SA banking system and financial system

continues to remain structurally sound, liquid and strongly capitalised

• Financial soundness of banking system improved from 15th to 6th place in World Economic Forum Global Competitiveness Report.
   

Capital adequacy

increased significantly again in 2009

Regulatory capital

• Core Tier 1 – from 7,2% (2007) to 8,2% (2008) to 9,9% (2009).
  
• Tier 1 – from 8,2% (2007) to 9,6% (2008) to 11,5% (2009).
• Total – from 11,4% (2007) to 12,4% (2008) to 14,9% (2009).

Economic capital

• In 2009 the group’s internal target solvency standard increased from A- (99,9%) to A (99,93%) while a more conservative definition of available financial resources (AFR), which covers the economic capital requirements, was also introduced.
• AFR surplus (after 10% capital buffer)
  • increased from R9,6 billion (2008) to R16,1 billion (2009), based on the old basis; and
  • amounts to R11,8 billion (2009), based on the new, more conservative basis.

Leverage ratio

• Low at 14,4 times (2008: 16,2 times), compared with international levels.

Stress and scenario testing

• Best-practice framework and process followed to confirm the robustness of the group’s capital adequacy and to assist in derisking the bank in appropriate segments ahead of the global financial crisis.
   

Liquidity

remains sound

• Lengthened funding profile, including successful R5,4 billion senior-debt issue in September 2009.
  
• Strengthened liquidity buffers.
  
• Well-diversified funding mix (ie retail vs wholesale deposit reliance).
  
• Strong deposit franchise (across Retail, Business Banking and Corporate Banking businesses).
  
• Low reliance on interbank, foreign and capital markets.
  
  

Risk and capital management systems

prove consistently effective

• Enterprisewide Risk Management Framework (ERMF) and Capital Management Framework remain effective and well-embedded across the group.
  
• Sound risk governance prevails.
  
• Prudent risk appetite followed.
  
• Risk-based remuneration practices applied since 2008.
  
• With the exception of the retail asset classes where impairments remain challenging, wholesale credit asset classes remained within target credit loss ratios throughout the global financial crisis and local recession.
  
  

Global regulatory developments

comprehensive response to global financial crisis is in progress

• Significant new international regulatory requirements and proposals (‘Basel III’) related to capital, liquidity, risk management and accounting provisioning, aimed at a more resilient global banking sector, are currently due for implementation end 2012.
  
• Comprehensive quantitative impact study and finalisation of the proposals are due end 2010.
  
• Impact of the liquidity proposals would be pervasive if implemented as is, but we anticipate modifications and changes appropriate for South Africa and its various structural issues.
  
• Impact on capital and all other proposals for Nedbank Group are initially anticipated to be moderate, not significant.
  
  

Balance sheet management

a new balance sheet management cluster was established in 2009

 

Background

In 2009 the local banking industry continued to experience a tough and volatile year as a result of the impact of the ongoing global recession, combined with cyclical credit stresses in the domestic economy. In response to the global financial crisis, during 2009 Nedbank continued its focus on proactive risk management and strengthening of capital ratios as well as further diversifying the funding base, lengthening the funding profile and increasing liquidity buffers. Although underlying conditions in the banking industry are expected to remain challenging for 2010, the SA economy is expected to grow by around 2,2%, which should translate into a better year for banking.

The landscape of banking is changing rapidly following the global financial crisis and the significant international regulatory response that is underway. Much of this change relates to and impacts the measurement and management of risk, the balance sheet (in particular, capital and liquidity) and financial performance, as well as the associated remuneration practices of banks.

South Africa’s banking industry has remained structurally sound and weathered the global financial crisis and local recession extremely well due to factors that include:

• Sound and proactive regulation of financial services, especially in the banking sector.
• Strong risk and capital management in the SA banking industry.
• Basel II being successfully implemented and embraced in South Africa.
• The National Credit Act being successfully implemented in South Africa to help minimise irresponsible lending practices, overgearing and excessive consumer debt.
• Fiscal authorities in South Africa never allowing interest rates to fall as low and for as long as in the United States, where this resulted in excessive borrowing and untenable levels of household debt. South Africa has not had negative real interest rates.
• Exchange controls preventing large flows of funds from local institutions out of the country.
• Rand liquidity remaining stable, with the interbank market operating normally.
• The' originate and sell’ business model and complex credit derivatives, which resulted in excessive leverage in some foreign banks, not being implemented and used in South Africa to the same extent.
• Lessons learned from the 2002/3 SA banking crisis.

In South Africa our banking regulator has consistently been effective, and this has played a significant role in preventing any local fallout from the global financial crisis. However, South Africa does operate in a globally regulated market and the significant response to the crisis by international regulators, in particular the Basel Committee on Banking Supervision (Basel Committee), will have an effect on the local banking industry.

Nedbank Group anticipates that the impact on the group of the proposed international regulatory changes will be moderate rather than pervasive, with one potential exception (see below). This view is substantiated by the sound positioning of the SA banking industry throughout the global financial crisis, successful Basel II implementation in 2008 and, in particular, Nedbank Group’s prudent risk appetite, sound governance and strong risk culture, which is evidence of Nedbank Group’s ‘business benefits’-based approach to the implementation of Basel II, where our emphasis was not only to comply with Basel II, but also to elevate the group’s risk, capital and balance sheet management to best-practice standards.

The possible exception to the moderate impact discussed above will be the new international regulatory liquidity proposals for which the impact would be pervasive if implemented as they stand, but we anticipate modifications and changes appropriate for South Africa and its various structural issues. SA banks are well-funded and liquid, and remained so throughout the global financial crisis mainly due to the sound, small and closed nature of the local funding system.

The new Group Executive Committee structure, which was completed in January 2010, also includes the creation of a specialist Balance Sheet Management cluster. This recognises the importance of managing risk on a portfolio basis and integrating the management of risk with liquidity and funding, capital management, shareholder value-add optimisation and reward practices. The creation of this new cluster is also acknowledgement that portfolio optimisation is an essential component of optimising the financial returns and long-term sustainability of the group.

Regulation 43 of the 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 is fully committed to regulation 43.

The requirements of regulation 43 are aligned with International Financial Reporting Standards but significantly extend the public disclosure requirements. This extension of disclosure is embodied in what is commonly known as ‘Pillar 3’ of the Basel II Accord.

A copy of the unabridged Pillar 3 Report may be found on the group’s website at www.nedbankgroup.co.za.

Global regulatory developments and the changing landscape of banking

The measures taken by the Basel Committee in July 2009 to strengthen the international Basel II framework, as well as the far-reaching proposals released in December 2009, are the committee’s comprehensive response, under the mandate of the group of 20 leading economies, to address the lessons of the global financial crisis.

The Basel Committee’s proposals aim to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the reform package is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

Through its reform package the Basel Committee also aims to improve risk management and governance as well as strengthen banks’ transparency and disclosures. Moreover, the reform package also includes the committee’s efforts to strengthen the resolution of systemically significant crossborder banks and the financial regulatory system.

The new Basel requirements and proposals are discussed in more detail below.

The first response package was released in July 2009 and included improvements to Basel II’s Pillars 1, 2 and 3.

• Enhancements to Pillar 1
  • Securitisation (implementation end 2009).
  • Market trading risk (implementation end 2010).
• Enhancements to Pillar 2 Internal Capital Adequacy Assessment Process (ICAAP) (implementation July 2009)
  • Bankwide governance and risk management.
  • Principles for sound liquidity risk management.
  • Principles for risk concentrations.
  • Sound remuneration practices (risk-based).
  • Valuation and liquidity risks of financial instrument fair-value practices.
  • Principles for sound stress-testing practices.
  • Off-balance-sheet exposures and securitisation activities.
  • Reputational risk and implicit support.
• Enhancements to Pillar 3 (public disclosure/market discipline)
  • Securitisation exposures (implementation end 2009).

The second response package, which includes only proposals at this stage, was released in December 2009. The objectives of the proposals in this package are as follows:

• Raising the quality, consistency and transparency of the capital base, while also harmonising the other elements of a bank’s capital structure.
• Strengthening risk coverage.
  
  In addition to the trading book and securitisation reforms announced in July 2009, the new proposals include strengthening of the capital requirements for counterparty credit risk exposures arising from derivatives, repurchase agreements (repos) and securities financing activities. The strengthened counterparty credit risk capital requirements will also increase incentives to move over-the-counter derivative exposures to central counterparties and exchanges, and generally improve counterparty credit risk management. The interconnectivity of large financial institutions is also a key focus area as reflected by, for example, introducing a multiplier (1,25) to the asset value correlation for these exposures held by banks.
  
• Introducing a leverage ratio as a supplementary measure to the Basel II risk-based framework.
  
