability and repay those investors. A possible restructuring action could be to consolidate the creditors’ debt into a long-term bond which, under certain conditions, could be swapped for subordinated debt. In Period 2, you migrate USD 40,000 million from Syndicated Loans to the MPL line relabeled as Restructured Creditors. The new MPL will be amortized over the next 12 years. Interest expense is expected to be a quarter of the current market spread for similar liabilities. The following steps describe the implementation of this scenario:

1. Set cell governors in [Entry] C103=1 (standard interest accrual liability) and D103=0 (cash payment);

2. Set the maturity in [Assumptions-BS] line 174;

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3. Select reference rate (from the 19 reference rates listed in [External]) for MPL in [Assumptions-PLA] D57, 7 for example, to link to the market reference bond rate;

4. Enter in the same line 14 a negative spread to reduce interest cost to a quarter of the market reference rate;

5. Enter in line 140 of [Actions] -40,000 to swap syndicated loans for the MPL; 6. Enter in line 144 of [Actions] +40,000 to reflect the new resulting MPL; 7. Change the name of the MPL line to Consolidating Bond in [Entry] cell E102; 8. Activate the [Actions] by setting the governor placed in H12 in [FPM Cover] equal to 1; 9. Before you hit the <F9> key to recalculate, go to [Summary]. Note the estimated value and

performance indicator of your choice; 10. Hit the <F9> key and see the effect on value and performance of the swap; 11. See in [Capital Market] the projected line of Consolidated Bond and its interest expense

contribution; 12. You can further test sensitivity: change to zero the spread and see the impact; 13. You can now simulate additional principal repayments entering say -5,000 per Period in line

144 of [Actions]; 14. You can also simulate that the restructured MPL line accrues interest but does not serve it

in cash; 15. To do that, set the governor cell in [Entry]: D103=1. You will see interest to accrue (not

served in cash).

We offer several more examples to implement a “game at play” (restructuring alternative) through use of MPL in FPM® in the table below. Remember to run plays with and without [Actions] activated, so that you can quantify and report the sensitivity of value and performance to alternative scenarios of its drivers.

When you do this, keep in mind that some actions can improve the proxy of capital adequacy but have little impact on earnings, or that even if capital adequacy does improve, earnings might not enhance value. All will depend on whether the present value of free cash flows available for distribution (discretionary dividends) improves thanks to improved risk or return contribution of the business. The rest of the financial engineering might be merely accounting cosmetics.

Game at Play [Entry] C103

[Entry] D103

[Assumptions-BS]

Line 147 Comments

[Assumptions-PLA] D57

Swap a liability for another zero-coupon liability. At any time, you can pay in cash all or part of the MPL and its accrued discount entering a negative [Action] with or without another liability or asset or letting

0 1

Set maturity to recognize discount as (non-cash) cost and to govern the maturity of the principal plus the accrued expense

Enter in [Actions] line 147 as “+” the discount on the zero coupon asset, say 8,000.

No value needed (will not take effect given the formula)

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FPM® balance itself.

Swap of a liability with another periodic cash payment debt.

1 0

Set maturity to control final maturity of the MPL

At any time you can control the maturity or swap principal by another liability entering a negative [Action] or let FPM® balance itself through interaction.

Link spread to reference rate and use it to modulate level of cost for the liability.

Swap of a liability with a periodic cash payment (not relevant).

0 0

Set maturity to amortize principal but not amortize expense

You will see the discount decrease as it is recognized in the P/L, but not added to cash flow until maturity (controlled by [Assumptions-BS] line 57).

Even with D57 active no cash payment involved

Coupon bearing but with no cash recognition: interest expense accrued does not count as operational cash flow (but you can cash it with an absolute [Action]).

1 1

Set maturity to control final maturity of the MPL. You will see IAP in line 23 of [Capital Market] on the MPL to increase due to accruals.

Control maturity with [Assumptions-BS] Line 157 or force maturity entering a negative [Action] to amortize or swap the MPL for another liability (or to pay it with a given asset!).

D57 must be activated for interest costs to accrue while not paid until maturity.

Final note: In [Actions] you can capitalize the bank (lines 151 to 156), entering the disbursement in the form of any of the asset lines available for absolute [Actions], including our MPL. You can capitalize debts of the bank and transform them into capital using [Actions]. An interim step can be the consolidation of these debts into the MPL, to simulate the effect on value and performance of different instruments used to implementing capital restoration programs. However, using MPL allows you to isolate the effect on the P/L. This isolation allows you to estimate the PV of any solvency support granted to the bank, including grace period and “low-interest maintenance loans”, such as the consolidation of ELA into a long term MPL.

What is a “low interest maintenance loan”? It is a liability, at zero cost or below market rate, provided to support liquidity and structural funding needs which, given its rate, provides a spread subsidy in PV terms to the bank. This type of loan thus covers operating losses that would otherwise be recognized. For example, let us presume that the target bank loses money because of too many staff. Solution: fire the staff and absorb the cost. Problem: social unrest and bad press. Interim step: the central bank grants a five-year zero-interest rate loan to the bank, which it reinvests into a CB-issued market rate bond. The differential rate accrues to the

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bank and gives it time to reorganize or rationalize its headcount and net worth, without creating bad press and social unrest.

D. Preferred Stocks in the Model

1. Type of Preferred Stocks (PS) in the [Entry] sheet

There are two governors in [Entry] to control the behavior of preferred stock in a projection:

1) The value in cell C118 controls the type of preferred stocks: Non-cumulative when 0 and Cumulative when 1

2) The value in cell D118 controls the distribution of dividends based on compliance with the capital adequacy rule: Capital adequacy ratio restriction on dividends when 0 and No restriction on dividend distribution when 1

Naturally, this is subject to the condition that the FPM® reports positive net income after taxes (NIAT).

2. Balance of Preferred Stocks (PS) in the [Capital] activity sheet

Formula: I7 = H7 + (Actions! I153*ACT)

I7 (PS in this period) = H7 (previous balance of PS) + (Actions! I153*ACT) (absolute change in PS from Actions)

As you can see, you can issue and amortize preferred stocks in [Actions] as well as swap them for common stocks. You may also use their lines (public and private) to enable other types of eligible capital instruments, provided they behave basically as a preferred stock, including their eligibility for capital adequacy purposes.

Controlling their cost (dividends distributed) and the income earned in their investment, you can approximate the PV of any “subsidy” to a bank. You can “disburse” a preferred stock with a bond, placing that bond in the MPA line to identity and track its income contribution.

Otherwise, the funds injected through the PS will be balanced by the FPM® using FF and reinvested in the mix of AFS and loans selected. Thus the income contribution to quantify the subsidy or “net earnings” impact will come from that mix. Further, running the projection with and without [Actions] provides you with the precise effect on value (PV of discretionary dividends available for distribution) and performance (proxy indicator of choice from [Summary]).

3. Dividend on Preferred Stocks (PS) in the [Operations] activity sheet

Several cases are possible based on the value of the governor in [Entry] cell D118 (whether the bank complies with the capital adequacy rule) and whether net income after taxes (NIAT) is positive. The cases and formulas that follow and the graph presented below show the mechanics of our implementation.

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Cell I42 in [Operations] projects the dividends paid in Period 1: Formula: I42 = IF('Projected PL'! BE97 < 0, 0 , IF(Entry!$D$118=1, MIN('Other A&L and OBS'!H41+(('Projected BS'!BE117 + 'Projected BS'!BE118) *I150), 'Projected PL'!BE97), IF(Capital!I32>Capital!I28, MIN('Other A&L and OBS'!H41+(('Projected BS'!BE117 +'Projected BS'!BE118) *I150), 'Projected PL'!BE97, Capital!I29), 0)))

Case 1: If 'Projected PL'!BE97 (NIAT) < 0, (meaning there is no profit to distribute), then the dividends on PS will be zero: I42 = 0

Case 2: If ('Projected PL'!BE97 (NIAT) >= 0 and Entry!$D$118=1, (in this case NIAT is not negative and no capital adequacy rule constraint is in effect), then: I42 = MIN('Other A&L and OBS'!H41 (dividend in arrears)+(('Projected BS'!BE117 (balance of public PS) +'Projected BS'!BE118 (balance of private PS))*I150 (dividend rate on the PS)),'Projected PL'!BE97(profit after tax))

The bank can pay dividends on the Preferred Shares (in arrears and the dividends due for the current year) up to the limit of the net income after taxes for the year, but never more than that amount. Case 3: If ('Projected PL'!BE97 >= 0 and Entry!$D$118=0, (in this case NIAT is not zero but the capital adequacy rule constraint is in effect) hence, dividend payment depends on meeting the constraint. Thus,… IF(Capital!I32 (Capital adequacy ratio before dividends) > Capital!I28 (required minimum capital adequacy ratio), MIN('Other A&L and OBS'!H41 (dividend in arrears )+(('Projected BS'!BE117

Distribution of Dividends to Preferred Stocks

ProjectedPL!BE97

I42 (Dividend of PS)

I42 (Dividend of PS)

Case 1

< “0” losses

Case 2

> “0” profits

NIAT

Dividends on Preferred Stocks (PS)

in [Operations] = “0” no payment possible

Minimum of arrears and dividends

due for the year or NIAT, if lower

Same distribution only if it complies

with minimum CaR rule

$D$118 = 1 No

Car constrained

$D$118 = 0

CaR constrained

If PS cumulative, accumulate the dividend

not distributed updating dividend in

arrears in [Other A&L and OBS] line 41

Dividend in arrears + balance of PS * % dividend rate

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(balance of public the preferred stocks) +'Projected BS'!BE118 (balance of the private preferred stocks))*I150),'Projected PL'!BE97 (profit after tax), Capital!I29), 0))) …which means there are two possibilities:

i) If the projected capital adequacy ratio before dividends is larger than the required capital adequacy ratio, the bank can pay dividends on the Preferred Shares (in arrears and due for the current year) up to NIAT or excess of capital before paying the preferred dividend; or

ii) On the other hand, if the capital adequacy ratio before dividends is equal or smaller than the minimum required, the bank will not be able to pay dividends and I42 = 0.

4. Dividend in arrears in the [Other A&L and OBS] activity sheet

Several cases are possible based on the value of the governor in [Entry] cell C118 (whether dividends on the PS are cumulative), whether the bank complies with the capital adequacy rule, and whether net income after taxes (NIAT) is positive. The cases and formulas that follow show the mechanics of our implementation. I41 below projects the dividends in arrears in Period 1 located in the [Other A&L and OBS] sheet.

Formula: I41 = +IF('Projected PL'!BE97<0, +Entry!$C$118 *(H41+ ((+'Projected BS'!BE117 + 'Projected BS'!BE118) *Operations!I150)), +Entry!$C$118 *IF(Capital!I32 < Capital!I28, MAX (H41+ (+'Projected BS'!BE117 +'Projected BS'!BE118) *Operations!I150 -Entry!$D$118 *'Projected PL'!BE97, 0 ), MAX(H41+((+'Projected BS'!BE117 +'Projected BS'!BE118) *Operations!I150) - Entry!$D$118*'Projected PL'!BE97-(1-Entry!$D$118)*MIN('Projected PL'!BE97,Capital!I29),0))) Case 1: If 'Projected PL'!BE97 <0, NIAT is less than zero, then I41= Entry!$C$118*(H41+(('Projected BS'!BE117 +'Projected BS'!BE118) *Operations!I150)), meaning dividend in arrears depends on the type of PS (cumulative or non-cumulative). Thus,

i) When non-cumulative PS, indicated by Entry!$C$118 = 0, I41 = 0 (no accumulation). ii) When cumulative PS, indicated by Entry!$C$118 = 1, I41 = (H41 (previous balance of

dividend in arrears) +(('Projected BS'!BE117 (balance of public PS) ('Projected BS'!BE118) (balance of private PS) * Operations!I150 (dividend rate of the preferred and cumulative shares)))

Case 2: If 'Projected PL'!BE97 >= 0, NIAT is zero or positive, then I41= Entry!$C$118 *IF (Capital!I32 < Capital!I28, MAX (H41 +('Projected BS'!BE117 +'Projected BS'!BE118) *Operations!I150 -Entry!$D$118 *'Projected PL'!BE97, 0), MAX (H41 +(('Projected BS'!BE117 +'Projected BS'!BE118) *Operations!I150)- Entry!$D$118*'Projected PL'!BE97-(1-Entry!$D$118)*MIN('Projected PL'!BE97,Capital!I29),0))

i) When non-cumulative PS, indicated by Entry!$C$118 = 0, then I41=0 (no accumulation).

