Philip Wessels (50)
Chief Risk Officer

14 years’ service • BCom, CTA, CA (SA), Diploma in Advanced Banking Law, Institute of Stockbrokers

RISK AND CAPITAL MANAGEMENT REPORT

EXECUTIVE SUMMARY

ACHIEVEMENTS AND REVIEW OF THE PAST YEAR

The volatility faced by banks and other financial institutions has emphasised that risk management is key to being at the forefront of today’s financial landscape. As a process it is critical that risk management is at all times embedded, but evolving in nature so that it remains dynamic and relevant to the business of the group.

Nedbank’s three-lines-of-defence strategy has played a significant role in implementing strong risk governance, which is applied pragmatically and consistently as the foundation for successful risk management.

The three-lines-of-defence concept forms the backbone of the Enterprisewide Risk Management Framework (ERMF), which has been instrumental in assisting the group in weathering the international financial storm. It incorporates a strong sense of accountability, responsibility, independence, reporting, communications and transparency, both internally and with all key external stakeholders.

In recognition of the success of Nedbank’s risk strategy the Institute of Risk Management South Africa (IRMSA) for the second consecutive year recognised Nedbank for having the Most Effective Company Risk Management Programme.

OUTLOOK FOR THE YEAR AHEAD

Through the annual strategic business planning exercise Group Risk identified seven main strategic focus areas for 2009, which are aligned with the strategic focus areas of Nedbank Group. These focus areas include the following:

• Optimise economic profit through worldclass risk management. This will be achieved through the correct pricing of risks together with an increased focus and early recognition of potential problems across all credit portfolios.
  
• Enable business to become client-driven. As an enabler to business, one of the main objectives of the central risk function is to continue to embrace new and existing legislation and operationalise regulations in the course of normal business operations.
  
• Manage risk as an enabler. This will ensure that Nedbank is well-positioned to identify and manage risks within the ongoing volatile environment. Embedding and leveraging the principles of economic profit and Basel II will further empower the business to increase levels of growth, innovation and competitive advantage.
  

• Enhance productivity and execution. Business continuity management will receive additional impetus to comply with Payments Association of South Africa (PASA) requirements.
  
• Maintain strong risk management culture for competitive advantage. Maintaining a strong oversight of the group’s ERMF will continue to place a strong emphasis on accountability for managing the group’s risk universe.
  
• Accelerate transformation. To align with the group’s strategic aspiration of leading transformation, transformation risk has now been formally recognised as a main category of risk in the ERMF, rather than a subcategory of HR risk.
  
• Lead as a corporate citizen. All business undertakings will be aligned with Nedbank’s position to remain a leader in corporate social responsibility.
  

In an era that is unprecedented Group Risk is conscious of the challenging global conditions facing the industry, and it continues to commit itself to risk management as an integral component of the business. Proactive, timeous and sound response to the impact of changes within the scope of operations is essential to sustaining and building on the solid fundamentals of risk management already engrained throughout the organisation.

EXECUTIVE SUMMARY

In the wake of the global financial crisis in which shareholder value around the world has been eroded in momentous proportions and many large financial institutions have gone insolvent, been taken over and/or received significant government support, considerable blame has been directed at poor risk management and corporate governance within the financial services industry, and at inadequate regulation and prudential supervision by related governments.

This has extended across the broad sphere of the entire financial system where some financial activities and institutions were either inadequately regulated or not at all. Finally there is the fair-value, mark-to-market (MTM) accounting rules that some blame for exaggerating the writedowns and deepening the crisis.

In this Risk and Capital Management Report the following are covered:

• Evaluation of the origins of the crisis, resultant lessons learnt and a perspective on the role of the Basel II principles.
  
• Perspective on the impact of the crisis on South Africa, and Nedbank in particular.
  
• Nedbank Group’s strong risk and capital management culture which, together with sound corporate governance, has helped the group maintain a prudent, conservative risk appetite. This will be illustrated through reference to a summary of Nedbank’s current risk profile and capital adequacy.
  
  It is highlighted that capital adequacy levels must be seen in relation to a bank’s unique risk profile and risk appetite, which should be transparent. This is a core objective of Basel II, namely that banks should not all be measured on a ‘one size fits all’ basis, but rather that banks with higher-risk profiles should have commensurately higher capital ratios. This was reinforced by the Basel Committee in January 2009.
• Nedbank Group’s financial, risk and capital management profile for the year ended 31 December 2008.
  
• Nedbank Group’s current understanding of the key changes and new requirements on the international regulatory front in response to the crisis, and the group’s view on the implications of these for the group together with its actions to date and plans going forward.
  
  In South Africa the Banking Regulator has consistently been effective, and this has played a significant role in preventing any local fallout from the crisis. South Africa does, however, operate in a globally regulated market and as a result of the significant response to the crisis by international supervisors, this will have a knockon effect.
  