  The leverage ratio will help contain the buildup of excessive leverage in the banking system. To ensure comparability the details of the leverage ratio will be harmonised internationally, fully adjusting for any remaining differences in accounting.
• Reducing procyclicality and promoting countercyclical capital buffers
  
  The key objectives are:
  
  • Dampen any excess cyclicality of the minimum capital requirement.
  • Promote more forward-looking credit provisions based on ‘expected losses’, rather than the current ‘incurred loss’ provisioning model under the International Financial Reporting Standards.
  • Conserve capital to build buffers that can be used in stress by the introduction of a framework linking the amount of earnings a bank is allowed to distribute to shareholders to the bank’s capital ratios.
  • Protect the banking sector from periods of excess credit growth by requiring banks further to increase capital buffers available when selected macroeconomic indicators suggest that credit volumes have grown excessively.
• Introducing a global liquidity framework.
  
  This would consist of a stressed liquidity coverage ratio, a longer-term structural stable funding ratio and a common set of monitoring metrics to assist in identifying and analysing liquidity risk trends. These complement the Basel Committee’s‘ Principles for sound liquidity risk management and supervision’ issued in September 2008.
• Addressing systemic risk and banks’ interconnectedness.

More specific proposals are expected to be developed in the first half of 2010.

The Basel Committee is mindful of the need to introduce these measures in a manner that raises the resilience of the global banking sector over the longer term, while avoiding negative effects on bank lending activity that could impair the economic recovery. To this end the committee is initiating a comprehensive impact assessment of the capital and liquidity standard proposals and has highlighted that ‘decisions on the final proposals and their calibration will be made only after a thorough analysis of the impact assessment and the comments received on the consultative documents. The committee will ensure that implementation of the new standards is consistent with financial market stability and sustainable economic growth’.

The key timelines are as follows:

• Consultation period for the December 2009 proposals until 16 April 2010.
  
• Undertaking of a comprehensive impact assessment during the first half of 2010.
  
• Development of a fully calibrated set of standards by end 2010.
  
• Targeted implementation by end 2012 (including phase-in measures and grandfathering arrangements beyond 2012).
  

The complexity of the Basel Committee’s proposals, the risks of unintended consequences and the interaction between these and other developments place a strong burden on the banking industry to assess the impacts carefully and ensure that the right balance is achieved between risk management and economic wellbeing.

In conclusion, most of these new developments are still at the proposal stage and changes are expected following the quantitative impact study, calibrations and consultative process. The exact impact remains uncertain, however, and the issue is not ‘if’, but ‘how much?’.

Impact of the international regulatory developments on Nedbank Group

Nedbank Group is supportive of the recent international regulatory developments. While some details and clarity are still sought and refinement needed before they are finalised, the principles behind most of the proposals are appropriate, prudent and necessary.

The proposed changes will have an impact on the SA banking industry, although this will only come into effect after a minimum of three years following finalisation by the Basel Committee, as discussed above, and after the SA Reserve Bank (SARB) has determined exactly what will be adopted and/or modified as appropriate for the SA banking industry.

At this early stage Nedbank Group’s expectation is that the impact of these proposals will be moderate, both on implementation requirements, strategy and financial performance returns, with the possible exception of the liquidity proposals.

In summary, our reasons for this view are as follows:

• South Africa fully embraced its Basel II implementation successfully completed two years ago, which involved a very strong collaborative approach among the regulator (SARB) and the banking industry.
  
  Nedbank Group’s approach since 2004, which at all times embraced the true spirit of Basel II, involved implementing, inter alia, best-practice enterprisewide risk management across the group. We have invested significantly in advanced risk and capital management capabilities, as well as human resources and systems, and transformed these using our comprehensive Basel II programme as the main catalyst. Additionally, we launched the SMART Programme in H1 2009 to respond proactively to the global financial crisis.
  
  Many of the global issues around poor risk, capital and balance sheet management were a matter of implementation, governance and risk cultures, and risk management lessons that needed relearning. A significant portion of the new Basel proposals are about enforcing what was already required and/or expected, albeit in principles that are now more detailed and specific. The new proposals comprehensively formalise these requirements and therefore reduce opportunities for regulatory arbitrage. It’s mostly the environment in which banks operate that has changed materially.
• As far as the proposed new capital requirements are concerned, SA banks’ regulatory capital rules are already considerably more conservative than the Basel II international rules. The Tier 1 minimum ratio is 7% in South Africa, compared with 4% in Basel II, while the coreTier 1 minimum at 5,25% is more than double the minimum 2% of Basel II. In addition, all the major SA banks are currently operating at capital ratios significantly above the minimum regulatory ratios required in South Africa.
  
  All the major SA banks have also completed comprehensive ICAAPs in both 2008 and 2009. These are required to be signed off by the board of directors of each bank and then be subjected to a supervisory review and evaluation process by SARB.
  
  In view of the above we do not foresee a change for SA banks in the minimum capital requirements.
  
  The new Basel proposals have, however, significantly increased the focus on, and quality of, core Tier 1 capital (with ordinary shareholders’ equity and retained earnings by far the predominant form of Tier 1 capital).
  
  In view of Nedbank Group’s significantly strengthened capital ratios over the past two years to levels well beyond our target regulatory capital ratios and expected further strengthening over our current 2010 – 2012 business plan as a result of our ongoing Risk-weighted Asset Capital Optimisation Programme, SMART Programme, managing for value strategic focus area and internal generation of capital from projected retained earnings, Nedbank Group does not anticipate the need to raise additional capital in response to these global developments, notwithstanding the list of additional regulatory deductions being proposed.
  
  The global financial 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 and that 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 than the one-size-fits-all approach among all banks that Basel I engendered. The Basel Committee confirmed this again in 2009.

• Concerning the finalised (ie July 2009) and proposed (ie December 2009) new risk coverage requirements, Nedbank Group’s trading book is small in relation to its total bank operations, securitisation exposure/activities are low and counterparty credit risk, including repurchase transactions and securities financing, is mostly restricted to low-risk, non-complex transactions, with credit derivatives activities restricted to single-name trades of SA exposures and biased towards providing risk mitigation. We therefore do not envisage a significant overall increase in minimum capital requirements related to these new requirements and proposals.
  
• With regard to the proposed new leverage ratio, at 14,4 times, excluding off-balance-sheet exposure (2008: 16,2 times), this requirement will not be an issue of concern for Nedbank Group. The risk appetite target approved by the board of directors is 18 times, well below the international average.
  
• With reference to the procyclicality and countercyclical capital framework proposals, the intended dampening of procyclicality via potentially more conservative through-the-cycle or downturn probabilities of default (the regulations already require the use of downturn loss given defaults) used in the Internal Ratings-based Credit Approach may have a marginal impact on Nedbank Group’s minimum credit capital requirements.
  
  Nedbank Group agrees with the objectives of the November 2009 exposure draft (ED) released by the International Accounting Standards Board on the proposed move to an ‘expected loss’ approach to credit provisioning rather than the current ‘incurred loss’ model. However, much still needs to be worked out in this ED over the consultative period, such as whether it in fact would adequately reduce procyclicality, as well as the practicality of the implementation of the ED. At this stage it is too early to comment on the expected impact of the ED.
  
  The other capital conservation and capital buffer proposals generally align with current Nedbank Group practices and our target capital ratios that are validated by the group’s ICAAP and extensive stress and scenario testing.
• As far as the new liquidity risk proposals are concerned, while our liquidity risk management aligns closely with best practice, the proposed new Basel liquidity ratios as they stand are a potential pervasive issue for the SA banking industry, as the local industry, compared with other first-world countries, has certain structural differences. These include, by way of example:
  
  • South Africa not being aligned with other jurisdictions in terms of deposit insurance schemes.
  • SA savings levels being low partly due to the lack of a large middle class, which typically generates significant pools of stable retail deposits.
  • SA banks having been disintermediated by money market funds, which account for nearly a third of total funding. This has resulted in more expensive funding (due to the wholesale nature) as well as a shorter liquidity profile.
  • Almost 90% of assets being corporate and mortgage loans, which typically have a long duration.
  • Small and less liquid local capital markets limiting the SA banks’ ability to bolster liquidity buffers and/or lengthen their funding profiles.
  
  It is also important to recognise various positive structural differences between the SA and international financial markets that are currently not taken into account in the new Basel proposals. SARB may well consider adapting the new proposals to meet SA requirements.
  
  Some items that may be considered in modifying the proposals include:
  
  • Changes to some definitions (eg apply look-through principle to money market funding and classify as retail).
  • Lengthening the implementation period to make compliance practically achievable for the SA banks and importantly also to allow SARB adequate time to interact with government and the National Treasury to address some of the structural issues.
    
  • Reducing the minimum target ratio; maintaining global comparability of calculations, but modifying for South Africa’s structural issues.
    