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ii) When cumulative PS, indicated by Entry!$C$118 = 1, and Capital!I32 < Capital!I28, the capital adequacy ratio before dividends is less than the required minimum, then …

MAX(H41 (previous balance of dividend in arrears)+('Projected BS'!BE117 (balance of public PS) +'Projected BS'!BE118 (balance of private PS)) *Operations!I150 (interest rates on PS) -Entry!$D$118 (capital constraint) (*'Projected PL'!BE97 (the profit after tax), 0)

…and the result will be different based on whether the capital adequacy constraint, D118 in [Entry], is activated:

a) If the capital adequacy constraint is activated, Entry!$D$118=0, then: MAX(H41 (previous balance of dividend in arrears) +('Projected BS'!BE117 (balance of public PS) +'Projected BS'!BE118 (balance of private PS)) *Operations!I150 (interest rates on PS, 0)

This means the balance of dividends in arrears will be equal to the amount of previous balance, plus the dividends in the current period. Since the required minimum capital adequacy ratio is less than the capital adequacy ratio before dividends, and the capital adequacy constraint is activated, the bank may not be able to use its profit after tax for the dividend distribution and this amount will be added to previous balance of dividend in arrears.

b) If the capital adequacy constraint is not activated, Entry!$D$118=1, then: MAX(H41 (previous balance of dividend in arrears) +('Projected BS'!BE117 (balance of public PS) +'Projected BS'!BE118 (balance of private PS)) *Operations!I150 (interest rates on PS)- (*'Projected PL'!BE97 (the profit after tax),0)

This means the balance of dividends in arrears will be equal to the amount of previous unpaid dividends, plus the dividends in the current period, after using NIAT for dividend payments. Even though the required minimum capital adequacy ratio is less than the capital adequacy ratio before dividends, because the capital adequacy rule is not activated, the bank may be able to use all its NIAT for paying dividends. Accordingly, NIAT will be netted with the previous balance of dividend in arrears and the dividends of the current period.

iii) When cumulative PS, indicated by Entry!$C$118 = 1, and Capital!I32 >= Capital!I28, the

capital adequacy ratio before dividends is larger than the capital adequacy requirement, then…

MAX(H41 (previous balance of dividend in arrears) +('Projected BS'!BE117 (balance of public PS)+'Projected BS'!BE118 (balance of private PS)) *Operations!I150 (interest rates on the PS) -Entry!$D$118 (capital constraint) * 'Projected PL'!BE97 (the profit after tax) -(1-Entry!$D$118)* MIN('Projected PL'!BE97,Capital!I29 (Excess capital)),0))

…and the result will be different based on whether the capital adequacy constraint, D118 in [Entry], is activated:

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a) If the capital adequacy constraint is activated, Entry!$D$118=0, then: MAX(H41 (previous balance of dividend in arrears) +('Projected BS'!BE117 (balance of public PS) +'Projected BS'!BE118 (balance of private PS)) *Operations!I150 (interest rates on PS,) - MIN('Projected PL'!BE97, Capital!I29 (Excess capital)),0))

This means the balance of dividends in arrears will be equal to the amount of previous balance of unpaid dividends plus the dividends of the current period, after being netted with the excess capital to be used for the dividend payments. In order to comply with capital adequacy rule, the bank may not be able to use all the profits but only its excess capital.

b) If the capital adequacy constraint is not activated, Entry!$D$118=1, then: MAX(H41

(previous balance of dividend in arrears) +('Projected BS'!BE117 (balance of public PS)+'Projected BS'!BE118 (balance of private PS))*Operations!I150 (interest rates on PS)- (*'Projected PL'!BE97 (the profit after tax),0)

This means that the balance of dividends in arrears will be equal to the amount of the previous balance of unpaid dividends plus the dividends of the current period, after having used NIAT for dividend payments. Since the capital adequacy rule is not active, the bank may be able to use not only its excess capital but also its profits even if the latter is bigger than the former.

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E. Income Tax in the Model

The following paragraphs explain the mechanics of income taxes and available tax credit in the FPM®.

1. Income Tax Expense in the [Operations] activity sheet

Formula: I40 = IF('Projected PL'!BE95>0, MAX(('Projected PL'!BE95 -'Other A&L and OBS'!H42- 'Other A&L and OBS'!I157) * I147, 0), 0) Case 1: 'Projected PL'!BE95>0, means that the net income before taxes is positive, then: I40 = MAX(('Projected PL'!BE95 (net income before tax) - 'Other A&L and OBS'!H42 (balance of available tax credit) - 'Other A&L and OBS'!I157 (absolute change of available tax credit from Actions)) * I147 (income tax rate), 0), 0) Case 2: 'Projected PL'!BE95<=0, net income before tax is zero or negative, so that the income tax will be zero: I40 =0) * Note that acquisition of a “bad” bank or the implementation of a restructuring plan may lead to or require an absolute change of the available tax credit. 2. Available Tax Credit in the [Other A &L and OBS] activity sheet

Formula: I42 = H42+ (Actions!I176*ACT) + IF('Projected PL'!BE95<0, -'Projected PL'!BE95, -MIN('Projected PL'!BE95, H42 +(Actions!I176*ACT))) Case 1: If 'Projected PL'!BE95<0, when net income before taxes is negative, then: I42 = H42 (beginning balance of available tax credit) + (Actions!I176*ACT) (absolute change of available tax credit from Actions) -'Projected PL'!BE95 (net losses). Case 2: If 'Projected PL'!BE95>=0, when net income before taxes is zero or positive, then: I42 = H42 (beginning balance of available tax credit) + (Actions!I176*ACT) (absolute change of available tax credit from Actions) -MIN('Projected PL'!BE95 (Net income before tax), H42 +(Actions!I176*ACT) (netted with net income before taxes of the Period)) * Note that MIN('Projected PL'!BE95, H42 +(Actions!I176*ACT)) represents how much of the available tax credit is used in the current year. The model assumes that all available tax credit may be used over all periods. In case where a bank loses some tax credit due to a long period of consecutive losses, you can use an absolute change in the Actions to decrease the “available tax credit” line as required.

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F. Operational Expenses and Other Operational Expenses in the Model

Together with growth and spread, operational expenses (OpEx) are a crucial driver of value and performance. Before you simply extend recent trends observed in the costs of a bank’s staff and overheads, you may consider trying to gain further insight into the non-financial cost structure of the target bank. Such an effort could include analyzing the cost essentials suggested in Annex 1.

The FPM® has a governor placed in [Entry] cell C208 which provides you three options to project Personnel Expenses:

∙ If C208 = "0", personnel expenses will grow in line with nominal GDP. The user may change the growth rate by adding a percentage in [Assumptions-PLA].

∙ If C208 = "1", personnel expenses will be a percentage of total assets specified in [Assumptions-PLA].

∙ If C208 = "2", personnel expenses will be the average expenses per employee entered in [Assumptions-PLA] times the total head-count of employees (for which you may need detailed information of headcount, salaries and other costs).

Similarly, the FPM® has a governor placed in [Entry] cell C212 which provides you three options to project Other Administrative Expenses:

∙ If C212 = "0", Other Administrative Expenses will grow in line with nominal GDP. The user may change the growth rate by adding a percentage in [Assumptions-PLA].

∙ If C212 = "1", Other Administrative Expenses will be a percentage of total assets as selected in [Assumptions-PLA].

∙ If C212 = "2", Other Administrative Expenses will grow by a percentage rate set in [Assumptions-PLA].

1. The balance of Operational Expenses and Other Operational Expenses in [Operations] activity sheet

* Since the formulas of the sub segments of the Operational Expense and Other Operational Expense are same, we review only Salaries line item below as an example.

Formula: I24= IF(Entry!$C$208=0, H24*H4/ I4 * (1+External!I$92+External!I$93+I120), IF(Entry!$C$208=1, I121 * ('Projected BS'!I80+'FPM Cover'!$H$13*'Projected BS'!AO80), IF(Entry!$C$208=2,+I122*I49, 0)))

I24 = IF(Entry!$C$208=0,H24*H4/I4*(1+External!I$92+External!I$93+I120), IF(Entry!$C$208=1,I121*('Projected BS'!I80+'FPM Cover'!$H$13*'Projected BS'!AO80),IF(Entry!$C$208=2,+I122*I49, 0)))

Case 1: If Entry!$C$208=0, Salaries will grow in line with nominal GDP plus an add-on factor:

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I24= H24 (the salaries in the previous period)*H4 (frequency adjustment)/I4 (frequency adjustment) * (1+External!I$92 (real GDP growth rate) + External!I$93 (inflation rate) + I120 (add on factor))

Case 2: If Entry!$C$208=1, Salaries will be a percentage of total assets:

I25= I121 (percentage of total assets) * ('Projected BS'!I80 (total assets in LC.CY.) + 'FPM Cover'!$H$13 (good bank-bad bank approach) * 'Projected BS'!AO80 (total assets in FG.CY.))

Case 3: If Entry!$C$208=2, the Salaries will be the average expenses per employee entered in Assumptions times the total head-count of employees: I25= +I122 (average salary per employee) (*I49 (number of employees), 0)))

G. Estimation of Capital Adequacy Ratio in the Model

The Model allows you to estimate a regulatory capital adequacy ratio. In this model, risk-weighted assets (RWAs) are calculated for four types of risk: i) credit risk in the B/S and OBS; ii) market risk; iii) operational risk; and iv) FX risks. Users can set a minimum regulatory capital adequacy ratio and risk weights for each B/S asset item and OBS item. Part I. Calculation of risk-weighted assets for 1. Credit, 2. Market, 3. Operational, and 4. FX Risks.

1. RWAs for Credit Risk is calculated in the following steps 1) to 4) 1.1) RWAs for credit risk in the balance sheet ([Projected BS] line 161) ∙ Risk weights: Users set regulatory risk weights for each B/S item in [Projected BS] sheet

Column D (for items in local currency) and Column AK (for items in foreign currency). ∙ Calculation of RWAs: The amount of RWAs for credit risk in the B/S is calculated by

summing up the multiplication of the risk weight and the balance of an asset for all asset items (Cells DA6:DL79 in [Projected BS]).

1.2) RWAs for credit risk in the off-balance sheet ([Projected BS] line 162) ∙ Credit conversion factor (CCF) adjusted Risk weights: Users set regulatory risk weights for

each OBS item in Column D (for items in local currency) and Column AK (for items in foreign currency) in [Projected BS]. Users are required to set risk weights that are multiplied by relevant credit conversion factors.

∙ Calculation of RWAs: The amount of RWAs for credit risk in the OBS is calculated by summing up the multiplication of the risk weight and the balance of an asset for all OBS items (Cells DA124:DL140 in [Projected BS]).

1.3) Add-on to RWAs for credit risk ([Projected BS] line 163) ∙ Add-on to RWAs for credit risk is calculated by multiplying add-on factors by the sum of

RWAs for credit risk, both in the B/S and in the OBS. Users can set add-on factors in Line 229 of [Assumption BS].

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1.4) Total RWAs for credit risk ∙ The amount of total RWAs is the sum of the above three. 2. RWAs for Market Risk ([Projected BS] line 164)

∙ Trading book position (line 195 in [Projected-BS]): Users can project trading book exposure

by using lines 253 to 255 in [Assumptions-BS] (i.e., percent of total assets and liabilities) ∙ Required capital for market risk (line 196 in [Projected-BS]): Users can approximate a

required regulatory capital charge for market risk by multiplying Line 258 (percent of projected trading book) in [Assumptions-BS] times the projected trading book size.