  Regulation 43 of the revised regulations relating to banks in South Africa requires disclosure to the public of reliable, relevant and timely qualitative and quantitative information that enables users of that information, among other things, to make an accurate assessment of a bank’s financial condition, including its capital adequacy, financial performance, business activities, risk profile and risk management practices. Nedbank Group Limited and Nedbank Limited (collectively ‘Nedbank’) are fully committed to regulation 43.
  
  The requirements of regulation 43 are aligned with International Financial Reporting Standards (IFRS) but significantly extend the public-disclosure requirements, in terms of both content and frequency, relating to risk and capital management. This extension of disclosure is embodied in what is commonly known as Pillar 3 of the Basel II Accord.
  
  Basel II and the revised regulations were effective in South Africa, and introduced successfully in Nedbank from 1 January 2008.
  
  This report contains a summary of the salient features of our risk and capital management for the year ended 31 December 2008. Nedbank’s full Pillar 3 Report is available on our website at www.nedbankgroup.co.za.

ORIGINS OF AND LESSONS LEARNT FROM THE GLOBAL FINANCIAL CRISIS

History has shown that the key risks that cause a bank to fail are the following:

• The quality of a bank’s board and/or executive management, and/or their failure to endorse sound risk management.
  
• Liquidity risk (banks borrow short, lend long).
  
• Concentration risk(s) – especially credit risk and associated poor-quality lending.
  
• Poor governance, risk management and/or internal controls.
  
• Lack of transparency (and undue complexity).
  
• Reputational risk (erosion of a bank’s franchise value).
  

In this crisis all these key risks and more have materialised and are exacerbated by several additional key factors, all acting in concert and resulting in what some refer to as the ‘perfect storm’. A summary of the crisis is set out below.

• Liquidity, asset quality, leverage and valuation

  • Excess liquidity and low interest rates leading to cheap credit and poor-quality/subprime lending.
  • Excessive risk taking and ‘originate and sell’ strategies, fuelled by aggressive remuneration practices, as well as a strong push for growth.
  • Excessive leverage facilitated by complex, unregulated exotic credit derivatives, as well as a lack of international supervision over reckless lending, gearing and excessive consumer debt.
  • Resultant undue concentration risk in poor-quality/subprime credit exposure leading to large writedowns following the economic slowdown and resulting in a global recession.
  • Accounting fair-value MTM rules that require assets and liabilities of firms to be measured at current market prices rather than their accrued value, where they are designated as such or held for trading. As liquidity dried up in the financial markets and the crisis deepened, such market prices dropped to fire-sale levels, resulting in significant valuation difficulties and further writedowns of significant magnitude that may not ever represent fair value.

• Regulation and prudential supervision, and risk management and governance in banks

• Aside from the credit derivatives market in the United States, investment banks and other non-deposit-taking institutions were insufficiently regulated.
  
  Generally, international prudential supervision was found wanting mainly due to the extent of globalisation and regulators from different jurisdictions and/or authorities not working together optimally. This meant that the supervision of systemic risk, critical to macroeconomic financial stability, fell short, especially in a severely stressed environment.
• Risk cultures, governance and risk management were weak in some banks and, together with an underestimation of certain risks, certain weaknesses in Basel II existed.

The deficiencies in some banks are believed to be related to the following:

• Poor liquidity risk measurement and management.
• Excessive concentration risks around
  • certain credit portfolios,
  • wholesale funding for liquidity, and
  • assets and liabilities subject to MTM fair-value accounting.
• Poor credit underwriting and an overreliance on, or inappropriate use of, and/or incorrect assumptions and valuation techniques used in quantitative risk models, especially in the trading book, complex credit derivatives and securitisations, with a failure to overlay the quantitative science with qualitative information, common sense and experience.
• An overreliance on external rating agencies, who themselves were left unregulated.
• Counterparty credit risk management, including securitisation and other off-balance-sheet activities.
• An overreliance on value-at-risk (VaR) models to measure market-trading risk, which models underestimated risk in a stressed environment.
• Inadequate stress and scenario testing, and the resultant inadequacy of capital buffers.
• Poor data quality and risk information technology infrastructure and systems.
• Lack of clearly articulated risk appetite in financial terms that are embedded in strategic plans and monitored.
• Inadequate enterprisewide risk governance, including ineffective challenge and debate, and insufficient understanding of risk from board level to the front-office, together with lack of a clear mandate of the group risk function.

• Integration of risk, capital, strategy and reward, and the principles of Basel II

  • While the crisis has revealed some shortcomings in Basel II, this needs to be put in perspective. A line was drawn in the sand in 2006 in order that Basel II could be implemented, and it was clear on many aspects that it could be enhanced and added to over time. Additionally, it is unfortunate that Basel II was fully effective in some jurisdictions only from 2008, while in other jurisdictions, including the United States, implementation was delayed even beyond that.
    