  • Adjusting for South Africa not being aligned with other jurisdictions in terms of deposit insurance schemes.
    
  • Clarifying whether cash reserves and liquid assets will be allowed to qualify as part of the stock of highly liquid assets. Currently only 25% of liquid assets and 0% of cash reserves qualify (the Basel paper suggests that 100% of sovereign paper and 100% of cash reserves could qualify).
    
  • The closed nature of SA money markets, mainly resulting from exchange controls, which means that rands are more ‘sticky’ for SA banks in the rand system than for euro- or dollar-denominated banks in their respective systems that are more open.
    
  • SA asset managers having four large banks for depositing funds. In Europe and the United States there are significantly more major banks for depositing funds, meaning wholesale funding is less ‘sticky’ compared with South Africa.
    
  • Given that liquidity risk is a consequential risk, legislation such as the National Credit Act (NCA) reduces systemic risk and so the need for oversized liquidity buffers. Many developed economies do not have the safety net of NCA-type legislation yet.
    
    These are some of the SA structural issues that we anticipate are likely to be addressed collectively by government, SARB and the financial services industry for SA banks practically to align with the proposed liquidity ratios.
• On the banking industry systemic risk proposals, further work is ongoing on the proposals by the Basel Committee, but in South Africa a unique Pillar 2(a) 1,5% and Pillar 2(b) add-on, additional to the minimum Basel II 8% ratio requirement, are already in place.

As regards the emphasis on risk-based remuneration practices, Nedbank Group is positioned very well and has only a few minor gaps to close given our risk-based approach already implemented in recent years see the Remuneration Report .

In summary Nedbank Group recognises that to become worldclass at managing risk is a journey, not a destination. We believe we have made excellent progress over the past five years and that overall our risk, capital and balance sheet management, and ICAAP, align closely with best practice. This positioned the group to be resilient through the global financial crisis and local economic recession. However, there is always room for improvement, and as the bar has been raised with the new international regulatory proposals, we will continue with our endeavours strongly focused on continuously enhancing the group’s risk, capital and balance sheet management processes and systems.

Key internal developments in 2009

The following is a summary of key enhancements made to Nedbank Group’s Internal Capital Adequacy Assessment Process (ICAAP) during 2009:

• Significantly strengthened capital adequacy ratios, on the back of our Risk-weighted Asset Capital Optimisation Programme, and set higher target capital adequacy ratio ranges.
• Significantly strengthened liquidity buffers and lengthened the funding profile, including the successful R5,4 billion senior-debt issue in September 2009.
• Introduced more conservatism into the group’s economic capital framework that is used for ICAAP:

  –	Increased the target debt solvency standard from A-(99,9%) (the same as Basel II) to A (99,93%). This aligns with the targeted standard of our parent company, Old Mutual plc.
  –	Refined the definition of 'available financial resources’ to cover the economic capital requirements.
  		The ‘50% of next year’s earnings’ are no longer included (even though business risk economic capital is still included).
  		A Tier A and Tier B category were created, with Tier A to cover at least the minimum economic capital requirements at the new, more conservative A rating.
  		Definitions Tier A = core Tier 1 regulatory capital and qualifying reserves* Tier B = perpetual preference shares and hybrid debt capital (* In ‘qualifying reserves’ we now include a share-based payments reserve, foreign currency translation reserve and available-for-sale reserve, as we believe this to be correct and appropriate for economic capital calculations. These are currently excluded for regulatory capital purposes.)

• Elevated stress and scenario testing to yet a new height in line with new best practice developing over the past year on the back of the global financial crisis.
  
• Appointed a head for the newly established Group Data Management Office to champion groupwide data governance and data quality, following the launch of the Group Data Project.
  
• Further embedded our economic profit and managing for value approaches in the 2010 – 2012 updated business plans and day-to-day operational management. Completed the second full year of using economic profit driven off risk-based economic capital allocation to determine bonuses (short-term incentives) across the group’s businesses.
• Delivered comprehensive, best-practice Pillar 3 public disclosure reports and were awarded two prizes at the annual Investment Analysts Society (IAS) Reporting and Communication Awards. The IAS is the society that most of the SA buy- and sell-side analysts and fund managers belong to, and their 2 000 members vote on the awards. The awards cover the 2008 year and are these analysts’ view on the investor reporting Nedbank Group disclosed last year.
  
  Our awards were:
  
  • Award for best reporting and communication.
  • Overall Best Reporting and Communication Award, which is the main award (all the winners in each JSE Limited category competed).
• Enhanced and cascaded the group-level risk appetite metrics down to business clusters (see here).
• Completed, with the assistance of international consultants, ‘deep dives’ into the potential risks inherent in:
  • Commercial real estate portfolio (Property Finance).
  • Mortgage/home loans portfolio (Nedbank Retail).
  • Specialised lending portfolio (Nedbank Capital).
  • Motor vehicle finance (Nedbank Retail and Imperial Bank).
• Enhanced the incorporation of risk in the group’s three-year business planning process for the 2010 – 2012 period via a more formal and comprehensive requirement for each major business to produce a risk strategy component, integrated with their business strategy. This is in addition to the group-level risk and capital strategy document produced.
• Addressed the Basel Committee’s first response package to the G20’s eight-point plan released in January 2009, following the meeting in November 2008, benchmarking these points against Nedbank Group’s current practice and incorporating any gaps into the SMART Programme.
• Despite the difficult international markets, successfully raised Tier 2 subordinated debt in March 2009 in the amount of US$100 million and at acceptable pricing levels (London Interbank Offered Rate + 150 basis points).
• Implementation of new Quantitative Risk Management software for our asset and liability management process is progressing well and is due for completion in early 2010.
• Ongoing refinement and enhancement of Nedbank Group’s Advanced Internal Ratings-based credit system and related credit modelling.
• And finally, after having invested significantly in a worldclass Basel II risk and capital management environment, we embarked on our programme of managing for value to extract significant value for the group from this investment, while ensuring that we continue to improve the underlying data that drives financial and non-financial information. This initiative has further been supported by the implementation of an enhanced financial reporting architecture, which has improved our target-setting processes, financial management activities and external reporting capabilities.

In addition there are a number of economic capital allocation methodology enhancements that will be implemented for 2010, which are expected to have a significant impact on the allocation of capital across the group’s business clusters. The impact of the changes by business cluster will be disclosed with the 30 June 2010 results. The following is a summary of the key enhancements being implemented for 2010:

• Full alignment of the group’s actual book capital with the aggregate amount allocated to the various business clusters using bottomup economic capital.
  
• Updating of the credit portfolio modelling correlations and credit economic capital allocation methodology taking into account recent global developments (including downturn years) and the new regulatory thinking in line with the new Basel III proposals discussed earlier.
  
• Measurement of operational risk for economic capital purposes using the Advanced Measurement Approach instead of the Standardised Approach. We submitted our application to use this approach to the SA Reserve Bank in January 2010 and await its feedback.

Risk appetite

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

We measure and express risk appetite qualitatively and in terms of quantitative risk metrics. The quantitative metrics include earnings at risk (or earnings volatility) and, related to this, the chance of regulatory insolvency, chance of experiencing a loss and economic capital adequacy. These comprise our group-level risk appetite metrics. 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 risks).

In 2009 we sought to enhance the consolidation, focus and reporting of the key financial risk appetite metrics, and the cascade from group level down to cluster, business unit and monoline level.

Accordingly we established an enhanced suite of base case [through-the-cycle (TTC)] risk appetite metrics and incorporated these within the 2010 – 2012 business plans at both group and business cluster levels (see here). Stressed (extreme event) risk appetite metrics, linked to our stress- and scenario-testing programme, will be finalised in H1 2010. 

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

• No direct exposure to US subprime credit assets nor associated credit derivative transactions.
• Conservative credit underwriting practices that have culminated in a high-quality well-collateralised wholesale book and further tightening of our retail book since 2007 in anticipation of the economic downturn and introduction of the National Credit Act.
• Reasonable credit concentration risk levels:
  • Large individual or single-name exposure risk is low. Refer here for details.
  • Geographic exposure risk is high (refer here for highlights that 94% of the group’s loans and advances originate in South Africa), but in reality this concentration has been positive for Nedbank Group, given the global 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 our property exposure appears high, but this is in line with our domestic peer group and most banks worldwide. As a result of this perceived risk, we undertook a more detailed analysis, assisted by international risk consultants, of our commercial property exposures.
    
    The conclusions and recommendations that resulted from this detailed analysis were:
     

    	Potential credit losses in a stressed scenario would remain within Nedbank Group’s risk appetite.
    	The portfolio is well-balanced, and higher risk loans are closely monitored.
    	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 our risk appetite over the past few years.
    	The commercial property portfolio is largely focused on developed properties with a track record of predictable cashflows from rentals over the medium term.