∙ RWAs for market risk (line 164 in [Projected-BS]): The amount of RWAs for market risk is calculated by multiplying the required capital for market risk by 12.5 (which is the inverse of 8 percent)

3. RWAs for operational risk ([Projected BS] line 165) ∙ Beta for operational risk (line 235 in [Assumptions-BS]): User can set beta values for

operational risk. The beta can be scaled up or down by applying scaling factor for beta in line 262 in [Assumptions-BS].

∙ Gross income for operational risk calculation (line 199 in [Projected-BS]): Users can approximate gross income for operational risk calculation by using three-year average gross income and conversion factor for gross income (in line 261 in [Assumptions-BS].

∙ Calculation of RWAs for operational risk (line 165 in [Projected-BS]: The amount of RWAs for operational risk is calculated by multiplying i) Beta for operational risk; ii) scaling factor for Beta,; and iii) gross income for operational risk calculation.

4. RWAs for FX risk ([Projected BS] line 167) ∙ Risk weights: Users can set a regulatory risk weight for FX net positions in Line 237 of

[Assumptions-BS]. ∙ Calculation of RWAs: The amount of RWAs for FX risk is calculated by multiplying the risk

weight by the value (in local currency) of FX net positions (line 155 in [Projected BS]) where FX net positions is the value of assets in foreign currency less the value of liabilities and net worth in foreign currency.

Part II. Calculation of Eligible Regulatory Capital

1. Tier 1 Capital ([Projected BS] line 171) ∙ Estimation of Tier 1 Capital: Tier 1 capital is estimated as Total Shareholder’s Equity less

Revaluation Reserves less Gains/Losses on AFS securities less “Goodwill” less Preferred stocks that are not included in Tier 1 capital.

* Note that “preferred stocks that are not included in Tier 1 capital” is estimated by using “percent of Tier 1 preferred stocks out of total preferred stocks” in line 241 in [Assumptions-BS].

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2. Tier 2 Capital ([Projected BS] line 181) Estimation of Total available Tier 2 capital: Total available Tier 2 capital is estimated as eligible subordinated bonds plus eligible general loan loss provision plus eligible preferred stocks plus eligible gains/losses on AFS securities plus eligible revaluation reserves.

“Eligible subordinated bonds” is estimated by multiplying percent of subordinated bonds in Tier 2 (in line 246 of [Assumptions-BS]) by the balance of subordinated bonds (in line 101 of [Projected BS]).

“Eligible general loan loss provisions” is estimated by taking the smaller value between the two: i) the balance of General loan loss provision (in line 105 of [Projected BS]) and ii) the product of percent charge of general loan loss provisions in Tier 2 (in line 247 of [Assumptions-BS]) and RWAs for credit risk in the balance sheet (in line 161 of [Projected BS]). The formula excludes generic provisions as eligible capital instrument from Tier 2 if the user chose this option through the governor placed in [Entry] D301.

“Eligible preferred stocks” is estimated by taking the amount of preferred stocks that are not included in Tier 1 capital estimated by using percent of Tier 1 preferred stocks out of total preferred stocks in line 241 in [Assumptions-BS].

“Eligible Gains/Losses on AFS securities” is estimated by multiplying percent of Gains/Losses on AFS securities in Tier 2 (in line 244 [Assumptions-BS]) by the balance of Gains/Losses on AFS securities (in line 118 [Projected BS])

“Eligible revaluation reserves” is estimated by multiplying percent of Revaluation reserves in Tier 2 (in line 248 [Assumptions-BS]) by the balance of “Revaluation reserves (in line 120 [Projected BS])

∙ Estimation of Maximum Eligible Tier 2 capital: The final Eligible regulatory Tier 2 capital is

the smaller between the two: i) Tier 1 capital and ii) Total available Tier 2 capital. Part III. Calculation of Regulatory Capital Ratios

∙ Leverage ratio: Shareholder’s equity / Total assets ∙ Tier 1 capital ratio: Tier 1 capital / Total RWAs ∙ Total capital ratio: (Tier 1 capital + Eligible Tier 2 capital) / Total RWAs

H. Financial Derivatives (Forwards and Swaps)

The FPM® does not yet have the capability to implement all types of financial derivative (FD) activities, only Forwards and Swaps. We started the [Derivatives] sheet with foreign exchange (FX) forward contracts and swaps since most emerging countries are exposed to FX risk and protect themselves from this risk by entering into large amounts of forward and swap contracts.

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Part I. Forward Contracts

The user can project long and short forward contracts in foreign currencies, included in the definition of cross-currency parity. In addition, you can force the bank to enter into forward contracts by triggering a governor that keeps the FX position within a legal limit. The fair value of forward contracts will be reflected on the B/S and P/L automatically. In the [Entry] sheet’s B/S section, lines 79 and 111 are used reflect the fair value accounting (FVA) of FD activities. These lines allow the user to enter the fair value of all existing forward contracts that are recorded off-balance sheet. For simplification purposes, we assume that line 137 in [Entry] reflects the notional value of FD contracts. In the [Entry] sheet’s P/L section, line 199 refers to Gains (Losses) from Forward Contracts. In the [Other A&L and OBS] sheet, lines 14 (Financial Derivative Assets) and 23 (Financial Derivative Liabilities) are dedicated to project the calculated fair value of Forward contracts. If the fair value of the long and short positions is positive, it is to be recognized under assets:

Financial Derivative Assets (FVA) =+IF (Derivatives!Y10 (Fair value of long position)>0, Derivatives!Y10,0)+IF(Derivatives!Y14 (Fair value of short position)>0, Derivatives!Y14, 0);

If the fair value of the long and short positions is negative, it is to be recognized under liabilities:

Financial Derivative Liabilities (FVA) = -IF (Derivatives!Y10 (Fair value of long position)> 0, 0, Derivatives!Y10) -IF(Derivatives!Y14 (Fair value of short position)>0, 0, Derivatives!Y14)

…where the fair value of the forwards is recognized in [Derivatives] sheet lines 10 and 14. The amount is calculated by applying the difference between forward rates and spot rates to the notional amount of forward contracts at the valuation date. For a long position, the fair value will be:

Y10 =+Y58 (Notional amount of long position) *(IF('Assumptions-BS'!$Y$353 (Currency unit of long position)='FPM Cover'!$H$8 (Reference currency),Y6 (FX Spot rate), Y6*External!I114 (Cross currency parity) -Y9 (Amortized FX rate))* *$D$19+Y20 (Notional amount of long position) *(Y6-Y9)*(1-$D$19)

For a short position, the fair value will be:

Y14 =+Y62 (Notional amount of short position)*(Y13 (Forward exchange rate)-IF('Assumptions-BS'! $AA$353 (Currency unit of short position)= 'FPM Cover'!$H$8 (Reference currency),Y6 (FX Spot rate), Y6 *External!I114 (Cross currency parity)))*$D$19 (Notional amount of short position)+Y21*(Y13-Y6)*(1-$D$19)

The fair value of long and short positions is recognized on both the B/S and P/L. The “stock” of fair value will be accounted for under Financial Derivative Assets and Financial Derivative

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Liabilities on the B/S. On the P/L, the “flow” of fair value, or the change in the fair value in a given period, will be recognized under Other Trading Income or Gains (Losses) on Derivatives:

Y62 =+Derivatives!Y16 (Net gains and losses on derivatives) …where Net gains and Losses on Derivatives = IF(Y20=0,0, (Y10 (Fair value of long position in the current period) -IF(OR(AND(Y59<=1,X59<=1), 'Assumptions-BS'!Y355>0),0, X10 (Fair value of long position in the previous period)))) *$D$19 +IF(Y21=0,0,(Y14 (Fair value of short position in the current period) -IF(OR(AND(Y63<=1,X63<=1), 'Assumptions-BS'!Y372>0),0, X14 (Fair value of short position in the previous period)))) *$D$19+Y15*(1-$D$19) The FPM® has two options for the projection of forward contracts. In the first option, you can enter the notional amount, maturity, and forward contract by hand. The second option forces the bank to enter into enough forward contracts to keep the FX position within the legal limits. In this case, the forward contract will be renewed each period and forward rates will be set automatically based on interest rate parity. Notional amount of the long position= IF('Assumptions-BS'!$Y$353 (Currency unit of long position)='FPM Cover'!$H$8 (Reference currency), Y58 (Delivery amount), Y58* External! H114 (Cross currency parity))*Derivatives!$D$19 (Governor for automatic forward transactions)+IF(IF(ROUND(Capital!I16 (Eligible capital),0)<=0,0, 'Projected BS'!Y153 (Net FX position) /(Capital!I16/External!I94 (Exchange rate)))<-'Assumptions-BS'!Y10 (Regulatory FX position rate), - ('Projected BS'!Y153+'Assumptions-BS'!Y10 *(Capital!I16/External!I94 (Exchange rate))),0) *(1-Derivatives!$D$19) The governor for triggering the constraint on the net FX position is in [Assumptions-BS] cell X11. 1. Set [Assumptions-BS] cell X11 = Y: The FPM® can create a long or short position if the user places a constraint in the [Assumptions-BS] sheet to keep the FX net position within the limit. As a part of prudential regulations, countries require its banks’ foreign currency net open position to be within a statutory limit. In this situation the notional amount of derivatives will depend on the sign of the net open position excluding derivatives: If the current FX open position is negative, the FPM® will force a long position of the amount below:

Long position= +IF(IF(ROUND(Capital!I16 (Eligible capital),0)<=0,0, 'Projected BS'! Y153 (Net FX position) /(Capital!I16/External!I94 (Exchange rate)))<-'Assumptions-BS'! Y10 (Regulatory FX position ratio), - ('Projected BS'! Y153+'Assumptions-BS'! Y10* (Capital! I16/External! I94 (Exchange rate))),0)*(1-Derivatives!$D$19)

If the current FX open position is positive, the Model will create a reverse position (short position) of the amount below:

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Short position = IF(IF(ROUND(Capital!I16 (Eligible capital),0)=<0,0,'Projected BS'!Y153 (Net FX open position)/Capital!I16/External!I94 (Exchange rate))>'Assumptions-BS'!Y10 (Regulatory FX open position ratio), ('Projected BS'!Y153-'Assumptions-BS'!I10*Capital!I16/ External!I94)), 0) )*(1-Derivatives!$D$19)

If the user triggers the constraint, there is no need to enter assumptions on the maturity and forward rates for the long and short positions in [Assumptions-BS] sheet, cells 355 to 361. The FPM® automatically takes the frequency of periods as the maturity of the forward contracts (a year, 6 months, 3 months, a month, a week, or a day, depending on the chosen frequency). Forward contract rates will be assumed by the Model based on the interest rate parity between two currencies as below:

Forward rate= X6 (Spot rate at the beginning of the current year)*(1+External!I99 (government short-term rate in the current year)/(1+External!I97 (Short term international interest rate in the current year))

2. Set [Assumptions-BS] line X11 = N: If there is no constraint on the FX position, the FPM® can project long and short forward contracts at the user’s discretion. If the user enters new long or short contracts within the life span of the previous contract, the Model will use the forward rate and maturity of the later contract for the valuation of both contracts. Even though the user can enter up to 12 contracts for each long or short position, each new contract will renew the maturity and forward rate of previous contracts. On the other hand, if there is a period difference between the end of previous contract and the beginning of the new contract, the FPM® will use the original maturity and forward rate of each contract.

Part II. Swap Contracts

A swap is an agreement between two parties to exchange principal and/or interest payments of an underlying asset in one currency for equivalent aspects of another underlying asset in another currency. The amount (interest payment for interest rate swaps and notional payment for currency/cross currency swaps) to be received by a party is a long position and the amount to be paid by the same party is a short position.