    Those banks that truly embraced the spirit of Basel II, and so have adequate risk and capital management, generally will have weathered this ‘perfect storm’ better.
  • Basel II, and accompanying supervisory guidance, specifically requires in its Pillar 2 that banks must have a comprehensie Internal CapitalAdequacyAssessment Process (ICAAP) that is subject to an Supervisory Review and Evaluation Process (SREP) by their banking regulators.
    • The main ICAAP components require of banks:
    • effective board and management oversight;
    • comprehensive risk assessment and management processes;
    • sound capital assessment and capital management;
    • monitoring and reporting; and
    • Internal control review.
  • Properly implemented and consistently applied ICAAP should provide the transparency and management information to manage, control and optimise risk and at the same time ensure financial sustainability. For a large bank it should be aligned with best-practice enterprisewide risk management and be forward-looking, enforcing the essential integration of risk, capital, strategy and reward.
  • This effectiveness, however, is pervasively influenced by a bank’s risk culture and governance, active and consistent executive management and board support, and the operating business model.

• Remuneration practices

  • These have been too short-term focused and not aligned with long-term sustainability and shareholder value creation principles. Here IFRS accounting rules (‘point in time’) are at odds with Basel II principles that are focused on long-term sustainability (‘through the cycle’).
  • These have encouraged excessive risk-taking.
  • These often have no clawback provisions.
  • Risk department remuneration out of line with front-office staff remuneration.
  • Limited application of risk-adjusted performance measures in reward schemes.

• Transparency and disclosure

  • Generally inadequate, exacerbated by undue complexity and lack of regulation in certain financial activities and transactions.

IMPACT OF THE GLOBAL FINANCIAL CRISIS ON SOUTH AFRICA AND NEDBANK

South Africa’s banking industry has remained structurally sound and stood up extremely well amid the crisis. Currently Nedbank is experiencing cyclical financial stress and an economic slowdown in a banking cycle and is indirectly impacted by the crisis, but not on a scale comparable with the unprecedented storms in the international financial system.

South Africa has been sheltered to a large degree from the crisis due to factors that include the following:

• There is sound regulation of all financial services, especially the banking sector.
  
• South Africa did not experience to the same extent the ‘originate and sell’ mentality and use of complex credit derivatives that resulted in excessive leverage in some foreign banks.
  

• Government never allowed interest rates to fall so low as in the United States as to encourage excessive borrowing and untenable levels of household debt.
  
• The National Credit Act was successfully implemented in South Africa to help minimise irresponsible lending practices, overgearing and excessive consumer debt.
  
• Exchange controls prevented large flows of funds from local institutions out of the country.
  
• Rand liquidity has remained stable, with the interbank market operating normally.
  
• Good risk and capital management was implemented in South African banks.
  
• Basel II was successfully implemented in South Africa.
  

Nedbank specifically stands behind the message given in its annual reports over the past few years with respect to its strong risk and capital management culture and commitment.

• Since 2004 the Nedbank vision has been to become southernAfrica’s most highly rated and respected bank by its staff, clients, shareholders, regulators and communities.The vision is supported by the group’s 10 Deep Green aspirations, which include becoming‘worldclass at managing risk’.
  
• Aligned with the successful recovery and turnaround of the Nedbank Group completed in 2007, a business-based approach to its Basel II implementation was followed, not only to comply with Basel II, but also to elevate the group’s risk management, capital management and performance measurement to worldclass standards.
  
• Nedbank successfully implemented Basel II in line with the revisions to the Banks Act and the revised Basel II-based banking regulations introduced in South Africa, from
  1 January 2008.
  
• Nedbank’s Capital Management Framework (CCMF) embraces the integration of risk, capital, strategy, performance measurement and incentive schemes across the group.
  

Nedbank received favourable outcomes from the SREP of our group’s ICAAP by the South African Reserve Bank (SARB), and an external audit of our regulatory returns and associated processes, both of which were concluded in the latter half of 2008. In addition, an independent audit firm was employed to review the ICAAP submission.

While striving to ‘become worldclass at managing risk’ is a journey and not a destination, and as there are always areas to improve on, Nedbank fully embraced the spirit of Basel II, which commenced back in 2004, and this has assisted sound financial performance and sustainability amid the crisis and South Africa’s economic downturn.

The protracted global financial crisis and its continuing developments in early 2009, as well as increasing concerns in the more traditional loan books of banks, are naturally of major concern. Nevertheless, Nedbank’s continuing sound profitability, albeit at marginally lower levels, and the successful turnaround of the group have generated strong capital levels and appropriately positioned it to weather the challenges prevailing in the environment.