    Stemming from this detailed analysis were several useful benchmarks derived from the experience that international banks had, where we compare favourably.
    
    The analysis has been useful not only from the business perspective of shaping our commercial property loan origination and deal-pricing approach for the future, but also from the credit risk management perspective of providing us with additional relevant benchmarks against which to monitor our commercial property exposures and of highlighting risky exposures on which to focus increased risk management.

• Counterparty credit risk almost exclusively restricted to non-complex banking transactions. There is continued emphasis on the use of credit mitigation strategies, such as netting and collateralisation of exposures.
  
  Credit derivative activities have been restricted to single-name trades of SA exposures and biased towards providing risk mitigation. Refer here for further details on our relatively low counterparty credit risk exposure.
   
• A strong, well-diversified funding deposit base and a low reliance on offshore funding. Additionally, Nedbank Group’s reliance on its top 10 depositors is not unduly concentrated.
  
  Refer here for our analysis in support of this and our prudent liquidity risk management.

 
• Low level of securitisation exposure.
  
  Refer here  for summary detail on this exposure.
   
• Low leverage ratio (total assets to shareholders’ equity) of 14,4 times (16,2 times: 2008), which compares very favourably on an international benchmarking basis.
• Low risk of assets and liabilities exposed to the volatility of International Financial Reporting Standards fair-value mark-to-market accounting. ‘Consolidated statement of financial position – categories of financial instruments’ and ‘Consolidated statement of financial position banking/trading categorisation’ for details.
• Small market trading (proprietary) risk in relation to total bank operations (economic capital held is only 1,8% of total and is conservatively based on limits rather than utilisation, plus a 10% capital buffer). Although proprietary trading activities are small, they play an essential role in facilitating client trades.
  
  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 forex products.
  
  The overall performance of the trading business in 2009 was sound, an indication that the impacts from the credit crunch and difficult equity markets were successfully navigated, and our risk systems sound. In addition, over the past year Nedbank Capital proactively managed and reduced the risk pertaining to single-stock futures and contracts for difference, and the forfaiting business was closed with the existing exposure being managed over the maturity of the book.
  
  Refer here for more details.
   
• Low interest rate risk in the banking book, as reflected by the sensitivity analysis provided.
• Low equity (investment) risk, including private equity, exposure. The total equity risk exposure, including our private equity business, is R3,9 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.
   
• Immaterial assets non-core to the business of banking.
• Low foreign currency translation risk to the rand’s volatility, which is in line with Nedbank Group’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.
• Well-diversified subordinated debt and non-core Tier 1 profile. Despite the difficult international markets, Nedbank Group successfully raised Tier 2 subordinated debt in March 2009 in the amount of US$100 million and at acceptable pricing levels (ie LIBOR + 150 basis points).
• Comprehensive stress and scenario testing to confirm the adequacy and robustness of our capital ratios and accompanying capital buffers.

Risk appetite – enhanced suite of metrics finalised in 2009

	Group target (board-approved)
Credit risk profile
Credit loss ratio (%)	0,60% – 1,0%
Credit risk-weighted assets (RWA): Loans and advances (%)	52% – 58%
Credit property exposure: Loans and advances (%)	< 45%
Properties in possession (PIPs): Loans and advances (%)	< 0,1%
Average probability of default (PD) (%) – performing book (TTC)	< 3%
Average loss given default (LGD) (%) – performing book (TTC)	18% – 22%
Average expected loss (EL) (%) – performing book (TTC)	0,6% – 0,7%
Defaulted exposure of default (EAD): Total EAD (%)	< 2%
EAD: Exposure (%)	< 120%
Counterparty risk (derivatives) profile
Counterparty credit risk (CCR) EAD: Total EAD (%)	< 2%
CCR economic capital (Ecap): Total Ecap (%)	< 0,5%
Securitisation risk profile
Securitisation RWA: Total RWA (%)	< 0,4%
Trading market risk profile
Value at risk (99%, three-day)	< 127
Stress trigger (Rm)	< 846
Trading Ecap: Total Ecap (%)	< 3%
Equity (investment) risk profile
Exposure: Total assets	< 2%
Equity investment Ecap: Total Ecap (%)	< 7%
Asset and liability management (ALM) risk profile – liquidity
Short-term (0 to 31 days) funding: Total funding (%)	58% (tolerable deviation +5%)
Medium-term (32 to 180 days) funding: Total funding (%)	18% (tolerable deviation +7%)
Long-term (> 180 days) funding: Total funding (%)	24% (tolerable deviation -7%)
Contractual maturity mismatch (0 to 31 days): Total funding (%)	38% (tolerable deviation +5%)
Net interbank reliance: Total funding (%)	< 1,5% (tolerable deviation +1%)
ALM risk profile – interest rate risk in the banking book
Net interest income (NII) interest sensitivity: Equity (%)	< 2,5%
NII interest sensitivity: 12-month NII (%)	< 7,5%
NII interest sensitivity: Interest-earning assets (basis points)	< 25 bps
Economic value of equity: Equity (%)	< 5%
ALM risk profile – foreign currency translation risk
Currency equity/Total equity	< 5%
Group risk appetite metrics
Earnings at risk	< 100%
Chance of a loss (1 in x years)	> 10
Chance of regulatory insolvency (1 in x years)	> 50
Available financial resources: Ecap (A solvency target)	> 110%
Total RWA: Total assets (%)	55% – 57%
Leverage ratio	< 18 times
Group capital adequacy
Core Tier 1 (in current environment target above top end of range)	7,5% – 9%
Tier 1 (in current environment target above top end of range)	8,5% – 10%
Total (in current environment target above top end of range)	11,5% – 13%

Individual risk appetite targets, as relevant to the approved business activities, have been approved and cascaded down from group level for each business cluster, major business unit and the monolines in Nedbank Retail.

One of the risk appetite metrics that we are currently in excess of due to the retail asset classes and the current economic environment, and which is in line with our peer group, is the group’s target credit loss ratio range, details of which may be found here. We currently expect to remain outside the target range in 2010, but addressing this is a key component of the 2010 – 2012 business plans. The reversals of provisions in the balance sheet is expected to take longer as defaulted advances continue to increase, albeit at a slower rate. The group remains cautious about impairments.

In conclusion, Nedbank Group has a strong risk culture and a conservative risk appetite, which is well-formalised, managed and monitored on an ongoing basis, bearing the board’s ultimate approval and oversight.

Overview of the Internal Capital Adequacy Assessment Process

In line with the four key principles contained in Pillar 2 of Basel II, the SA regulations relating to banks set out in regulation 39 the Internal Capital Adequacy Assessment Process (ICAAP) requirements of banks and related Supervisory Review and Evaluation Process (SREP) requirements of the SA Reserve Bank (SARB). A summary of this is depicted below.

In addition, SARB have provided further guidance on the 12 ICAAP principles.

Click to enlarge

ICAAP is primarily concerned with Nedbank Group’s comprehensive approach, assessment, coverage and management of risk and capital from an internal perspective, that is over and above the minimum regulatory rules and capital requirements of Basel II.

ICAAPs have first been completed in South Africa in 2008, are approved by the board and then submitted to SARB for review.

Risk management

Summary of perspectives on Nedbank Group’s risk profile and risk strategy

The key highlights for 2009 are as follows:

• Risk management systems
  • Continuously proving effective.
  • Enterprisewide Risk Management Framework remains sound and well-embedded.
• Competition Commission inquiry into banks
  • Await National Treasury response to the commission’s recommendations.
• Group structure

  –	Board/Management structures
  		New board members, Chief Executive Officer, Group Executive Committee and business clusters’ Excos have been finalised.
  –	Management of Old Mutual/Nedbank Group strategy is ongoing.

• Risk appetite
  • Prudent risk appetite prevails.
  • In Retail, increased appetite for unsecured lending while secured, asset-backed lending now has a much stronger emphasis on managing for value.
• Profitability

  –	Resilient performance in challenging environment.
  –	Earnings volatility too high in secured lending businesses in Retail; being addressed.
  –	Wholesale risk profile remains sound.
  		Successful stress-testing strategy implemented in Business Banking in 2008.
  		Black economic empowerment (BEE) exposure contained and regularly stress-tested.
  –	Consistent, well-managed earnings growth in Nedbank Capital (the investment bank).
  –	Non-interest revenue subscale bankwide (and this impacts earnings volatility of group); key strategic focus area.

• Market risk

  –	Risk appetite remained largely unchanged over the past two years; low proprietary trading risk.
  –	Focused on the domestic market with a bias towards local interest rate and equity products.
  –	Risk appetite for complex equity derivatives significantly curtailed in 2007.
  –	Equity trading risk
  		Mainly in Nedbank Group’s securities companies.
  		Risk appetite and limits remain low.
  		Low exposure to illiquid instruments.
  –	Overall performance of the trading business has been sound.
  –	Proactively managed and reduced the risk pertaining to single-stock futures and contracts for difference, and closed the forfait book.
  –	Significant investment in risk management systems continues.