1. Type of Swap Contracts

The FPM® allows the user project three types of swap transactions: (i) Currency/Cross Currency Swap; (ii) Interest Rate Swap; and (iii) a Mixed Swap (combination of interest rate and currency swaps). The drop-down list for picking a swap transaction type is set in cell Y363 in [Assumptions-BS] sheet. The user will pick “0” for Currency/Cross Currency Swap, “1” for Interest Rate Swap, and “2” for the Mixed Swap. Option “0” - Currency/Cross Currency Swap: The parties will exchange an underlying asset in one currency for another underlying asset in another currency at maturity. In this option, the parties are assumed not to exchange interest payments on underlying assets.

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The user may project long and/or short positions in local and/or foreign currencies. If both positions are assumed to be in foreign currency, one of them must be stated in the "reference currency" which is set in cell H8 in the [FPM Cover] sheet and the other one in any of the selected foreign currencies in the drop-down list located in cells Y364 and AA364 in the [Assumptions-BS] sheet. In this case, you must keep in mind that the second currency must match one of the currencies which are included in the definition of the “cross-currency parity” in the [FPM Cover] sheet. For the purpose of projection, “reference currency” specifies how much a foreign currency is worth in terms of the local currency, and “cross-currency parity” specifies how much another foreign currency worth in terms of the “reference currency”. In cross currency swaps, the user is able to project swap transactions between the “reference currency” and another foreign currency which is included in the definition of "cross currency parity" in the [FPM Cover] tab. For example, if the “reference currency” is "US$", the cross-currency swap transactions must be between "US$" and another foreign currency, say €. In this case, the "cross-currency parity" must be defined as "€/US$” or, in other words, value of € in terms of US$. In currency swaps, the user is able to project swap transactions between a foreign currency and the local currency. The user may pick the "reference currency" as a foreign currency or the currency that was used for deciding the "cross-currency parity" in the [FPM Cover] tab. Option “1” - Interest Rate Swap: The parties are assumed to exchange interest payments on the underlying assets. The notional amounts of underlying assets may be stated in local and/or foreign currencies. The user can project the swap transaction in which short and long positions are denominated in local and/or foreign currencies. The user may pick the "reference currency" or the currency used in "cross-currency parity" as a foreign currency to enter notional amounts of long or short positions. If the user wants to project floating interest rates on long and short positions and to set base rates onto which basis points are to be added, then look-up numbers must be entered in the cells Y366 and AA366 in the [Assumptions-BS] sheet which correspond to particular interest rates in the [External] tab. Users have the flexibility to enter "basis points" on floating rates in the lines 369 and 373 in the [Assumptions-BS] sheet. To project a swap contract with a fixed interest rate, these lines are used to enter fixed interest rates. Option “2” - Mixed (Currency and Interest Rate) Swap: With this option you will be able to project swap transactions which incorporates mixed features of both currency and interest rate swaps. For example, you can assume the parties might exchange both underlying assets and their interest yields at maturity.

2. Fair Value of Swap Transactions:

Based on the assumptions, the FPM® will value swap transactions and feed the results into B/S and P/L accounts on the [Other A&L and Operations] sheet.

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Since the FPM® handles currency/cross currency swaps and interest rate swaps differently, it is useful to explain them separately.

i) Interest Rate Swap:

The parties are assumed to exchange interest payments on long and short positions in local and/or foreign currencies at the end of each period. Interest payments on long and/or short positions might be linked to floating rates or fixed rates.

The interest payments on long position:

Y31=IF(Derivatives!$D$30(Long position-local or FX currency?)=0, IF(Derivatives!$D$35 (Short position-local or FX currency?)=0, Y67 (Delivery amount of long position)*Y70 (Interest rate)*IF('Assumptions-BS'!$AA$365 (Currency unit of short position)='FPM Cover'!$H$8 (Reference currency unit), Y$27 (Spot cross currency parity)*Y$6, Y$6 (Spot FX rate)), Y67*Y70*Y$6), Y67*Y70)*IF('Assumptions-BS'!$Y$363 (Type of the swap)=0,0,1)

The interest payments on short position:

Y36=IF(Derivatives!$D$35 (Short position-local or FX currency?)=0, IF(Derivatives!$D$30 (Long position-local or FX currency?)=0, Y73 (Delivery amount of long position)*Y76 (Interest rate)*IF('Assumptions-BS'!$Y$365(Currency unit of long position)='FPM Cover'!$H$8 (Reference currency unit), Y$27 (Spot cross currency parity)*Y$6, Y$6 (Spot FX rate)), Y73*Y76*Y$6), Y73*Y76) *IF('Assumptions-BS'!$Y$363 (Type of the swap)=0,0,1)

The net interest income of interest rate swap transactions will be accounted for on the P/L. The FPM® assumes net interest income (or expense) for each period will be received (paid) in cash fully at the end of the period. Therefore, there is no need to calculate accrued interest on swap transactions. In any case, the user does not need to set the interest period for swap transactions. The FPM® assumes that the interest period is equal to the frequency of each period, and interest income and expenses will be calculated and netted at the end of each.

ii) Currency/Cross Currency Swap

The positive stock of fair value of currency/and cross currency swaps is to be recognized in Financial Derivative Assets on the B/S:

Financial Derivative Assets (FVA) =+IF (Derivatives!Y10 (Fair value of long FWD position) >0, Derivatives!Y10, 0) +IF(Derivatives!Y14 (Fair value of short FWD position)>0, Derivatives! Y14, 0)+ IF (Derivatives!Y32 (Fair value of long SWAP position)>0, Derivatives! Y32, 0) +IF(Derivatives!Y36 (Fair value of short SWAP position)>0, Derivatives!Y36, 0)

If the stock of fair value of currency/cross currency swaps is negative, it is to be recognized in Financial Derivative Liabilities on the B/S:

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Financial Derivative Liabilities (FVA) = -IF (Derivatives!Y10 (Fair value of long FWD position)>0, 0, Derivatives!Y10)-IF(Derivatives!Y14 (Fair value of short FWD position)>0, 0, Derivatives!Y14) -IF (Derivatives!Y32 (Fair value of long SWAP position)>0, 0, Derivatives!Y32)-IF(Derivatives!Y36 (Fair value of short SWAP position)>0, 0, Derivatives!Y36)

The stock of fair value of currency/cross currency swaps is recognized in the line 32 and 37 in the [Derivatives] sheet. It is calculated by applying the difference between amortized forward rates and spot rates to the notional amount of forward contracts at the valuation date.

FX Gains=IF((1-Derivatives!$D$30 (Long position-local or FX currency?))*(1-Derivatives! $D$35 (Short position-local or FX currency?))=1,IF('Assumptions-BS'!$AA$365 (Currency unit of short position)='FPM Cover'!$H$8 (Reference currency unit),+Y67 (Delivery amount of long position)*(Y$27(Spot cross currency parity)-Y30(Amortized FX ratio))*Y6(Spot FX ratio), 0),Y67*(Y$27-Y30)*(1-Derivatives!$D$30))*IF('Assumptions-BS'!$Y$363 (Type of the swap)= 1, 0,1)

The flow of fair value, or the change in the stock of fair value in a given period, is calculated in line 38 on the [ ] sheet.

Y38=IF(Y67(Delivery amount)=0,0,IF(OR(AND(Y68(Time until delivery)<=1,X68<=1), 'Assumptions-BS'!Y368>0), Y32(FX Gains) ,Y32-X32))+IF(Y73(Delivery amount)=0,0,IF(OR(AND(Y74(Time until delivery)<=1,X74<=1, 'Assumptions-BS'!Y372>0), Y37(FX Gains),Y37-X37))

The flow of fair value of currency/cross currency swaps is also to be recognized on the P/L, under Other Trading Income or Gains (Losses) on Derivatives:

Y62=+Derivatives!Y16 (Net gains on derivatives)+Derivatives!Y38(Net FX Gains on Swaps)+Derivatives!Y39 (Net Interest income on Swaps)

3. Assumptions for Swaps:

i) Delivery Amounts for Long and Short Positions

The user can place delivery amounts of long and short positions into the lines 368 and 372 in the [Assumptions BS] sheet. The amounts must be denominated in their original currency units. The user can project a transaction for each period provided that the maturity of the transaction is equal to or shorter than the frequency of the period. Otherwise, new entry into latter periods which fall within the life span of the previous transaction will renew the maturity and forward rate of the previous swap. ii) Time until Delivery Users can enter the maturity of swap contracts in the lines 369 and 373 in the [Assumptions BS] sheet. Maturity must be entered in terms of number of years. For example, if the maturity is in 3 years the user must enter 3; if 3 months, it must be stated as 0.25 (3 month/12 month).

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iii) Fixed Rate or Basis Points If the user projects interest rate swaps, she must decide whether the interest rates on the underlying assets are fixed or floating. If fixed, the user must enter fixed interest rates along 12 periods in lines 370 and 374 in the [Assumptions BS] sheet. If floating, the user may enter basis points on floating interest rates in these lines.

NOTE: [Assumptions-BS] lines 375 and 376, columns Y to AJ have been added to facilitate your entry of forward rates. With line 375 set at zero, line 376 will show the expected spot rate that has been set in [Macro] (line 8). Therefore, you can use line 375 to decide the cost in percentage to be applied to this expected spot rate. Note that these two lines are for reference and are not automatically coded to any other cells, so that “cut-and-paste” is necessary to actually use these figures.

I. Net Foreign Exchange Position

A net FX open position consists of assets, liabilities, equities, and derivatives both on- and off-balance sheet. In the [Projected BS] sheet, line 152 calculates the net FX open position on B/S, line 153 calculates the FX open position on- and off-balance sheet except forwards, line 154 calculates the FX open position on- and off-balance sheet including forwards. Net FX open position ratio is: Y154= IF(ROUND(Capital!I16,0)=0,0,+Y154 (Net foreign exchange open position on and off balance sheet) *External!I9 (exchange rate)/Capital!I16 (Eligible capital instruments)) The FPM® has lines 10 and 11 in [Assumptions-BS] to trigger the constraint on the net FX open position. For example, if the user activates the constraint at 20 percent, the Model will force the bank to enter into a long or short forward contract which is enough to keep the net FX open position within ±20 percent of Eligible Capital Instruments.

J. Setting Reference Rates for Interest-Earning Assets and Interest-Bearing Liabilities

Interest rates are set by the user by adding a spread in [Assumptions-PLA] which is applied to one of 19 reference market rates listed in the [External] sheet. The code assigned in [Assumptions-PLA] column D to each interest-earning asset (lines 7 to 22) and interest-bearing liability (lines 40 to 57) is used to find the base reference interest rate to which the spread on the asset or liability entered will be linked in the projection, as coded in column D in [External]. In other words, the Model looks for that number in column D of [External] and adds the spread entered for the period for the interest-earning asset and interest-bearing liability items to the reference base rate selected. All rates entered are assumed to be annual rates before adjusting to the selected frequency. Each IEA and IBL has a default reference rate and a maximum choice of three other base rates. If you select a different base rate to those programmed here, the default based rate will apply. Otherwise, you may need to contact your account administrator to modify the coded program.

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K. Repricing of Assets and Liabilities

The FPM assumes, by default, interest-earning assets and interest-bearing liabilities are renewed every period at current interest rates, i.e. all assets and liabilities carry floating interest rates. A repricing feature has been developed for the user to be able to implement other repricing structures.

In order to activate the feature, the user has to set the governor, located in cell 5D in [Rates], to “0”. In addition, the current (base year) term structure (i.e. maturity gap) of the balance sheet has to be entered in [Entry] lines 8 to 118 from rows BI to BT for local currency activities and BY to CJ for foreign currency activities by entering the balance of each item in the projected periods consistent with the frequency selected for the projection in the [Cover] tab.