There is a proliferation of studies and responses to the international crisis. Most pertinent to Nedbank is the Switzerland-based Basel Committee on international banking supervision who, following a G20 summit late last year, announced a comprehensive strategy in the form of an eight-point plan to address the fundamental weaknesses revealed by the crisis related to regulation, supervision, risk and capital management.A summary of this and other pertinent international responses to the crisis will be provided in the full Pillar 3 disclosure update.

In 2009 Nedbank will, aside from continuing with its 2008 focus on strengthening capital ratios and liquidity, pursuing selective asset growth and growing market share based on economic profit, proactively respond to the international recommendations, guidance and other requirements, and address gaps that may remain as part of Nedbank’s ongoing journey to be ‘worldclass at managing risk’.

In so far as Nedbank’s capital levels are concerned, and in line with general global expectations and increased conservatism, it has revised its target regulatory capital adequacy ranges upward from 8% – 9% (Tier 1) and 11% – 12% (total) to 8,5% – 10% (Tier 1) and 11,5% – 13% (total). The group’s objective is to move towards the top end of these revised ranges. Refer here onwards for more details of Nedbank’s capital adequacy ratios.

NEDBANK’S CONSERVATIVE RISK APPETITE AND STRONG CAPITAL ADEQUACY

The crisis has highlighted that the appropriate level of capital for a bank is a direct function of its risk appetite, strategy and existing risk profile. This aligns directly with one of the key objectives of Basel II, which is to differentiate capital requirements and adequacy of capital buffers above the regulatory minimum, to reflect the unique risk profile on a bank-by-bank basis, rather following the ‘one size fits all’ approach among all banks that Basel I engendered. The Basel Committee reconfirmed this in January 2009.

In Nedbank risk appetite is an articulation and allocation of the risk capacity or quantum of risk it is willing to accept in pursuit of its strategy, duly set and monitored by the board, and integrated into its strategy, business and capital plans.

Nedbank has cultivated and embedded a prudent and conservative risk appetite, focused on the basics and core activities of banking. This is illustrated below:

• No direct exposure to United States subprime credit assets nor associated credit derivative transactions.
• Conservative credit underwriting practices culminating in a high-quality, well-collateralised wholesale book and further tightening of the retail book since 2007 in anticipation of the economic downturn and introduction of the National Credit Act.
• Reasonable credit concentration risk levels.
  • Large individual exposure risk is low. Refer here for details.
  • Geographic exposure risk is high (refer here, which highlights that 94% of the group’s loans and advances originate in South Africa), but in reality this concentration is positive for Nedbank, given the current international crisis, and reflects focus on an area of core competence.
  • Industry exposure risk is reasonably well-diversified. Refer here for details.
  • At first sight Nedbank’s property exposure appears high, but this is in line with its domestic peer group and most banks worldwide.As a result of this perceived risk, it undertook a more detailed analysis of its commercial property exposures.
    
    With the assistance of leading consultants Nedbank undertook this analysis to assess the level of economic risk in its commercial property portfolio in the light of concerns stemming from the devaluation of commercial property in several overseas countries. This was done with a view to improving not only Nedbank’s risk management practices, but also its strategic business options.
    
    The conclusions and recommendations that resulted from this detailed analysis were that:
    • potential credit losses in a stressed scenario would remain within Nedbank’s risk appetite;
    • the portfolio is well-balanced, but there are higher-risk loans that require closer monitoring; and
    • the most appropriate business strategy is one of selective origination, sacrificing business volumes and market share growth for risk-based pricing, economic profit and margin management. This is broadly in line with Nedbank’s approach over the last few years.
    • Stemming from this detailed analysis were several useful benchmarks derived from what international banks experienced, where we compare favourably.
    • The analysis has also been useful not only from the business perspective of shaping the commercial property loan origination and deal-pricing approach for the future, but also from the credit risk management perspective of providing Nedbank with additional relevant benchmarks against which to monitor its commercial property exposures and of highlighting risky exposures on which to focus increased risk management.
• Counterparty credit risk is almost exclusively restricted to non-complex banking transactions. There is continued emphasis on the use of credit risk mitigation strategies, such as netting and collateralisation of exposures.
  
  Credit derivatives activities have been restricted to single-name trades of South African exposures and are biased towards providing risk mitigation. Refer here for further details on the relatively low counterparty credit risk exposure.
• A strong, well-diversified funding deposit base and a low reliance on offshore funding. Additionally, Nedbank’s reliance on its top 10 depositors is not concentrated.
  