• Credit risk
  • Strong credit risk management framework.
  • Strengthening risk management in Retail.
  • Worsening group credit loss ratio from 1,17% (December 2008) to 1,47% (December 2009), on the back of retail impairments that remain challenging.
  • No large corporate defaults, but credit risk remains relatively high amid local recession.
  • Business Banking particularly resilient.
• Operational risk
  • Advanced Measurement Approach (AMA) application submitted to SA Reserve Bank in January 2010; to be adopted for economic capital in 2010.
• Imperial Bank
  • Nedbank has received section 37 approval from SARB for the acquisition of the minority shareholding in Imperial Bank, and its full integration into Nedbank Group will be a key focus in 2010.

Credit risk

Loans and advances and Basel II exposure
Demand for credit grew at historically low rates and retail impairments increased dramatically as consumers came under severe pressure from falling income, job losses, declining asset prices and record high debt burdens. By the end of 2009 growth in asset finance had slowed to 1,0% year-on-year. Interest rates were reduced by 450 basis points to cushion the effects of a rapidly slowing economy and increasing unemployment.

Corporate deman–credit initially held up but lost momentum due to weak global and local demand, which eroded corporate profits through weaker pricing power, lower commodity prices and a strong rand. Support came from construction projects and increased government spending, boosted primarily by the public sector’s infrastructure drive and preparations for the 2010 FIFA World Cup.

Net loans and advances after impairments are R450 billion, 3,7% up on the previous year. Gross loans and advances increased by 4,1% to R460 billion. The gross loans and advances by business cluster are as follows:

* These relate to eliminations passed through Central Management.

The 4,1% increase in gross loans and advances reflects:

• Ongoing growth in Nedbank Capital and Imperial Bank.
• Slower growth in Nedbank Corporate and Nedbank Retail.
• Reduced advances in Nedbank Business Banking due to a slowdown in client demand for credit and a reduction of single-product loans in line with the drive to reduce higher risk exposures and focus on primary clients.

Growth in advances took place across a number of products, including personal loans, mortgage loans, preference shares, deposits placed under reverse repurchase agreements and other loans, offset by an ongoing decrease in overnight loans.

The group has focused on selective asset growth while improving margins, resulting in banking advances growth and lower levels of advances in the trading portfolio. Details of advances growth by division are as follows:

Loans and advances by business cluster

Rm	% change	2009	2008
Nedbank Capital	16,0	55 315	47 686
Nedbank Corporate	0,7	137 173	136 222
Nedbank Business Banking	(9,4)	50 115	55 321
Nedbank Retail	4,9	157 500	150 107
Imperial Bank	12,8	50 451	44 734
Other	(>100,0)	(253)	163
Net loans and advances	3,7	450 301	434 233

Summary of loans and advances by product

Rm	% change	2009	2008
Home loans	4,1	149 229	143 342
Commercial mortgages	4,6	76 364	73 031
Properties in possession	12,1	887	791
Term loans	6,5	68 321	64 144
Credit cards	1,2	7 334	7 248
Overnight loans	(212,2)	12 420	15 760
Overdrafts	(11,0)	11 093	12 461
Other loans to clients	1,8	45 382	44 581
Leases and instalment sales	4,5	64 128	61 362
Preference shares and debentures	6,2	16 633	15 667
Trade and other bills	(73,8)	282	1 075
Reverse repurchase agreements	>100	8 026	2 630
Gross loans and advances	4,1	460 099	442 092
Impairment of loans and advances	24,7	(9 798)	(7 859)
Net loans and advances	3,7	450 301	434 233

Basel II on-balance-sheet exposure at December 2009 is R528,6 billion. The reconciliation of the Basel II exposure to the gross loans and advances of R460,1 billion is shown below.

Balance sheet credit exposure³ by Basel II asset class and business cluster

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AIRB Approach for Nedbank Limited
All credit exposure and asset classes in Nedbank Limited are covered by the Basel II AIRB Approach.

Summary of the AIRB Approach for Nedbank Limited**
Basel II credit exposures by business cluster and asset class

Click to enlarge

Impairments and defaulted loans and advances
Credit quality deteriorated further in 2009, with Nedbank Retail’s impairments worsening significantly, although the rate of deterioration of new defaults slowed in the second half, while the business banking and wholesale-banking impairments ended the year at better levels than originally anticipated. Although the SA economy emerged from recession in the third quarter of 2009 and has begun to recover, some segments of the economy are still under significant strain. In the short term the recovery is expected to be hampered by high unemployment and high household debt levels.

The group’s credit loss ratio of 1,47% for 2009 (2008: 1,17%) showed signs of improvement after peaking at 1,67% at 31 March 2009. Defaulted advances increased by 56,3% from R17 301 million to R27 045 million and total impairment provisions increased by 24,7% from R7 859 million to R9 798 million over the past year.

The impact of the credit cycle has to date largely impacted consumers and smaller businesses as reflected in the continued deterioration of retail credit loss ratios. High levels of unemployment, lower collateral values due to weak house and vehicle markets, and delays in recoveries resulting from debt counselling have all played a part in the increase in defaulted advances in retail secured loans. However, the 450 basis point interest rate cuts in 2009 have reduced the financial pressure on consumers, as reflected in a slightly slower rate at which retail impairments are increasing as well as the improvement in early-stage arrears for seven consecutive months during the year.

Wholesale banking has performed resiliently, even at the peak of the interest rate cycle, and credit loss ratios have improved since June 2009, remaining at better-than-anticipated levels for the current economic cycle. On the whole credit quality in the books of Capital, Corporate and Business Banking has remained within acceptable levels, although in this volatile economic environment the risk of corporate default remains high. Imperial Bank’s impairments improved during the second half of the year as reflected in its lower credit loss ratio of 1,97% (June 2009: 2,50%). This was largely due to the improvement in recoveries and accounts in arrears in Motor Finance Corporation (MFC). 

Management has maintained a strong focus on risk management and improving asset quality, particularly in retail home loans. In addition, increased attention has been given to improving the collection processes in Retail. In 2010 retail advances growth is expected to be flat to lower single digits, with wholesale advances growing at a similar rate to that of 2009.

Most of the group’s exposure to BEE and other loans and advances secured by shares continue to be within their default cover ratios. Loans and advances that are below these cover ratios continue to service their debts and are considered to have appropriate impairment provisions.

The tables on the following pages summarise Nedbank Group’s defaulted portfolio and the level of impairments. The policies, principles and definitions relating to the defaulted portfolio and impairments are well-articulated in the group’s credit policy. The key definitions relating to the following section are included below:

• Past due
  
  A loan or advance is considered past due when it exceeds its limit (fluctuating types of advances) or is in arrears (linear types of advances).
  
• Defaulted loans and advances
  
  Any advance or group of loans and advances that has triggered the Basel II definition of default criteria and which is in line with the revised SA banking regulations. For retail portfolios this is product-centric and therefore a default would be specific to a client or borrower account (a specific advance). For all other portfolios except project-based financing, it is client- or borrower-centric, meaning that, should any transaction within a borrowing group default, then all transactions within the borrowing group would be treated as defaulted.
  
  At a minimum a default is deemed to have occurred where, for example, a specific impairment is raised against a credit exposure due to a significant perceived decline in the credit quality, a material obligation is past due for more than 90 days or an obligor has exceeded an advised limit for more than 90 days.
• Impaired loans and advances
  
  Impaired loans and advances are defined as loans and advances in respect of which the bank has raised a specific impairment (International Accounting Standard 39 definition).
  
• Specific impairment
  
  A specific impairment is raised in respect of an asset that has triggered a loss event where the discounted collateral held against the advance is insufficient to cover the total expected losses. Such a loss event may be, for example, significant financial difficulty of the issuer or obligor, a breach of contract, such as a default or delinquency in interest or principal payments, with ageing arrears as the primary driver.
  
• Portfolio impairment
  
  The standard portfolio represents all the loans and advances that have not been impaired. These loans and advances have not yet individually evidenced a loss event, but loans and advances exist within the standard portfolio that may have an impairment without the bank yet being aware of it.
  
  A period of time will elapse between the occurrence of an impairment event and objective evidence of the impairment becoming evident. This period is generally known as the emergence period. For each standard portfolio an emergence period is estimated as well as the probability of the loss trigger and the loss given events occurring. These estimates are applied to the total exposures of the standard portfolio to calculate the portfolio impairment.