For example, if annual frequency was chosen in [Cover] and the entity has a loan portfolio of 100 units which will be paid in equal amounts in ten years, the user must input the amounts below in the maturity gap cells in the [Entry] tab:

Base Period

Projected Periods

1 2 3 4 5 6 7 8 9 10 11 12

100 90 80 70 60 50 40 30 20 10 0 0 0

In addition to a maturity gap, the user needs to enter the percentage of assets and liabilities that have floating rates in cells I202 to AJ247 in [Assumptions-PLA]. The user must also provide the assumptions on the maturity of new interest-earning assets and interest-bearing liabilities in cells I251 to AJ296.

The FPM incorporates all the information about the maturity structure of the base year (user input into [Entry]), and assumptions on the floating rates portions of assets and liabilities, and the maturities of the new assets and liabilities to calculate the weighted-average interest rates in cells I94 to AJ139 in [Rates].

I94= +IF(I244=0,0,I144 (Floating rate portion of the item)*I6 (The rate in the current year)+(1-I144) (Fixed rate portion of the item)*($H6 (The rate in the base year)*I294 (The amount originates from the base year)+$I6 (The rate in the current year)*I344 (The increase in the item in the current year)/I244 (The total balance of the item in the current year) )

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L. Bank Resolution

The FPM has a broad range of applications in effective supervision, including identifying failing banks and developing resolution options for both failing and failed banks. Users can develop a wide range of resolution options, including reorganization, liquidation, purchase and assumption (P&A), bridge bank, open bank assistance, and some other resolution options or combinations. The International Association of Deposit Insurers (IADI) defines Resolution as a disposition plan for a failed or failing bank, which is directed by the responsible safety-net authority, and is generally designed to fully reimburse or protect insured deposits while minimizing costs to the deposit insurer. In the early stages of a bank’s failure, the supervisory authority should first consider a reorganization plan, open bank assistance, or merger and acquisition. Systemic risk consideration can force the authority to seek these resolution techniques even though the bank is not viable. A standard reorganization plan includes a strong management action plan to improve the profitability and asset quality of the bank. The plan must set detailed actions with a timeline and include performance criteria for management to ensure the desired outcome. The supervisory authority can require a management change if the management was deemed to have been the source of the problems. The action plan might include a capital injection by shareholders to be able to retire expensive borrowings and build up a high-yield portfolio. The reorganization option must be considered by supervisors provided that the management is capable of implementing the plan and shareholders can afford to raise the required capital. Open bank assistance aims to keep a failing bank alive with some support to strengthen its capital adequacy, profitability, liquidity, and asset quality. The type of open bank assistance can vary depending on the tools with which the supervisory authority is armed. For example, in some countries the supervisory authority doesn’t have at its discretion the ability to inject capital before taking over management and diluting the capital of current shareholders. Basic open bank assistance comprises of injecting capital, extending emergency liquidity assistance, and swapping bad loans with government securities. The primary use of the FPM is to assess the viability of the bank and as necessary, develop a reorganization plan and/or open bank assistance. If the financial condition of the bank has deteriorated beyond the point of recovery, the supervisory authority must rush to develop a resolution plan before the bank`s situation deteriorates further and puts the whole system in danger. The supervisory authority might end up taking over the management or revoking the license of the bank, before having time to develop a resolution plan. The resolution options in the FPM comprise of liquidation, deposit payoff, deposit transfer, purchase and assumption, bridge bank, and capital injection techniques. For running the least cost test in the FPM, users need to enter only the necessary assumptions in the [Macro], [Entry], [Assumptions PLA], and [Resolution] tabs.

1. Least Cost Test (LCT) The receivership, which is usually a deposit insurance fund (DIF), must aim to develop the least cost resolution in which the cost that tax payers have to bear is the minimum among all options.

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At times, systemic risk considerations might lead the authorities to go with a more costly resolution option. The least cost test in the FPM can help the authorities to compute and compare the cost of different resolution techniques. The cost of the liquidation, including insured deposit payoff, is a kind of benchmark for the DIF to develop the least cost resolution option.

Least Cost (Liquidation Cost with First Priority Payout) = (Asset Value – Loss/Profit Sharing – Resolution Cost + Revalued Effect of Tangible Assets + Appraisal of Intangible Assets – Covered Liabilities – Insured Deposits)

Any resolution technique which is less costly than liquidation cost would be the least cost resolution option. If the DIF shares pro rata with uninsured depositors, the least cost is computed as shown below:

Least Cost (if DIF Shares Pro Rata) = (Asset Value – Loss/Profit Sharing – Resolution Cost + Revalued Effect of Tangible Assets + Appraisal of Intangible Assets – Covered Liabilities – Deposits) * (Insured Deposits/Total Deposits)

If the government has provided a blanket guarantee, the least cost formula should be adjusted to include the cost of paying not only depositors but also creditors and other claimants:

Least Cost (Blanket Guarantee) = (Asset Value – Loss/Profit Sharing – Resolution Cost + Revalued Effect of Tangible Assets + Appraisal of Intangible Assets – Covered Liabilities – Insured Deposits-Other Guaranteed Liabilities – Loss on Off-Balance Sheet Liabilities)

The computation of the least cost must be on a net present value basis. This will require users to develop assumptions on discount rates and average maturities for Asset Value, Loss/Profit Sharing, and Resolution Cost in cells L20 to AJ22 in the [Resolution] tab. 2. Developing a Least Cost Resolution Plan The least cost test in the FPM allows users to implement a simple resolution plan (straight-forward liquidation or purchase and assumption), or a multi-part resolution plan (a combination of liquidation, P&A, and bridge bank techniques). i). Simple Resolution Plan:

In a simple resolution plan, users need to input loss or discount ratios in the [Entry] tab, in cells AB6 to AG79 (shown below) in order to calculate liquidation or P&A values respectively.

Snapshot: Loss and Discount Rates

Liquidation Purchase & Assumption

per Model LC.CY. US$ per Model LC.CY. US$

Assets

Cash & Balance with CB Suggested Actually Used Suggested Actually Used

Cash in Vault and 0% 0% 0% 0% 0% 0%

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ATMs

CB Reserve Req. (RR) 0% 0% 0% 0% 0% 0%

The proportion of covered and insured liabilities must be entered in cells AA85 to AF111 in the [Entry] tab (shown below).

Snapshot: Insured and Covered Liabilities

Insured Liabilities Covered Liabilities

LC.CY. US$ Total LC.CY. US$ Total

Assets

Customer Deposit Accounts 0 0 0 0 0 0

Demand Deposits 0 0 0 0 0 0

Now Accounts 0 0 0 0 0 0 Money Market Deposit Account 0 0 0 0 0 0

Depending on the guarantee regime in place the users might need to also enter loss ratios for off-balance sheet positions, such as financial guarantees and derivatives, in cells AB128 to AG142 in the [Entry] tab (shown below).

Snapshot: Loss Rates on Off-Balance Sheet Liabilities

Liquidation Purchase & Assumption

per Model LC.CY. US$ per Model LC.CY. US$

Off Balance Sheet Contingent Liabilities Suggested Actually Used Suggested Actually Used

Financial Guaranteed 0% 0% 0% 0% 0% 0%

Doubtful Guarantees 0% 0% 0% 0% 0% 0%

ii). Multi-part Resolution Plan:

The least cost test in the FPM can be used to develop a multi-part resolution plan for failing and failed banks. In this case, users have the flexibility to combine liquidation, purchase and assumption, and bridge bank techniques into a resolution plan. The resolution plan can be implemented in a sequence or in tandem. In the FPM, in addition to aforementioned assumptions needed for the simple resolution plan, users must enter the percentage of assets and liabilities which are to be put under purchase and assumption and bridge bank transactions in cells Y70 to Z175 in the [Resolution] tab (shown below). Based on the resolution rules for each asset and liability, the rest of the assets and liabilities will be liquidated. If the license was revoked and the bridge bank is not a resolution option anymore, some assets and liabilities would become worthless, such as tax assets and liabilities, fair valuation of derivatives, and generic reserves for loans and off-balance sheet guarantees. In this case, the resolution rules must be set at appropriate levels to put worthless assets and liabilities under liquidation and the loss ratios must be defined as 100 percent in relation to these assets.

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Snapshot: Resolution Rule

% Allocation Rule

Assets P&A Bridge Bank

Cash & Balance with CB

Cash in Vault and ATMs 0% 0%

CB Reserve Req. RR 0% 0%

3. Resolution Techniques i). Liquidation:

In a liquidation transaction, as soon as the license of a failed bank is revoked, the DIF pays out all insured depositors and appoints a management to liquidate the rest of the bank. The DIF can decide to liquidate some assets and liabilities or the whole balance sheet of the failing bank. Full liquidation might occur if there is no receiver for the loans, deposits, and other balance sheet items. In a basic liquidation, the authority will liquidate the most problematic assets and all other assets and liabilities will be put under purchase & assumption or bridge bank techniques. Deposit pay-off or transfer can be seen as a type of liquidation. If there is no demand from a receiver for assuming insured deposits, deposit payoff or insured deposit transfers would be an alternative. In a deposit payoff, the deposit insurance agency can use the branches of the failing bank to receive claims and make payments. Constrained with this purpose, a failing bank should keep its license to use payment and settlement systems. Deposit payoff is the most undesirable resolution method since no franchise value is recognized and the arrangement to make payoff has cost for the deposit insurance fund. Insured deposit transfer resembles deposit pay-off and deposit assumption. The deposit insurance agency transfers insured deposits to a contracted bank to make payments to the depositors. However, the depositors can decide to open a deposit account at the bank instead of receiving their money in cash.

ii). Purchase & Assumption (P&A):

A purchase and assumption transaction has some advantages over liquidation. First, it requires the receivers pay a premium over purchased loans and assumed deposits. In addition, the price of assets is higher in P&A rather than liquidation since the borrowers are more willing to continue to make their payments in the former. The bureaucratic structure makes also the receivership, which is usually the DIF, less efficient in the collection of payments. In a P&A transaction other banks purchase some or all of the assets and assume some or all of the liabilities of a failed bank. Assets and liabilities which are not sold to other banks are to be transferred to the receivership or conservatorship. A P&A scheme ranges from a “clean bank” that passes on cash and cash equivalents, interbank and deposits, a “whole P&A” that passes all assets and liabilities, to a “modified P&A” that passes on cash and cash equivalent assets, investments, pass and special mention loans, deposits, and some other borrowings.

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Some assets and liabilities never pass to the acquirer in a P&A transaction. These include tax receivables and liabilities, fair values for derivative assets and liabilities, provision for employee benefits, and provision for off-balance sheet liabilities. If risky assets, such as substandard and non-performing loans are passed on to the buyer, profit/loss sharing agreement might be involved to facilitate the sales.

iii) Bridge Bank:

A bridge bank transaction is a temporary resolution in which a bank can continue to operate until ultimate resolutions can be found. The deposit insurance fund can pass on the balance sheet to the bridge bank after cleaning out some balance sheet items in liquidation. A bridge bank can be an option if a bank is considered systemically important or the value of the bank is expected to be preserved better this way to gaining time to evaluate its options or to prepare the bank for the sale. If no option is developed, the bridge bank can eventually end up in liquidation or sale in part or as a whole. A bridge bank combines the attributes of both living and failed banks. It will continue to receive deposits and make loans but not be required to comply with capital adequacy, liquidity, and FX position rules. Since a bridge bank is a temporary solution, the authorities have to exempt it from complying with these rules until a resolution is found.