  Refer here onwards for an analysis in support of this and Nedbank’s prudent liquidity risk management.
• Low level of securitisation exposure, which was reduced during 2008. Refer here for summary details of this exposure.
• Low leverage ratio (total assets to shareholders’ equity) of 16,2 times, which compares very favourably on an international benchmarking basis.
• High ratio of risk-weighted assets to total assets of 62,7%, indicative of Nedbank’s conservative Basel II implementation and measurement of risk, which compares favourably on a local and international benchmarking basis.
• Low level of net assets exposed to the volatility of IFRS fair-value MTM accounting.
  • Banking book
    
    In terms of IAS 39 an entity has the option to designate a financial instrument at fair value provided:
    • the designation ‘fair value through profit or loss’ eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from using different bases to measure and recognise the gains and losses on financial assets and financial liabilities; or
    • the instrument forms part of a group of financial instruments that is managed, evaluated and reported to the appropriate level of management using a fair-value basis in accordance with a documented risk management or investment strategy; or
    • the financial instrument contains an embedded derivative that significantly modifies the cashflows of the host contract or the embedded derivative clearly requires separation.
  Nedbank meets the first two criteria when designating financial instruments at fair value through profit and loss.
  
  With regard to the first criterion Nedbank has entered into a large number of fixed-rate deals for both assets and liabilities. When a fixed-rate deal is entered into, an interest rate risk arises and is hedged with an interest rate swap derivative. This process is controlled and monitored by the Group Asset and Liability and Executive Risk Committee (Group ALCO).

  In terms of IAS 39 all derivatives need to be carried at fair value and it is the MTM of all these hedging derivatives that causes an accounting mismatch as discussed under the first criterion. To eliminate the accounting mismatch the underlying financial instrument is designated ‘fair value through profit and loss’ and subsequently fair-valued. All fair-value adjustments in this regard are unrecognised profits and losses and are disclosed in non-interest revenue.
  
  It is important to note that these profits and losses will not be realised and will merely unwind over time as the various financial instruments mature. The financial instruments are effectively fully hedged on an interest rate risk basis.The present volatility seen in the income statement on the designated fair-value line is a result of basis risk and because IAS 39 requires an entity to fair-value its own credit for financial liabilities designated ‘fair value through profit and loss’.
  
  With regard to the second criterion Nedbank carries all its investment securities, both listed and unlisted, at fair value. There are no material hedges in place for these investment securities and they are designated ‘fair value through profit and loss’, as management report and manage these investment securities on this basis. Please refer to the investment table here for details.
  
  Refer here ‘Nedbank Group: categories of financial instruments’ for details of the above.

  • Trading book
    
    The trading book is fair-valued and the impact taken through the income statement.
    
    
    The crisis and the consequent impact on the South African sovereign credit spreads had an effect on the value of certain assets within the trading portfolio. However, Nedbank’s holding of foreign assets in the trading portfolio has been constrained by its low-risk appetite for foreign credit risk. Consequently the portfolio was and remains relatively small with mainly shorter-dated assets with a bias to financial institutions and large corporate exposures.
    
    These MTM adjustments are included in the current year trading revenue. Nedbank’s bond portfolio in London was £273 million at 31 December 2008.
    
    The trading portfolio has limited exposure to the credit derivatives market and has been focused mainly on the provision of protection on South African corporate names.This, coupled with Nedbank’s conservative risk appetite, has restricted losses incurred in the portfolio in the current period.
    
    In the Lehman Brothers collapse Nedbank held incidental exposure (approximately US$1 million), which had been MTM during the runup to its 15 September 2008 Chapter 11 filing. All other exposures in Lehman Brothers were covered by margining agreements and were successfully unwound in terms of the supporting legal documents.
    
    Refer here ‘Categories of financial instruments’ and here ‘Balance sheet banking/trading categorisation’ for further details.
• Small market trading risk in relation to total bank operations (economic capital held is only 1,4% of total and is conservatively based on limits rather than utilisation, plus a 10% capital buffer).
  
  The risk appetite within the trading business has remained largely unchanged over the past two years. Trading activities have focused on the domestic market with a bias towards local interest rate and equity products. Subsequent to exiting from the Macquarie business alliance in 2007, the risk appetite for complex equity derivatives was significantly curtailed. Risk appetite is subject to periodic review, but there was no material change in trading limits during the 2008 financial year.
• The overall performance of the trading business was sound for 2008, an indication that the impacts from the ‘credit crunch’ and difficult equity markets were successfully navigated, and likewise that Nedbank’s risk systems were sound. Refer here for more details.
• Low interest rate risk in the banking book as reflected by the sensitivity analysis provided here.
• Low equity (investment) risk exposure.The total equity risk exposure, including Nedbank’s private-equity business, is R3,8 billion, comprising only 0,7% of total assets. Further, within this a wide range of individual investments exist and many are linked to a wider client relationship. Refer here for further details.
• Non-core asset disposal strategy successfully executed as part of the group’s strategic turnaround completed in 2007. Currently assets non-core to the business of banking are immaterial.
• Low foreign currency translation risk to the rand’s volatility, which is in line with Nedbank’s appropriate offshore capital structure. Refer here for more details.
• Well-diversified earnings streams. Most of the group’s earnings are generated by traditional, vanilla, annuity-based income in wholesale and retail banking, and specialised finance. Refer here of ‘Operational segmental reporting’ for an analysis of this.
• Well-diversified subordinated-debt profile, with no maturity of any existingTier 2 regulatory capital until 2011 (Nedbank Limited) and 2010 (Imperial Bank Limited). Refer here for details.
• Comprehensive stress and scenario testing to confirm the adequacy of our capital ratios and accompanying capital buffers.
  