Summary of impairments, defaulted loans and advances and credit loss ratios

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	Nedbank
	Business	Nedbank	Nedbank	Nedbank	Imperial
%	Banking	Corporate	Capital	Retail	Bank	2009	2008
Impairments to gross loans and advances	2,38	0,80	0,69	3,61	2,30	2,13	1,78
Specific impairments	1,59	0,43	0,56	3,18	1,78	1,70	1,26
Portfolio impairments	0,79	0,37	0,13	0,43	0,52	0,43	0,52
Impairments charge as a % of net interest income	10,48	11,02	12,69	70,20	47,07	40,68	29,82
Credit loss ratio	0,52	0,24	0,26	3,08	1,97	1,47	1,17
Credit loss ratio – specific	0,82	0,29	0,22	3,17	1,93	1,54	1,09
Credit loss ratio – portfolio	(0,30)	(0,05)	0,04	(0,09)	0,04	(0,07)	0,08
Defaulted loans and advances to gross loans
and advances	5,45	2,19	1,41	11,51	3,14	5,88	3,91
Properties in possession to gross loans and
advances	0,02	–	–	0,54	–	0,19	0,18

As discussed previously, 2009 saw Nedbank Group enhance the consolidation, focus and reporting of key financial risk appetite metrics. Business-cluster-specific credit loss ratio targets were formalised for the first time in 2009, after taking into account historic, through-the-cycle, sustainable performance as well as desired risk appetite. In addition to this, the group’s credit loss ratio target was reviewed separately but in conjunction with the consolidated business cluster targets.

Following this, and integrated with the group’s 2010 – 2012 business plans, the targeted credit loss ratio was increased from 0,55% – 0,85% to 0,60% – 1,00%. The decision to increase the target range was largely due to the projected change in mix between secured and unsecured products in Retail. This will help to lessen the volatility of Retail’s financial performance, which is generally associated with the current concentration of secured lending in its portfolio, particularly residential mortgages. As the unsecured Retail products tend to have higher credit loss ratios, this results in an increase in Nedbank Group’s target credit loss ratio range.

Nedbank Group also intends to update its methodology for calculating the credit loss ratio in H1 2010, appropriately removing the trading assets from loans and advances. Impairments are not raised against trading assets as these are designated at fair value through profit or loss, and therefore any losses are realised through a decrease in non-interest revenue. This is not expected to have a material impact on Nedbank Group’s credit loss ratio.

Nedbank Group’s current credit loss ratio, at 1,47%, is outside the targeted credit loss ratio range of 0,6% – 1,0%, and addressing this is a key component of Retail’s 2010 – 2012 business plans. The reversals of provisions in the balance sheet is expected to take longer as defaulted advances continue to increase, albeit at a slower rate. The group remains cautious about impairments.

The business clusters credit loss ratios over time are also shown below.

 

Summary of impairments

Click to enlarge

Defaulted loans and advances increased by 56,3% to R27 045 million, while specific impairments increased to R7 830 million for the same period. This resulted in a decrease in the coverage ratio from 32,0% in 2008 to 29,0% in 2009 as shown below.

The coverage ratio is the amount of specific impairments that have been raised for the total defaulted loans and advances. This is effectively the inverse of the expected recoveries ratio. The expected recoveries are equal to the defaulted loans and advances less the specific impairments, as specific impairments are raised for any shortfall that would arise after all recoveries are taken into account.

The expected recoveries of defaulted loans and advances include recoveries as a result of liquidation of security or collateral, as well as recoveries as a result of a client curing or partial client repayments.

The absolute value of expected recoveries of defaulted accounts (which includes security values) will increase as the number of defaults increase. The expected recovery amount will in most instances be less than the total defaulted exposure, as it is seldom the case that 100% of the defaulted loan would be written off.

A decrease in the coverage ratio (or increase in the expected recoveries ratio) may arise as a result of the following:

• Expected recoveries improving due to higher recoveries being realised in the loss given default (LGD) calculation.
  
• A change in the defaulted product mix, with a greater percentage of products that have a higher security value (and therefore a lower specific impairment), such as secured products (home loans and commercial real estate).
  
• An increase in the collateral value, which is an input into the LGD calculation and would result in a decrease in the LGD
• A change in the mix of new versus older defaults as, in most products, the recoveries expected from defaulted clients decrease over time.
• A change in the writeoff policy, such as extending the period prior to writing off a deal that will result in a longer period in which recoveries can be realised.
  

The decrease in the group’s coverage ratio is due largely to the change in the defaulted-product mix arising from the high amount of residential mortgage defaults in Nedbank Retail, as well as a higher amount of commercial mortgage and development loan defaults in Nedbank Property Finance.

The total defaulted loans and advances increased by R9,7 billion from 2008 to 2009. Residential mortgages account for 61% of this increase. Defaulted residential mortgages contributed 57,6% to the total defaulted loans and advances in 2008 and this increased to 59,0% in 2009. Residential mortgages have lower coverage ratios than most other asset classes due to the high amount of security generally held and therefore higher expected recoveries.

Similarly, defaulted commercial mortgages and development loans increased by R2,6 billion from 2008 to 2009 and contributed 5,1% of the total defaulted loans and advances in 2008, increasing to 13,0% in 2009. The majority of the exposures that defaulted were fully secured and therefore specific impairments increased by only R216 million from 2008 to 2009.

Defaulted loans and advances and related security and impairments by business cluster and asset class

Click to enlarge

 

The coverage ratio and expected recovery ratio by business cluster and by product is shown in detail in the table below.

Summary of impairments and defaulted loans and advances

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Properties in possession

Rm	Nedbank Business Banking	Nedbank Corporate	Nedbank Capital	Nedbank Retail	Imperial Bank	Central Management	2009	2008
Balance at the beginning of the period	18	3		770			791	308
Disposal/Writedowns/ Revaluations	(13)	(1)		(566)			(580)	(76)
perties in possession acquired during the period	4			672			676	559
Balance at the end of the period	9	2	-	876	-	-	887	791
Unsold	3	2		560			565	655
Sold awaiting transfer	6			316			322	136

Credit concentration risk

Single-name credit concentration

Our top-20-exposure analysis, in particular the ‘percentage of total group credit economic capital’, confirms that Nedbank Group does not have undue single-name credit concentration risk. Nedbank Group’s credit concentration risk measurement incorporates the asset size of obligors/borrowers into its calculation of credit economic capital. Single-name concentration is monitored at all credit committees, which includes the applicable regulatory and economic capital per exposure.

Nedbank Group also conducts stress testing of single-name large exposures, and their potential impact on capital ratios, in our stress and scenario testing in assessing the capital adequacy buffers.

Top 20 Nedbank Group exposures (excluding banks and government exposure)

	Internal Nedbank
	Group Rating (NGR)
2009	(probability of	Exposure at default	% of total group
No	default) rating	Rm	credit economic capital
1	NGR04	4 871	0,02
2	NGR04	4 396	0,17
3	NGR03	3 896	0,02
4	NGR08	3 383	0,23
5	NGR04	3 148	0,10
6	NGR09	3 245	0,24
7	NGR03	3 125	0,02
8	NGR04	2 701	0,01
9	NGR16	2 646	0,35
10	NGR03	2 628	0,00
11	NGR04	2 389	0,02
12	NGR07	2 368	0,08
13	NGR03	2 293	0,01
14	NGR08	2 280	0,14
15	NGR15	2 258	0,64
16	NGR06	2 239	0,10
17	NGR10	2 119	0,05
18	NGR12	2 058	0,28
19	NGR14	2 042	0,59
20	NGR08	1 797	0,12
Total of top 20 exposures		55 882	3,19
Total group		597 411

 

Top 20 Nedbank Group exposures (banks)

	Internal NGR
2009	(probability of	Exposure at default	% of total group
No	default) rating	Rm	credit economic capital
1	NGR05	5 606	0,10
2	NGR05	3 868	0,07
3	NGR05	3 777	0,07
4	NGR05	1 872	0,07
5	NGR04	1 185	0,04
6	NGR05	1 005	0,04
7	NGR06	975	0,05
8	NGR05	917	0,04
9	NGR05	709	0,03
10	NGR05	629	0,02
11	NGR04	627	0,02
12	NGR06	607	0,03
13	NGR06	565	0,03
14	NGR06	556	0,03
15	NGR07	512	0,04
16	NGR07	512	0,04
17	NGR04	512	0,02
18	NGR08	506	0,05
19	NGR04	398	0,02
20	NGR04	392	0,02
Total of top 20 exposures		25 730	0,83
Total group		597 411

 

Geographic concentration risk

Geographically, almost all of Nedbank Group’s credit exposure originates in South Africa (non-SA exposure is approximately 6%).

Industry concentration risk

Our credit portfolio modelling combines the industry segmentation of the portfolio and, as part of its calculation of the credit economic capital, accounts for any sectoral concentration inherent in the portfolio.