4. Valuation of Assets In the FPM, users have the flexibility to pick different valuation approaches for each of the different resolution techniques: Table: Valuation Matrix

Valuation Methods

Book Value Liquidation Value

P&A Value Discounted Cash Flow

Re

solu

tio

n

Tech

niq

ue

Liquidation

P&A

Bridge Bank

In the [Resolution] tab, users can set up valuation method for each resolution option, in cells AD68 to AL68 (shown below) choosing from the following options by entering its corresponding number: book value (0); liquidation value (1); purchase and assumption value (2); and discounted cash flow value (3). Snapshot: Valuation Options

Liquidation P&A Bridge Bank

LC.CY. US$ Total LC.CY. US$ Total LC.CY. US$ Total

Valuation Method Options* Valuation Method Options* Valuation Method Options*

i). Book value=0:

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The book value of a bank is the value of the assets according to its balance sheet after all reclassifications and adjustments in the [Entry] tab. The book value is an appropriate valuation approach for a bridge bank transaction.

ii). Liquidation value=1:

Liquidation value of the bank is calculated by applying loss rates to the asset accounts. If there are no historical loss rates of previous liquidation experiences, the loss rates published by other deposit insurance funds may be used. The assumptions on loss rates must be entered in columns from AB6 to AC79 in the [Entry] tab. The FPM has indicative loss ranges as a guide. Liquidation value is an appropriate valuation approach for a liquidation transaction.

iii). P&A value=2:

P&A value of a bank is calculated by applying discount rates to the asset accounts. If the country did not execute a P&A transaction before, discount rates published by other national deposit insurance funds may be used as a base. The assumptions on loss rates must be entered in columns from AF6 to AG79 in the [Entry] tab. The FPM has indicative discount rates as a guide. P&A value is an appropriate valuation approach for a P&A transaction.

iv). DCF value=3:

Discounted cash flow values are calculated based on the maturity and interest rate structures of the assets. The end of period residual balance of assets must be entered in cells BI6 to CJ79 in the [Entry] tab. The base interest rates and their spreads must be entered in cells D7 to AJ36 in the [Assumptions PLA] tab. The future cash flows which consist of principal payment and interest income will be discounted by the rate of average cost of capital. Users can add a spread on discount rates to reflect the information on default rates into the present value of assets in cells I298 to AJ298 in the [Assumption PLA] tab. Discounted cash flow is an appropriate valuation approach for liquidation and P&A transactions.

5. Summary of the Resolution Based on the user selected resolution technique for each asset and valuation method for the selected method, the FPM will produce the result of the resolution in the [Resolution] tab in cells AB6 to AP53. Below is the summary of the resolution framework in the FPM.

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Snapshot: Summary of the Resolution

Resolution Techniques

Resolution Plan

Liquidation

Purchase & Assumption Bridge Bank

I. Asset Value

-Loss/Profit Sharing

-Resolution Costs

+Revalued Effect of Tangible Assets

+Appraisal of Intangible Assets

II. Net Asset Value (NAV)

Covered Liabilities

III. NAV less Covered Liabilities

Insured Deposits

Other Guaranteed Liabilities

IV. Least Cost if DIF Shares Pro Rata V. 1st Priority Payout Cost (NAV less Insured Liabilities)

Uninsured Liabilities

VI. NAV less All Liabilities

Loss Estimated on OBS Positions

VII. NAV less all On/Off-BS Liabilities

Recapitalization

VIII. Final Cost: Blanket Guarantee

I. Asset Value The asset value of a resolution option depends on the selection of the resolution technique and corresponding valuation method for each asset and liability.

II. Net Asset Value The net asset value is the present value of the assets taking into consideration the loss/profit sharing, resolution cost, revalued effect of tangible assets, and appraisal of intangible assets.

i). Loss/Profit Sharing: The reason behind loss sharing agreements is to increase the attractiveness of nonperforming loans to receivers and align the interest of receivers and the deposit insurance fund. In a typical loss/profit sharing agreement the receivers will enter into a purchase and assumption agreement. The DIF will reimburse the receiver the appropriate amount of the net charge-offs of shared assets provided that the loss is incurred within the maturity of the contract. Usually, loss/profit share of the loans depends on the quality of the assets. For non-performing loans it would be usually higher than 50 percent. Loss rate should be set over the amount of assets sold to receivers. Average maturity shows the number of years in which the losses or profits are expected to be incurred. Discount rate is used to discount the future losses and profits

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to the contract day. All the assumptions related to the loss/profit sharing agreement will be entered in cells L11 to AJ14 in the [Resolution] tab.

Loss/Profit Share of the DIF= %

Loss (-) Profit (+) Rate in Future= %

Average Maturity= Years

Discount Rate= %

ii). Resolution Expense:

The DIF can make additional discount over the expected value of the assets given there is a potential risk which might hinder the realization of the expected value of the assets. Resolution expenses include all expenditures to implement a resolution, such as salaries, the rent of premises, and fees for legal and professional services. The users have to enter the expense ratio over the asset values for each resolution transaction, average years to complete the transactions, and the opportunity cost of resolution expenses in cells L18 to AJ21 in the [Resolution] tab.

Fixed Overall Deduction= %

Flat Administration Fee= %

Average Years to Complete= Years

Opportunity Cost of Financing= %

iii). Revalued Tangible and Intangible Assets: Users can enter the valuation of tangible and intangible assets in cells L25 to AJ36 in the [Resolution] tab. A failed bank can have very profitable subsidiaries and affiliates which should be included in the valuation of assets. The bank can also have profitable business units, such as credit card and consultant services which can be sold separately to interested investors. The deposit insurance fund can also ask for premiums in return for the bank`s deposits and loan customers.

Revalued Affect of Tangible Assets

Real Estate Owned 0

Other Real Estate Owned 0

Stock in Subsidiaries/Affiliates 0

Divestible Business Units 0

All Other Tangible Applicable 0

Appraisal of Intangible Assets

Core Deposit base 0

Loan Servicing Contracts 0

Safe Deposit Box Contracts 0

Proprietary Computer Software 0

Trust Accounts 0

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Leasehold Interest 0

III. NAV less Covered Liabilities Covered liabilities have priority to be paid over insured liabilities. Covered liabilities are comprised of all liabilities supported by collateral, usually repos, covered bonds, and foreign borrowings. The DIF has to pay these liabilities up to their collateral value. IV. Least Cost if DIF Shares Pro Rata: previously explained. V. First Priority Payout Cost (NAV less Insured Liabilities): previously explained. VI. NAV less All Liabilities This amount shows the net asset value after paying all liabilities, including uninsured and uncovered liabilities. VII. NAV less all On/Off-BS Liabilities This amount is equal to the net asset value after paying all on and off balance sheet liabilities. VIII. Final Cost: Blanket Guarantee Final cost of a resolution includes the payment of on and off balance sheet liabilities and capital requirement for the bridge bank. The capital requirement would be calculated only if the failed bank was put under a bridge bank in part or as a whole. The FPM calculates the required capital to meet the regulatory capital adequacy ratio as of the resolution date. In liquidation and purchase & assumption transactions, there is no need for recapitalization. A bridge bank might require recapitalization from the DIF, depending on the quality of the assets and capitals transferred to the bridge bank. To calculate the level of required capital, the FPM needs assumptions on risk weights in cells D20 to D394 and Tier I, Tier II and market and operational risks in cells H233 to AJ262 in the [Assumptions BS] tab.

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Annex 1: Suggested Topics in Understanding the Target Bank

The following topics are suggested in order to learn about the target bank whose financial statement you wish to project. The necessary, or possible, depth of analysis into each topic will require independent judgment. The topics highlighted in light grey will normally be of higher importance to a well-grounded projection/simulation exercise. If your engagement relates to official banking supervisors or bank management you should feel entitled to inquire about each and all of these topics as they relate, affect, and condition a reasonable and complete projection/simulation. Failure to grant access to the information should be reported as a material limitation of the projection/simulation.

Profile History

Type of bank: commercial, universal, retail, specialized, or other.

Type of license and main supervisor.

Most distinguishing features vis-a-vis its competitors.

General position in the domestic market and market shares.

Highlights of recent performance: growth, profitability, capitalization.

Management team and board profile and capacities.

Support provided or expected from local authorities.

Creation and evolution; major stages of evolution and changes.

Growth: organic vs. acquisitions, relevant trends and segments.

Organization; group membership and profile; subsidiaries and affiliates.

Type of clientele and change in products and activities.

Whether it does foreign payments and trade finance.

Last and recent external rating and Supervisory Risk Assessment.

Strengths and Risks/Weaknesses.

Capital (Ownership) Processes

Types of capital (hybrids and others) issued in previous years,

Sources and tiers (disbursed, retained earnings, revaluation of assets).

Types of shares with different rights.

Major owners (since what year) and how ownership is distributed.

Major / recent transfers of control.

Who exerts control and nominates the directors on the board.

Financial strength of major owners and capacity to support.

Plans to increase capital or to bring new partners.

Support of the bank to its related parties.

Internal Governance and board processes.

Organization of board and its committees.

Oversight and monitoring of management.

Control functions and MIS reporting top-down structure.

Identification and reporting of related and inter-group transactions.

Strategic planning, capital operational budgeting.

Risk management, and outputs and measures (risk assets review features).

Financial control, and outputs and measures.

Internal control and audit, and outputs and measures (risk asset reviews).

Strategy Organization

Board and Management Approach to Risk (materialization of risk appetite)

Statement of Risk Principles and Objectives

Business Goals, Plans and Planning Process

Fitness between strategy and organization and plans to change.

Main functions/departments: top managers’ profile and workforce.

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Means and measures to balance the equation risk-market goals

Bank's relevant risk dimensions according to local environment

Relevant Credit Risk highlights

Relevant Liquidity Risk highlights

Relevant Market Risk Highlights (FX, IR, price)

Other relevant risks applicable.

Branch network configuration, role of subsidiaries and affiliates.

Centralized vs. de-centralized decision making/risk assumption.

Degree and means of centralized risk and performance control.

Capacity to aggregate and consolidate risk and performance.

Internal distribution of capital: approach and criteria.

Process and responsibility to measure performance and risks.

Major partners and plans for the group.

Businesses Contribution

Business strategy: current and recent changes envisioned.

Main lines of operations and lines subject of future emphasis.

Client profile and product scope; delivery network and capacity.

Interest income and fee income products.

Deposits and funding products and markets.

Costing is aligned to competitive advantages.

Risks assumed in delivery to clients: quantification and trends.

Market shares of significant contributing activities.

Relevant concentrations in credit, funding and related parties.

Contribution of activities to risk, return and performance.

Corporate cost allocation: criteria and measures.

Systems to compute, measure, and report contribution measures.

Management aptitude to risk-reward and compensation.

Accuracy of financials and MIS to reflect the risk-reward-capital needs.

Metrics of volume, gross and net margin per contributing activity.

Recent moves in business areas.

Uniform performance report and functional cost analysis available.

Efficiency and productivity measures used

CREDIT RISK ESSENTIALS

Evaluation of credit risk across the entire spectrum of the bank's activities (including loans, debt securities, equity investments, on- and off-balance-sheet counterparty exposures, etc.):

Structure of B/S and relative mix in different credit-risk assets (e.g. low credit risk assets

such as government bills or interbank and higher risk assets such as loans or equities. Fixed-income securities (by type). Largest positions, their market value, and maturity structure. Equity securities, (by economic sector and largest exposures). Mix of investments relating to previous underwriting positions. Investment strategy, book value compared to market value.

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Credit portfolio broken down by multi-dimensions: Maturity, loan type, collateral, customer base, economic sector, size, currency and country.

Large exposures to specific segments, industries, markets, individual borrowers and loan types.

Breakdown of the real estate portfolio, with details of criteria for granting, maximum Loan-to-Value figures (LTVs) allowed, average LTVs for residential mortgage lending and for commercial real estate lending.

Percentage of the portfolio in the form of residential housing loans, its geographical distribution, breakdown of properties under development, rented properties and owner-occupied properties and breakdown by internal rating, and details of any repossessed properties.

Breakdown of any commercial real estate loan portfolio in terms of office, retail, industrial or other, geographic breakdown and by internal rating, with details of any repossessed properties in the books or in a special purpose entity (SPE).

Details of the retail loan portfolio for individuals, including how defined, maturity of this market in the country, existence of any credit bureaus, information on criteria for granting personal loans and any scoring systems in place.

Breakdown of the bank's non-bank risks (both on- and off-balance sheet) in terms of

economic sector, ultimate country risk, and currency. Breakdown of secured and unsecured lending, nature of the security, valuation and LTV

measures. Make-up of the bank risks (both on- and off-balance sheet) in terms of size, concentration to

single entities including groups of related entities. List of the twenty to forty largest non-bank risk exposures.