  Nedbank’s stress-testing strategy is performed across three levels and is duly overseen by a strong governance process:
  • Specific risk-type testing such as credit, liquidity, trading and equity risk.
  • Macroeconomic factor modelling, involving stressing capital levels in at least four scenarios
    • mild stress,
    • high stress,
    • severe stress, and
    • positive scenario (better-than-expected base case).
  • Specific-event scenario analysis. The four events currently chosen are
    • severe recession,
    • liquidity crisis,
    • property value crash, and
    • default of two and three large exposures (credit concentration risk).
• Since 2005 risk appetite is also expressed in terms of quantitative risk metrics as well as qualitatively. The quantitative metrics include earnings at risk (EaR) (based on earnings volatility) and, related to this, the ‘chance of regulatory insolvency’, ‘chance of experiencing a loss’ and economic capital adequacy. These comprise group-level risk appetite metrics and the current risk profile of the group, which are all within the ranges approved by the board and as previously reported.

Nedbank’s group level risk appetite metrics
Group metrics		Definition		Measurement methodology		Current targets		Target achieved
EaR		Pretax earnings potentially lost over a one-year period.		Measured as a 1-in-10-year event (ie 90% confidence level).		EaR less than 100% of pretax accounting earnings.
Chance of experiencing a loss		Event in which Nedbank Group  experiences an annual loss  (on an economic basis).		Utilises EaR by comparing with expected profit over the next year.		Better than 1 in 10 years.
Chance of regulatory insolvency		Event in which losses would result regulatory in Nedbank being undercapitalised  relative to minimum  capital ratios (both Tier 1 and total capital ratios).		Utilises EaR and compares with capital buffer above regulatory minimum – expressed as a 1-in-x-year chance of regulatory insolvency.		Better in 30 to 50 years.
Economic capital adequacy		Nedbank adequately capitalised on an economic basis to its current international foreign currency target debt rating.		Measured by comparing available financial resources with economic capital requirement.		Equivalent rating of A- or better (including a 10% capital buffer).

In addition, a large variety of risk limits, triggers, ratios, mandates, targets and guidelines are in place for all the financial risks [eg credit, market and asset and liability management (ALM) risks]. One of these that Nedbank is currently in excess of is the credit loss ratio range of 0,55% to 0,85%, the ratio being 1,17% at 31 December 2008. Prudent provisioning for this is reflected in Nedbank’s credit impairments, details of which may be found here. We currently expect to remain outside the range in 2009 as well.

Qualitatively, risk appetite is also expressed in terms of policies, procedures, statements and controls to limit risks that may or may not be quantifiable.

• Nedbank has had a strong focus since the beginning of 2008 on strengthening capital ratios and liquidity, and selective asset growth as per its proactive response to the deepening international crisis. Details on the significantly strengthened capital and liquidity positions are provided here and here respectively.
  

In view of all of the above, it is believed that Nedbank’s capital levels (both regulatory capital and internal capital assessment, economic capital) and provisioning for credit impairments are appropriate and conservative, and that Nedbank Group, Nedbank Limited and other subsidiaries are strongly capitalised relative to their business activities, strategy, risk appetite and risk profile and the external environment in which they operate. Additionally, no excess capital is currently held for acquisitions.

NEDBANK’S SOUND FINANCIAL, RISK AND CAPITAL PROFILE

Further to Nedbank’s conservative risk appetite discussed above and the group’s strategy focused on the basics of banking, an overview of the salient features of the group’s sound financial, risk and capital profile is set out below.

• Profitability and successful turnaround of Nedbank

  • The profitability and successful turnaround of the group have, inter alia, resulted in a strong capital position and appropriately stationed it to weather the challenges prevailing in the current external environment. Sound financial performance continued in 2008, but with growth rates declining in line with expectations amid more difficult markets. Details on the group’s financial position are provided in this 2008 Nedbank Group Annual Report.