We conclude that credit concentration risk is adequately measured, managed, controlled and ultimately apitalised. There is no undue single-name concentration. Nedbank Group is also a well-diversified banking group in the SA context, split across its five major business clusters.

Counterparty credit risk

Counterparty credit limits are set at an individual counterparty level and approved within the Group Credit Risk Management Framework. Counterparty credit exposures are reported and monitored at both a business unit and group level. To ensure that appropriate limits are allocated to large transactions, scenario analysis is performed within a specialised counterparty risk unit. Based on the outcome of such analysis, proposals regarding potential risk-mitigating structures are made prior to final limit approval. Limits for our Corporate and Business Banking businesses favour a nominal limit to facilitate monitoring. 

There is continued emphasis on the use of credit risk mitigation strategies, such as netting and collateralisation of exposures. Nedbank Group and its large bank counterparties have International Swaps and Derivatives Association (ISDA) and International Securities Market Association (ISMA) master agreements as well as credit support (collateral) agreements in place to support bilateral margining of exposures. Limits and appropriate collateral are determined on a risk-centred basis.

Netting is applied only to underlying exposures where supportive legal opinion is obtained as to the enforceability of the relevant netting agreement in the particular jurisdiction. Margining and collateral arrangements are entered into in order to mitigate counterparty credit risk. Haircuts, appropriate for the specific collateral type, are applied to determine collateral value. Margining agreements are pursued with interbank trading counterparties on a proactive basis. Margining thresholds constitute unsecured exposure to the counterparty and are assessed as such. To deal with a potential deterioration of counterparty credit risk over the life of transactions thresholds are typically linked to the counterparty external credit rating.

Nedbank Group applies the Basel II Current Exposure Method (CEM) for counterparty credit risk. Economic capital calculations also currently utilise the Basel II CEM results as input in the determination of credit economic capital.

Over-the-counter (OTC) derivatives for Nedbank Limited and London branch

OTC derivative products

Rm	Notional value	2009 Gross positive fair value	Notional value	2008 Gross positive fair value
Credit default swaps	2 272	8	2 104	2
Equities		1 155	4 497	778
Forex and gold	189 601	6 437	215 724	14 807
Interest rates	358 738	5 470	324 480	8 598
Other commodities	45	302	13	599
Precious metals except gold	2	56	4	36
Total	550 658	13 428	546 822	24 820

OTC derivative products

Rm	Gross positive fair value	Current netting benefits	Netted current credit exposure (pre- mitigation)	Collateral amount	Netted current credit exposure (post- mitigation)	Exposure -at- default value	Risk-weighted exposure
2009	13 428	7 028	6 963	779	6 443	9 566	3 018
2008	24 820	13 272	10 581	1 796	8 996	12 861	3 138

OTC derivatives per NGR (probability of default) band

		2009			2008
	Notional	Gross positive	Exposure-at-	Notional	Gross positive	Exposure-at-
	value	fair value	default value	value	fair value	default value
	16 774	718	922	12 741	241	236
NGR 04	76 202	1 377	1 735	187 234	8 198	2 187
NGR 05	217 937	4 792	2 261	239 191	10 601	5 114
NGR 06	106 964	2 011	585	33 544	1 885	990
NGR 07	51 229	1 406	611	23 213	896	968
NGR 08	19 377	297	316	2 846	123	142
NGR 09	8 464	610	645	4 216	163	181
NGR 10	3 859	100	158	10 093	909	994
NGR 11	5 953	137	162	4 154	162	178
NGR 12	8 141	152	201	1 878	108	121
NGR 13	3 003	94	127	2 561	145	116
NGR 14	2 283	100	117	2 955	142	168
NGR 15	10 320	296	372	3 566	123	143
NGR 16	1 087	195	124	5 861	109	201
NGR 17	930	31	38	1 546	58	74
NGR 18	875	67	35	797	15	19
NGR 19	192	8	10	135	6	7
NGR 20	16 460	306	434	9 506	367	444
NGR 21	264	596	599	144	3	5
NGR 22	29	1	1	72	539	539
NGR 23	148	6	7	190	15	17
NGR 24	1			319	2	6
NGR 25		123	99	2
NP	166	5	7	58	10	11
Total	550 658	13 428	9 566	546 822	24 820	12 861

* Nedbank rating scale is from NGR01 to NGR25. Currently there are no NGR01 and NGR02 exposures.

Securities financing transactions (SFTs) for Nedbank Limited and London branch SFTs

Rm	Gross positive fair value	Collateral value after haircut	Netted current credit exposure (post-mitigation)	Exposure-at-default value	Risk-weighted exposure
2009
Repurchase agreements	8 026	7 557	469	469	40
Securities lending	8 567	9 208	415	415	27
Total	16 593	16 765	884	884	67
2008
Repurchase agreements	2 630	2 529	101	101	8
Securities lending	4 686	4 672	14	14	1
Total	7 316	7 201	115	115	9

SFTs per NGR (probability of default) band

	2009		2008
Rm	Gross exposure	Exposure-at-default value	Gross exposure	Exposure-at-default value
NGR03	467	36	725	27
NGR04	1 831	213	185	6
NGR05	9 182	293	5 155	41
NGR06	2 261	145	729	21
NGR07	1 157	96	430	13
NGR08	1 656	98	10
NGR11	35	2	82	7
NGR20	4	1
Total	16 593	884	7 316	115

 

Securitisation risk

Nedbank Group entered the securitisation market during 2004 and currently has three securitisation transactions, Synthesis Funding Limited (Synthesis), an asset-backed commercial paper programme (ABCP) launched during 2004, Octane ABS 1 (Pty) Limited (Octane), a securitisation of motor vehicle loans advanced by Imperial Bank Limited through its subsidiary MFC that was launched in July 2007, and GreenHouse Funding (Pty) Limited (‘GreenHouse’), a residential mortgage-backed securitisation programme (‘RMBS Programme’) launched in December 2007.

Nedbank Group has used securitisation primarily as a funding diversification tool and has an established inhouse securitisation team within Nedbank Capital.

The contraction in the local and international securitisation markets experienced in 2008 continued in 2009. As a result the group did not implement new securitisations as an alternative source of funding over this period. Amidst the difficult external environment, although credit quality deteriorated, all securitisation vehicles continued to perform well and the ratings of the various transactions have been affirmed by the rating agencies and remain stable.

During the last quarter of 2009 arrears levels in GreenHouse exceeded the arrears trigger as a result of the deterioration in underlying asset performance. In the event that the arrears levels continue to exceed the arrears trigger at the first determination date in 2010, no further home loans (other than servicing redraws – ie access facilities on existing GreenHouse loans) can be acquired for as long as the arrears level remains above the arrears trigger level, and all capital repayments will be directed to the noteholders. However, Nedbank Group decided, in the interest of the noteholders, to exercise its discretion and not make further loans available for purchase by GreenHouse from December 2009, rather than waiting until the first determining date in 2010.

With regard to Octane, the transaction has started to repay investors in the normal course, as envisaged in the transaction documents. 

The group’s securitisation initiatives are overseen by the Group Asset and Liability Committee (ALCO) and Executive Risk Committee. All securitisation transactions are also subject to the stringent SA Regulatory Securitisation Framework.

From an IFRS accounting perspective the assets transferred to GreenHouse and Octane vehicles continue to be recognised and consolidated in the balance sheet of the group. Synthesis is also consolidated into Nedbank Group.

On-balance-sheet securitisation exposure

Click to enlarge

Off-balance-sheet securitisation exposure

Transaction			Exposure
Rm	Transaction type	Exposure type	2009	2008
Own transactions
Synthesis	ABCP conduit	Liquidity facility	5 824	7 806
Third parties
Private Residential Mortgages (Pty) Limited	Securitisation	Liquidity facility	100	100
Private Mortgages 2 (Pty) Limited	Securitisation	Liquidity facility	40	40
Private Mortgages 2 (Pty) Limited	Securitisation	Redraw facility	428	436
Total			6 392	8 382

 

The table below contains a summary of Synthesis.

						Conduit size
Transaction Rm	Year initiated	Rating agency	Transaction type	Asset type	Programme size	2009	2008
Synthesis	2004	Moody’s and Fitch	ABCP conduit	Asset-backed securities, corporate term loans and bonds	15 000	5 820	7 801
Total					15 000	5 820	7 801

The various roles fulfilled by Nedbank Group in the securitisation transactions mentioned above are indicated in the table below.

Transaction	Originator	Investor	Servicer	Liquidity provider	Credit enhancement provider	Swap counterparty
GreenHouse
Octane
Synthesis
Private Residential Mortgages (Pty)
Limited
Private Mortgages 2 (Pty) Limited

The table below shows the Basel II internal ratings-based consolidated group capital charges per risk band for securitised exposures retained or purchased by Nedbank Group.