Bank’s internal definitions of doubtful and/or non-performing (or equivalent) exposure, and

differences in definitions for retail and corporate loans. Underwriting standards by major segments. Metrics of loan pricing by risk grade. Large problem-credit exposures. Internal tracking and reporting of levels and changes of nonperforming assets and past-due,

re-aged, and rolled-over loans. Details of these loans and other exposures, specifying amounts, whether domestic or

foreign, and if any, largest accumulated loan loss provisions. Restructured loans and other problem-asset categories and how bank/ supervisors classify

overdrafts. Expected future trends. Reserving policy and adequacy. Loan loss reserves, broken down by type, general and specific. Reserves against on/off B/S exposures, taxed and untaxed. Reconciliation of each type of reserves over the past (five) years. New provisions, reversals, charge-offs and recoveries. Workout of adversely classified loans.

Information on any exposure to major shareholder(s) or any of their associates, affiliates of

major shareholder(s).

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List of the twenty largest interbank exposures plus assessment criteria for such exposures and limits in place.

List of the largest counterparties in the securities portfolio (both trading and investment) as well as a breakdown of these portfolios by internal and external rating category.

FUNDING AND LIQUIDITY ESSENTIALS

To the extent possible, evaluation of the bank's sources of funds and factors influencing its liquidity position, including: Access to and importance in local and national capital and money markets. Liquidity facilities at the Central Bank, and other sources of asset liquidity. Philosophy with regard to liquidity and liquidity planning. Composition of funding: type of depositor (core retail compared with other retail, wholesale

and institutional markets) and lender, currency, and type of instrument. Diversity of funding sources: concentration of borrowing, currencies involved, and the

countries of origin of the lenders; details of outstanding debt issued, including the type of debt, currency, and maturity.

Principal sources (list of the twenty largest) and information which would help to assess the historical stability of the retail funding base.

Dependence on any major shareholder[s] for funding. Flow of funds (net deposit flows, deposit maturities, stability of funding). Asset liquidity, including short-term deposits and securities, and long-term marketable

securities. Extent of pledged assets and ability to sell or securitize loans. Copies of regulatory returns relating to liquidity ratios. Effect of securitization programs and SPE activities. Significant long-term borrowings which will mature in the first and second year of the

projection/simulation. Funding plan for the next 12 months, indicating the likely form (senior, subordinated, etc.)

and timing of any debt issuance. Details of any plans to raise regulatory hybrid capital. Details of any standby lines of credit which are available to the bank including confirmed or

unconfirmed lines. Pro-forma contractual and expected maturity of assets, liabilities and OBS items in each

currency (“gap” analysis). Plans to cover any negative gaps and find the necessary liquidity.

EARNINGS ESSENTIALS

Evaluation of the bank's earnings levels, trends, and stability - basic long-term earning power of the bank: Local regulations and practices on income recognition, reversals, suspension, and

capitalization of interest income.

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Non-performing and restructured assets on an accrual basis. Non-performing and restructured assets on a cash basis. Tax position: management's philosophy towards tax payment position and cushion. Historical and future use of net operating loss carry-backs and carry-forwards, and other

strategies that affect tax position. Impact of inflation on earnings, return on equity versus the reporting period's inflation rate.

Copy of the budget for the current financial year and any management assessment of

earnings and other prospects for the current year and beyond. Earnings outlook, year-to-date budget versus actual. Projections for following year, and medium-term plan. Quality of bank's accounting practices and policy recognition of interest on problem loans.

Breakdown of earnings by business line and profitability figures for each business line (in

terms of operating and/or net income as a percentage of allocated equity capital, average assets or other customary metric in use).

Businesses considered top contributors to earnings and with most potential in terms of earnings growth for the bank.

Factors influencing business mix; distribution network; degree of automation. Net interest income: margin trends and ability to maintain volume. Trends in net interest revenues and net interest margins. Non-interest income: diversity and sustainability of other income sources and growth

potential. Breakdown of fees and commissions by type and expected development of these items. Proportion of earnings from trading activities and proportion of revenues that is customer-

related and own-account trading. Operating expenses: level and trend of overhead relative to key factors in comparison to

peers, and an explanation of the tax charge. Restructuring charges incurred and, where reported, included in operating or exceptional

expenses. Breakdown of exceptional income and expenses, including any significant capital gains,

provisions for unrealized capital losses, and goodwill charges. Impact of extraordinary gains and/or charges. Breakdown of other income and percentage of the recurrent gross operating earnings. Net operating income analysis (level and trend). Quality of earnings: proportion of income recognized as core earnings.

Ability of earnings to meet current and future needs and loss provisioning. Loan loss provision (current level, past volatility, and ability to absorb future requirements). Ability to price risk into various products and actual return on the perceived risk on the

books. Reconciliation of published figures to accounts used by management if figures differ

substantially. Appropriations (if any) to equity or quasi-equity reserves made as deductions from income

and/or of transfers (if any) from equity or quasi-equity reported as income in the bank's published figures.

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CAPITAL ESSENTIALS

Evaluation of the bank's capital, its quality and its composition:

Levels of common/preferred stock, convertibles, subordinated and perpetual debt. Other types of quasi-equity and details of any hybrid debt issues outstanding (that are

included in the bank’s Tier 1 capital), including preference shares. Levels of minority interests, goodwill and other intangibles and revalued assets. Details of any other forms of quasi-equity (such as silent partnerships, revaluation reserves,

embedded value, unrealized gains, underprovided non-performing loans and overvalued assets) which are included in your calculation of capital.

Levels of: unrealized capital gains and loan loss reserves in excess of probable losses. Breakdown of the movements of the solo/consolidated loan loss/risk reserve(s)/

allowance(s) / accumulated provision(s), including: the opening balance; the transfer (provision) from income for the year; adjustments for exchange rate variations; write-offs (charge-offs) against the reserve(s); recoveries of past write-offs and write-backs of past provisions and the closing balance of the reserve(s)/allowance(s) and accumulated provision(s).

Details of any valuation reserves (i.e., market value higher than carrying value) on securities, foreign exchange and commodities if applicable.

Details of any real estate undervaluation and overvaluation. Details of significant intangible assets. If a holding company structure is involved, level of double leverage above bank level and

implications. Comparison of capital with the perceived/quantified level of risk in institution's business. (Basel) risk-weighted assets adjusted for high credit risk assets or market-risk activities. Capital position with respect to local and Basel requirements. Details of the capital adequacy calculation ratio in accordance with the national

requirements if these differ from the existing Basel G10 Accord (or, where relevant, the EU capital requirements).

Dividend payout ratio, internal growth rate of capital. Absolute size of bank's capital base and its ability to absorb extraordinary and unexpected

losses. Contingencies based on the bank's business mix. Ability to tap external sources of capital and long-term funding. Bank's market capitalization compared with book value. Management's philosophy regarding risk asset and loan leveraging of its capital base. Capital projections. Economic capital allocation methods, if used.

COSTS AND PRICING ESSENTIALS

Evaluation of the cost structure and pricing practices of the bank:

Measures and drivers of cost structure: funding, direct operational expenses, indirect costs; services and cost of capital (risks).

Measures of efficiency and productivity targeted and tracked (volumetrics, indicators, benchmarks).

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Headcount segmented by unit, function, age and salary. Remuneration policy, social security, pension and other non-salary related expenses

(bonuses, overtime). Drivers of the top five cost contributors and relationship to volumes (staff; IT/EDP;

communication; premises; other relevant): trend and outlook for plan & budgeting. Cost allocation system applied to units, products and services; means to track, report and

update. Cost allocation and contribution effect for particular groups of accounts and services; needs

to rationalize costs to enhance revenue. Main elements of the pricing strategy for service range. Consistency of pricing policies with its overall marketing strategy and competitive position. Measures of profit maximization tracked and internally reported; sustainability and impact

in the bank’s long-term strategic position. Market share vs. quality of service vs. capacity maintenance. Measures of services cost

structure. Global vs. branch pricing: deposits, loans and services. Service discounting policy (volume vs. value). Pricing strategy: discriminatory per segment and product; “skimming” tactics, penetration

pricing.

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Annex 2: Mapping Spreadsheet

The worksheet Mapping.xls has been designed to map a bank’s raw data available from a wide range of sources. The worksheet puts the data into a format used for the FPM®. It accepts up to five periods of input data (the sample shot shows only one year). The [User Notes] sheet of Mapping.xls explains how to perform the mapping and associated analysis. This worksheet can/should be sent in advance to local counterparts to perform the initial mapping work (a simplified version with just the first four input sheets is available to facilitate faster return of data, after which you would perform a more in-depth analysis - historical trends for assumptions and other data). The sample shot below shows the basic structure of Mapping.xls.

Under the column for the name of the account you can copy and paste, or enter by hand, all the relevant lines of the source financial statements (be it the local chart of accounts, the relevant set of prudential returns, the lines extracted from the notes to the annual reports, data from the bank’s internal MIS, etc.). For each line, an appropriate code is allocated. In the sample above, we show two lines mapped: Cash and CB reserve requirements. The amounts entered for LC.CY. and FG.CY. are taken by the formulas coded to the transposed lines. Aside from [User Notes], the Excel workbook includes the following tabs:

[Mapping] where the bank’s data is entered and relevant codes assigned;

[Data entry format] which shows the result of mapping into FPM format of B/S and P/L;

[Data entry adjusted] where you can modulate and adjust the initial mapping (for example, to reclassify items);

[Other Info] which includes information not typically found on B/S and P/L but pertinent to the Model;

[BS assumptions] which approximates the calculation of historical trends for assumptions for projecting balance sheet items;

[PLA assumptions] which approximates the calculation of historical trends for assumptions for projecting profit and loss accounts items;

Sample Shot of Mapping.xls

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Performing this analysis is fundamental to preparing a stabilized projection based on historic trends and to modulate forward the scenarios that you wish to evaluate. A simplified version of this Mapping worksheet is also available. This version includes only the first four [sheets] above.

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Annex 3: Hints on Subrogate PDs and LGD

In some cases, country officials will not have good information about the dynamics of the loan portfolio of an individual bank or the banking system. In other cases, officials may not want to share the information they have gathered from examination risk assessments, or other activities like external audits. Even if it is available, such information may not always be accurate. These are important limitations that must be documented in any accompanying reporting.

In such cases, the best available option may be to approximate alternative assumptions. Listed below are several approaches that utilize analysis of public information to build reasonable assumptions (for example, interpolating the information provided in the notes to financial statements regarding composition of loans and segment analysis).

Even with the alternative approaches listed below, the ideal would be to conduct a deep due diligence of existing management risk asset reviews, supervisory risk assessments, and external audit reviews, if such reports are accessible. A robust due diligence may even encourage local supervisors to launch a multi-year program to upgrade their tools, regulatory standards, and risk assessment, as well as their sources of information regarding credit risk dynamics. Such an action may also prompt supervisors to require bankers to better quantify risk measures, including estimating loan migration matrices by segment.

But, be cautioned: reported information can be distorted and it is often highly dependent on the conservatism applied by bank managers in applying IAS 39, including the rigor of existing regulatory accounting and supervisory practices. Continuous “ever-greening” of problem loans, poorly structured restructuring of troubled borrowers, and mending arrears via re-aging and rolling over maturities work against the transparency of reported data. Review reported data for these issues and be skeptical of numbers that appear overly positive for the economic context.

In applying the approaches indicated below, you should keep in mind the tenet which supports them: we assume that the PD is an estimation of the probability that a loan in a certain segment defaults, i.e., migrates downward from its original grade (A or B) to C/D loans. To be useful even when available data is minimal, we use the term PD broadly, merely to represent the flow of problem loans. Expected defaults and the real quality of loans may be two different things. Avoid confusing statistics with real life. In real life, bank management tends to hide loan losses as long as they can, always and everywhere. If you use any historical covariance methods, remember that the data reported can be highly distorted and regressing false problem loans produces false estimations.