• Significant strengthening of capital levels and capital ratios through 2008

  • Basel I was in effect and relied on for the past 20 years, and Nedbank actual capital levels today remain well-above those that would have been required under Basel I. The impact of moving to Basel II in 2008 was a marginal decrease in Nedbank’s minimum regulatory capital requirements. However, qualifying capital and reserves decreased to a significant extent due to certain reserves no longer qualifying as regulatory capital in South Africa as discussed from here. These currently amount to approximately R1,6 billion at group level.
  • There is an excess of R9,5 billion (group) and R9,4 billion (Nedbank Limited) of total Basel II regulatory capital resources over the minimum capital requirements.
  • The group’s Basel II regulatory capital ratios are now well above the top end of our 2008 board-approved target ranges for Tier 1 and total capital adequacy. In line with general global expectations Nedbank has revised its target capital ratios range upward from 8% to 9% (Tier 1) and 11% to 12% (total), to 8,5% to 10% (Tier 1) and 11,5% to 13% (total). A target range has been introduced for core Tier 1 capital, namely 7,5% to 9%. In the current external environment the group’s objective is to move towards the top end of these new target ranges by the end of 2009. Refer here onwards for details on Nedbank’s capital ratios.
  • The group is satisfied with the composition of its Tier 1 capital as reflected here of the report, and its intention is to operate within the regulatory limits for non-core Tier 1 capital (ie perpetual preference shares and hybrid debt capital). It is recognised that, following the global financial crisis, much greater focus is now being given to the core Tier 1 and leverage ratios and Nedbank has responded to this. The actual core Tier 1 ratios are 8,2% (group) and 8,0% (Nedbank Limited) at 31 December 2008, and its group leverage ratio 16,2 times.
    
    The group’s dividend cover policy range remains at 2,25 to 2,75 times headline earnings per share.
    
    What has been pleasing, and reinforces the sentiment towards and reputation of Nedbank, has been the inaugural hybrid debt capital (non-core Tier 1) issue in South Africa by Nedbank. The total of R1,75 billion issued in 2008 in challenging market conditions not only represents another important milestone for Nedbank, but also demonstrates continued investor appetite for Nedbank paper.
  • At 31 December 2008 Basel II minimum regulatory capital requirements were higher by R6,0 billion (group) and R3,9 billion (Nedbank Limited) than internally determined economic capital requirements.
    
    Nedbank’s internally determined capital requirements (ie economic capital) are based on a sophisticated, best-practice framework and are comprehensively used across the group for capital allocation, performance measurement and remuneration, as well as risk-based pricing and client value management in the group’s business.
  • Nedbank’s internal capital assessment (ie economic capital) reflects a surplus of available financial resources over economic capital requirements of R9,6 billion (group) and R10,4 billion (Nedbank Limited) based on its target solvency standard (A- or 99,9% confidence level; currently same as Basel II), including a buffer of 10% applied to the economic capital minimum requirement.

• Worldclass risk and capital management frameworks are embedded groupwide

  • Strong risk and capital management is in place at Nedbank Group based on a best-practice ERMF and CMF, built on rigorous governance, challenge and debate.These frameworks are supported by a strong level of expert and experienced human resources, for which succession plans are in place. These are regularly monitored and updated.
    
    The principles of prudence and conservatism prevail in Nedbank’s frameworks and economic capital numbers. Basel II has even higher levels of conservatism, including for example downturn loss-given default (dLGD) credit risk parameters and the Pillar 2a addon (unique to South Africa), and does not recognise inter-risk diversification in the Pillar 1 minimum regulatory capital requirements.
  
  
  • Nedbank’s economic capital outcome and process are comprehensively in use across the group, including within businesses on a day-to-day basis, and in performance measurement and reward schemes that are now primarily based on economic profit, using risk-based economic capital allocation.
  • Nedbank Limited was granted approval, effective 1 January 2008, by SARB for use of the Advanced Internal Ratings-based (AIRB) approach for credit risk for the bank’s entire credit portfolio.
    
    Nedbank’s AIRB credit system forms the basis of its measurement and management of credit risk across the bank.The Group Credit Portfolio Management Unit in the Group Capital Management Division measures, manages and strives to optimise the group’s credit portfolios and credit concentration risk. For this purpose the group uses a tailored Credit Portfolio Model (CPM) run on KMV Portfolio Manager software.
    Nedbank’s credit economic capital (which comprises above 60% of total economic capital) is separately derived by integrating the key Basel II AIRB credit risk parameters with Nedbank’s sophisticated CPM.The CPM also takes credit portfolio concentrations and intrarisk diversifications into account.

    Nedbank is a well-diversified banking group in the context of South African markets, split across its four major business clusters.

    

    Nedbank’s top-20 individual exposure analysis, in particular the ‘percentage of total Nedbank Group credit economic capital by individual borrower’, indicates that it does not have undue single-name credit concentration risk. Nedbank’s CPM model incorporates the asset size of obligors/borrowers into its measurement and calculation of credit economic capital. In the group’s stress and scenario testing, and arriving at conclusions on the adequacy of capital buffers, stress testing of single-name large exposures and their potential impact on capital ratios are also included.

    Geographically, almost all credit exposures of the group originate in South Africa (non-South African exposure is approximately 6%). This geographical and industry concentration risk is also built into Nedbank’s CPM.
  • The group’s internal risk and capital assessments are complemented by a comprehensive and sophisticated stress and scenario-testing process.
  • Nedbank has made a significant investment (in excess of R350 million in external costs alone over the past four years) in its journey to worldclass risk management to implement best-practice economic capital modelling and the ICAAP, and scores highly in the ‘use test’ across the group, which demonstrates Nedbank’s significant commitment toWorldclass Risk Management and a belief in its economic capital numbers.

• Comprehensive business planning integrated with active capital management driven off internal capital generation across a well-diversified banking group

  • The group’s financial performance is characterised by diversified, sound and stable capital generation. Most of the group’s headline earnings are generated by business portfolios servicing traditional wholesale and retail banking, and specialised finance.
  • Current expected (base case) three-year projections to 31 December 2011 reflect further strengthening of capital adequacy and are in line with the revised target regulatory capital ranges at both group and bank level, both internal economic capital adequacy and regulatory capital.
  • The quality and diversification of Nedbank’s capital base is sound, as reflected by its Tier 1 and Tier 2 composition.This includes the replacement over the previous two years of the concentrated NED1 (R2 billion) and NED2 (R4 billion) subordinated debt with a smooth, well-diversified maturity profile with eight subdebt issues totalling R7 billion and their maturity relatively evenly spread over seven years from 2011 to 2017.
  • A sound capital management and capital planning process is applied continuously, in which procyclicality and stressed scenarios are comprehensively addressed, confirming the adequacy of the group’s target (and actual) regulatory capital ratios and economic capital buffer levels.
  • The group is not currently holding any excess capital for acquisitions. It is currently focused on growing organically, mainly within southern Africa, and concentrates on small but consistent market share gains based on value (ie strong economic profit focus) rather than volume.

• Comprehensive stress and scenario testing is used to stress Nedbank’s base case projections, and so assess and conclude upon the adequacy of its capital buffers and target capital ratios

  • Nedbank’s strategic planning process, rolling forecasts and integrated capital planning include three-year projections of expected (base case) financial performance, Basel II and economic capital requirements, which are compared with projected available capital resources and risk appetite metrics. The three-year projections and base case capital planning are derived from the group’s three-year business plans that are updated quarterly during the year and revised on a full bottomup basis annually.
  • The main objective of the group’s stress testing is to assess the effect of possible unexpected events on its base case projections, including its capital requirements, resources and adequacy of capital buffers for both regulatory and economic capital. In addition, stress testing is an important tool for analysing Nedbank’s risk profile and risk appetite.

• Various contingency options exist should the need arise

  • Further tightening of credit limits and/or active management of asset growth, using Nedbank’s risk-based economic capital allocation to its businesses and ‘manage for value’ (economic profit lens) approach to achieve this optimally.
  • Capacity to raise capital externally if required, despite the current market turmoil, as evidenced by Nedbank’s R1,75 billion hybrid-capital issues to 31 December 2008.
  • A strong, well-capitalised parent company, Old Mutual Life Assurance Company (SA) Limited.

CONCLUDING COMMENTS

Nedbank recognises that to become ‘worldclass at managing risk’ is a journey, not a destination. It is believed that good progress has been made over the past five years and that the group’s risk and capital management including ICAAP generally align closely with best practice internationally. This has accordingly positioned the group well to be resilient through the current global financial crisis. Nevertheless, Nedbank is continuously enhancing its risk and capital management processes and systems and remains firm in this endeavour.

In the group’s proactive response to the deepening global crisis, although it has had a much reduced impact on South Africa and Nedbank, there has been a strong focus since the beginning of 2008 on strengthening its capital ratios and liquidity position, and selective asset growth based on economic profit (using its ‘manage for value’ philosophy).

In view of all of the above, and cognisant of the risks and ongoing volatility inherent in global financial markets, the board of directors and executive management believe that capital levels, both regulatory capital and our internal capital assessment (ie economic capital) and provisioning for credit impairments are appropriate and conservative, and that Nedbank Group, Nedbank Limited and the other subsidiaries are strongly capitalised relative to their business activities, strategy, risk appetite, risk profile and the external environment in which they operate. Additionally, no excess capital is held for acquisitions.

The board of directors is also satisfied with the overall effectiveness of the processes relating to corporate governance, internal controls, risk management, capital management and capital adequacy.