The approaches suggested are not mutually exclusive. In parallel to analyzing the outputs of the projection, you have to control for the trends and shifts seen in net provisioning costs, to ascertain their consistency and outlook (given changes expected or simulated in the economic cycle), to compare with other banks (local and foreign peers), and to attest that the accounting of risk pricing via provisions makes sense. Look at lines 78 and 87 (% Net cost of credit loss) in [Loans] and line 62 (net provisioning) in [Summary], both their growth and relationship to total assets (columns X to AJ) and gross operating margin (columns BC to BO).

The first suggested approach is to use what you have at hand to estimate a PD and a LGD for each segment, leaving intact in the projection (as much as possible) the characteristics of C/D default/impaired loans observed at the end of the base period. This is not optimal but serves to

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give a baseline to the projection and to allow you to then simulate changes to those parameters. You can use the output of the Mapping.xls as the baseline entry data.

A second approach is to visit a number of local banks that might have more refined estimates of PD and LGD, including loan migration by segment, and inquire if they will share their estimations with you. Certainly, such data is within the reach of local bank supervisors for cases where they have authorized a bank to apply IRB under Basel II. Accounting for possible differences in underwriting standards and risk appetite between banks, you could use the PD/LGD with certain caveats to build a set of basic PD/LGD by segment

A third approach is to apply the locally standardized PD implicit in the country regulations and then introduce changes to that implicit PD. For example, start from the assumption that the LGD is 50 percent across all segments. Basel II uses a LGD of 35 percent and 45 percent as a foundation for the IRB. Most regulations apply a 50 percent specific provision for doubtful loans.

Accordingly, if the generic provision for a well-graded loan (say to an A borrower) is 1 percent, which is the implicit PD? The answer is simple: 2 percent, since 50 percent (LGD) times 2 percent (PD) equals 1 percent (generic provision). If the provision for a less well-graded loan (say to a B grade borrower) is 5 percent (as in many county regulations), its implicit PD is 10 percent (10 percent times 50 percent equals the typical 5 percent generic provision of a “special mention” borrower). This explanation introduces basic concepts and gives you a starting point which then you can modulate, moving LGD up or down, or applying it to any other level of regulatory provisioning.

A fourth approach is to use the PD and LGD seen in other countries, including an add-on figure to reflect the relevant country conditions. For example, you can use the estimated PD published by the Basel Committee on Banking Supervision in its Quantitative Impact Analysis 5, which includes PD and LGD for different countries. Naturally, after the current global economic crisis, these estimates of PD and LGD might be very far from what would have been expected normally; thus, you may like to adjust them upward considering their standard deviation, square root of (PD-PD2) and 25 percent across the board for LGD estimates.

A fifth practical approach is to use (if you wish to rely on them) the PD and LGD published for structured finance transactions rated by a rating agency. For example, Fitch IBCA has published some of these estimates and compared them with PD and LGD made public by the Federal Reserve of the U.S. and the Bank of England.

Be aware of the following aspects in simulating the dynamics of non-performing loans (NPL):

Section B of Chapter V explains how the PD and LGD are used in the projection;

Any change in the accumulation of impaired/defaulted C/D loans needs to be tested against trends and practices;

You can use the work-out and charge-off assumptions ([Assumptions-BS] lines 114 to 130) to adjust the dynamics;

Monitor the ratios of NPL to total loans and coverage in [Loans] and [Summary];

Use [Assumptions-PLA] lines 60 to 67 to set the portion of interest-earning C/D loans;

Narrow the spreads for loan products to simulate interest arrears using lines 15 to 22 in [Assumptions-PLA];

Scale the PD and LGD with lines 169 and 170 in [Macro]; and

Adjust each PD and LGD directly in lines 84 to 111 in [Assumptions-BS].

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Annex 4: Governors and Other Issues

The following table lists in alphabetical order Governors (internal variables that act as switches to achieve flexibility in projecting different alternatives and scenarios.) that are built into the FPM® to facilitate its operation. By changing a governor and running a new projection, the user can very quickly recalculate the effect of an assumption or alternative and assess the sensitivity of value and solvency proxies to that particular variable.

Name Location Purpose Possible Cell Values Notes

Frequency

[FPM Cover] in cell H5 to S5

Chooses the frequency of the projection

"1" – annual; "2" – semiannual; "4" – quarterly; "12" - monthly; "52" - weekly; "365" - daily projections

Selecting different frequencies will adjust annual rates accordingly. Enter assumptions in annual terms regardless of chosen frequency.

Scenario [FPM Cover] H6 Select which scenario will be applied to the projection

“1,2,3” to select one of the three scenarios of external variables in [Macro]

Actions [FPM Cover] H12

Includes or excludes absolute amount adjustments that the user specifies for select items in the [Actions] sheet

“0” - exclude; “1” - include actions

Changing this value recalculates a projection excluding or including the actions, conforming to a particular situation or set of restructuring measures.

Single or Dual Entities or “Good” or “Bad” Bank Tests

[FPM Cover] in cell H13

Allows user to play a “double entity” game by allocating one entity (good bank) to the LC.CY. book and a second entity (bad bank)

“0”- OpEx will be projected separately for LC.CY. (book for good bank) and FG.CY. (book for bad bank) based on related assumptions for both

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to the FG.CY. book currencies; “1” - OpEx will be projected together for both activities based on the assumptions for LC.CY. activities

Liquidity Assets

[Entry] in column C lines 6 to 20

Include or exclude lines that are eligible as liquid assets

“0” to exclude; “1” to include the line as an eligible asset

This governor is combined with the one listed below.

Liquidity Assets Discount

[Entry] in column D lines 6 to 20

Assigns as liquidity discount (if included as eligible in Liquidity Assets above)

Percentage figure from 0 to 100 %

Multipurpose Asset (MPA)

[Entry] C22 Controls the type of asset simulated in the MPA

“0” - simulate a zero coupon asset booked at discount; “1” - simulate a coupon bearing asset booked at face/nominal value

This governor is combined with the one listed below.

Multipurpose Assets (MPA)

[Entry] D22 Controls the interest payment of the MPA

“0” - simulate a cash interest income asset; “1” - non-cash interest income asset

Reserve Requirement

[Entry] in columns B (LC.CY.) and X (FG.CY.) lines 84 to 99

Chooses whether deposit-products will be subject to reserve requirements

“0” - exempt; “1” – require the line from compulsory reserve in the CB

Liquidity Liabilities

[Entry] in column C lines 84 to 99

Include or exclude lines of liabilities that are to be covered with liquid assets

“0” to exclude; “1” to include the line as a liability to be covered

This governor is combined with the one listed below.

Liquidity Liability Discount

[Entry] in column D lines 84 to 99

Assigns a discount to a liability line subject to liquidity coverage as part of the liquidity rule (if included as eligible in Liquidity Liabilities above)

percentage figure from 0 to 100 %

Multipurpose Liability

[Entry] C103 Controls the type of liabilities simulated in the

“0” – MPL is a discounted or zero-coupon liability;

When the governor C103 is set at

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MPL “1” - MPL is a standard coupon-bearing liability

1, the manner in which interest is recognized (cash or accrued) depends on the value of governor in D103.

Multipurpose Liability

[Entry] D103 Controls the interest expense payment of the MPL

“0” - interest service of MPL is made in cash in every period; “1” - interest service of MPL is accrued and paid at maturity

Dividend Pay-Out (Common Stock)

[Entry] C116

Controls the distribution of dividends in case the bank does not comply with the capital rule

“0” - no pay-out if below the capital rule; “1” - can pay out even if below the capital rule

Dividend Pay-Out (Common Stock)

[Entry] C116

Controls the distribution of dividends in case the bank does not comply with the capital rule

“0” - no pay-out if below the capital rule; “1” - can pay out even if below the capital rule

Dividend Pay-Out (Common Stock)

[Entry] C116

Controls the distribution of dividends in case the bank does not comply with the capital rule

“0” - no pay-out if below the capital rule; “1” - can pay out even if below the capital rule

Preferred Stock [Entry] cell C118 Govern whether preferred stock is cumulative

“0” for non-cumulative; “1” for cumulative

Preferred Stock [Entry] cell D118

Controls whether dividends can be paid to preferred stocks when the bank does not comply with the capital adequacy rule

“0” - Payment cannot take place; “1” – payment takes place

Personnel Expenses

[Entry] C208 Controls how personnel

“0” - grow at the pace of nominal GDP plus an

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expenses behave (grow) in the projection

add-on placed in line 120 [Assumptions-PLA]; “1” - a % of total assets specified in [Assumptions-PLA] in lines 121, 123 and 125; “2” - the product or an average employee cost placed in lines 122, 124 and 126 times the head-count of the bank

Other Administrative Expenses

[Entry] C212 Controls how overheads behave (grow) in the projection

“0” - grow at the pace of nominal GDP plus an add-on in line 127 [Assumptions-PLA]; “1” - a % of total assets in lines 128, 130, 132, and 134 [Assumptions-PLA]; “2” - growth at a rate specified in lines 129, 131, 133, and 135 [Assumptions-PLA]

Generic Provisions Deduction

[Entry] C301 Choose whether to deduct generic loan loss provisions from RWAs and generic provisions

“0” - No deduction of generic provisions from Risk weighted Assets or eligible capital from Tier II (International reporting); “1” – generic provisions are deducted from RWAs, eligible Tier II, and presented on a net basis in Summary BS

Repayment of ELA

D15 in [Assumptions-BS]

Controls the use of available for sale securities (AFS) to repay ELA

“0” - no forced sale; “1” - forced sale to repay ELA in case that funds are owed

Liquidity Rule [Assumptions-BS] H9 (LC.CY.) and X9 (FG.CY.)

Chooses to subject the projection to liquidity constrains

“Y “- Yes; “N”- No

Capital risk weights (Basel I)

[Assumptions-BS], cells in columns D and U, lines 20 to

Assigns the percentages to risk weight assets and designated off-

percentage figure from 0 to 100 %

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265 balance sheet items as a proxy for the Basel I regime

FX Position Constraint

[Assumptions-BS] cell X11

Triggers the constraint on the net FX position to the amount in [Assumptions] line 10

“Y “- Yes (FPM forces bank to enter into FWD contract to match this FX position amount in line 10); “N”- No (Use the derivatives assumptions in line 352 to 376; see whether regulatory position is met in [Summary] 114 and 115)

Reference Rates

[Assumption-PLA] in lines 7 to 22 and 41 to 58 in columns D for LC.CY. and U for FG.CY.

Selection of the rates of reference to which the spreads observed or expected on interest earning assets and interest bearing liabilities are linked

Repricing of assets and liabilities’ interest rates

[Rates] D5 Activates manual repricing (v. the Model’s default of repricing each period)

“0” – turn on repricing; “1” – Model’s default repricing (reprices at each period)

If “0”, also enter: maturity gap of starting balance of assets and liabilities in [Entry]; % of assets and liabilities with floating rates (I202 to AJ247) in [Assumptions-PLA]; and assumptions on maturity of new assets and liabilities in ( I251 to AJ296).

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Cost of Capital

[Valuation] H5

Chooses the rate representative of the bank’s cost of capital to approximate its value

“1” – Model-calculated cost of capital; “0”- cost of funds

Cost of capital is calculated in [External] line 103 from the components entered in section L of [Macro], while the cost of funds is described below.

Cost of Funds [Valuation] H6

Chooses cost of funds (COF) calculation method

“0” the FPM® uses a rate for COF entered by the user in [Macro] line 148. With “1” the FPM® uses the average cost of interest-bearing liabilities projected in the Model

“1” to select as cost of capital the average cost of funds calculated in [External] line 105 from components in section L of [Macro+; “0” to select as cost of funds the cost of capital described above.

Credit Growth Rule

in suspension until enabled in a forthcoming version of the FPM®

The limit of credit growth is “observed” by a governor which does not restrict credit growth above market share in the current version

“Y/N”