Capital charge

Rm	2009	2008
AAA or A1/P1	3,9	3,9
AA+ to AA-	1,1	1,1
A+	2,9	1,0
A or A2/P2
A-	5,8	5,7
BBB+
BBB or A3/P3	7,2	7,2
BBB-	9,4	9,4
BB+	15,7	15,9
BB
BB-
Unrated
Unrated liquidity facilities to ABCP	39,8	44,4
Total	85,8	88,6

Trading market risk

Trading market risk is the potential for changes in the market value of the trading book resulting from changes in the market risk factors over a defined period. The trading book is defined as positions in financial instruments and commodities, including derivative products and other off-balance-sheet instruments that are held with trading intent or used to hedge other elements of the trading book.

Categories of trading market risk include exposure to interest rates, equity prices, currency rates and credit spreads. A description of each market risk factor category is set out below:

• Interest rate risk primarily results from exposure to changes in the level, slope and curvature of the yield curve and the volatility of interest rates.
  
• Equity price risk results from exposure to changes in prices and volatilities of individual equities and equity indices.
  
• Currency rate risk results from exposure to changes in spot prices, forward prices and volatilities of currency rates.
  
• Credit spread risk results from exposure to changes in the rate that reflects the spread investors receive for bearing credit risk.
  
• Commodity price risk results from exposures to changes in spot prices, forward prices and volatilities of commodity products such as energy, agricultural products and precious and base metals.
  

Most of Nedbank Group’s trading activity is executed from Nedbank Capital. During 2009 it included market-making and facilitation of client business and proprietary trading in the commodity, equity, credit, interest rate and currency markets. Nedbank Capital primarily focuses on client activities in these markets.

In addition to applying business judgement, senior management uses a number of quantitative measures to manage the exposure to market risk. These measures include:

• risk limits based on a portfolio measure of market risk exposure referred to as value at risk (VaR), including expected tail loss; and
• scenario analyses, stress tests and other analytical tools that measure the potential effects on the trading revenue of various market events.

The material risks identified by these processes are summarised in reports produced by the Market Risk Department and which are circulated to, and discussed with, senior management.

VaR is the potential loss in pretax profit due to adverse market movements over a defined holding period with a specified confidence level. The one-day 99% VaR number used by Nedbank Group reflects at a 99% confidence level that the daily loss will not exceed the reported VaR and therefore that the daily losses exceeding the VaR figure are likely to occur, on average, once in every 100 business days. The VaR methodology is a statistically defined, probability-based approach that takes into account market volatilities as well as risk diversification by recognising offsetting positions and correlations between products and markets. VaR facilitates the consistent measurement of risk across all markets and products, and risk measures can be aggregated to arrive at a single risk number.

Nedbank Group uses historical data to estimate VaR. One year of historical data is used in the calculation. Some of the considerations that should be taken into account when reviewing the VaR numbers are the following:

• The assumed one-day holding period will not fully capture the market risk of positions that cannot be liquidated or offset with hedges within one day.
  
• The historical VaR assumes that the past is a good representation of the future, which may not always be the case.
  
• The 99% confidence level does not indicate the potential loss beyond this interval.
  

While VaR captures Nedbank Group’s exposure under normal market conditions, sensitivity and stress-and-scenario analyses (and in particular stress testing) are used to add insight into the possible outcomes under abnormal market conditions.

Trading market risk profile

The tables below reflect the VaR statistics for the Nedbank Group trading book activities for 2008 and 2009.

Group trading book VaR for 2009(i)
	Historical VaR (99%, one-day) by risk type
Risk categories
Rm	Average	Minimum(ii)	Maximum(ii)	Year-end
Foreign exchange	4,1	1,0	10,3	3,7
Interest rate	16,9	7,2	28,7	7,4
Equity	6,3	2,5	13,3	3,8
Credit	6,0	2,5	10,9	3,2
Commodity	0,5		2,4	1,2
Diversification(iii)	(12,5)			(6,0)
Total VaR exposure	21,3	9,9	33,1	13,3
Group tradsing book VaR for 2008(i)
	Historical VaR (99%, one-day) by risk type
Risk categories
Rm	Average	Minimum(ii)	Maximum(ii)	Year-end
Foreign exchange	6,1	2,3	20,1	3,4
Interest rate	13,8	7,4	25,0	19,3
Equity	7,8	3,3	21,2	6,5
Credit	6,2	3,4	8,7	6,6
Diversification(iii)	(14,2)			(11,8)
Total VaR exposure	19,7	10,3	36,5	24,0

(i)	Certain positions are illiquid and VaR may not always be the most appropriate measure of risk (a summary of the ‘other market risk measures’ applied to mitigate this will follow).
(ii)	The maximum and minimum VaR values reported for each of the different risk factors did not necessarily occur on the same day. As a result a diversification number for the maximum and minimum values have been omitted from the table.
(iii)	Diversification benefit is the difference between the aggregate VaR and the sum of VaRs for the four risk categories. This benefit arises because the simulated 99%/one-day loss for each of the four primary market risk categories occurs on different days.

Nedbank Group’s trading market risk exposure expressed as average daily VaR increased by 8,1% from R19,7 million to R21,3 million. The increase was mainly due to an increase in exposure to the interest rate markets in 2009. 

The graph below illustrates the daily VaR for the period 1 January 2009 to 31 December 2009. Nedbank Group remained within the approved risk appetite and the VaR limits allocated by the board. The daily VaR for the second half of 2009 decreased as the financial markets stabilised.

The risk appetite within all the risk factors remained largely unchanged, with foreign exchange and interest rate activities again producing consistent revenue.

VaR is an important measurement tool and the performance of the model is regularly assessed. The approach to assessing whether the model is performing adequately is known as backtesting. Backtesting is simply a historical test of the accuracy of the VaR model. To conduct a backtest the bank reviews its actual daily VaR over one year (about 250 trading days) and compares the actual daily trading revenue (including net interest but excluding commissions and primary revenue) outcomes with its VaR estimate and counts the number of times the trading loss exceeds the VaR estimate.

Nedbank Group used a holding period of one day with a confidence level of 99%, and had no backtesting exceptions for 2009. This suggests that VaR, as currently implemented, has been a conservative measure of the potential net revenue variability on the daily trading activities.

The following histogram illustrates the distribution of daily revenue during 2009 for Nedbank Group’s trading businesses (including net interest, commissions and primary revenue credited to Nedbank Group’s trading businesses). The distribution is skewed to the profit side and the graph shows that trading revenue was realised on 205 days out of a total of 250 days in the trading businesses. The average daily trading revenue generated for 2009 was R6,7 million.

Trading market risk stress testing

Nedbank Capital uses a number of stress scenarios to measure the impact on portfolio values of extreme moves in markets, based on historical experience as well as hypothetical scenarios. The stress-testing methodology assumes that all market factors move adversely at the same time and that no actions are taken during the stress events to mitigate risk, reflecting the decreased liquidity that frequently accompanies market shocks. In the case where certain positions are illiquid and VaR may not be the most appropriate measure of risk, stress tests are used to supplement VaR and more rigorous stress tests are used to calculate the potential exposure. Stress test results are reported daily to senior management and monthly to the Trading Risk Committee and Group ALCO.

Risk factors

Rm	Average	High	Low	Year-end
Foreign exchange stress	15	60	2	19
Interest rate stress	113	233	46	104
Equity position stress	129	351	15	281
Credit spread stress	24	59	2	48
Commodity stress	1	2		1
Overall	282	535	128	453

The high and low stress values reported for each of the different risk factors did not necessarily occur on the same day. As a result the high and low risk factor stress exposures are not additive.

In addition, other risk measures are used to monitor the individual trading desks and these include performance triggers, approved trading products, concentration of exposures, maximum tenor limits and market liquidity constraints. Market risk is governed by a number of policies that cover management, identification, measurement and monitoring. In addition, all market risk models are subject to periodic independent validation in terms of the Group Market Risk Management Framework. Market risk reports are available at a variety of levels and detail, ranging from individual trader level right through to a group level view.

Revisions to the Basel II framework

In the Revisions to the Basel II Framework published by the Basel Committee in July 2009, a guideline for calculating stressed VaR was provided. Stressed VaR is calculated using market data taken over a ‘period through which the relevant market factors were experiencing stress’. Nedbank Group used historical data from the period 26 March 2008 to 12 March 2009. This period captures significant volatility in the SA market.

The information in the table below is the comparison of VaR, using three different calculations at 31 December 2009. The three different calculations are historical VaR, extreme tail loss (measures the expected losses in the tail of the distribution) and stressed VaR, using a volatile historical data period. A 99% confidence level and one-day holding period was used for all the calculations.

Comparison of trading VaR

2009	Historical VaR 99% (one-day) Rm	Extreme tail loss 99% (one-day) Rm	Stress VaR 99% (one-day) Rm
Foreign exchange	3,7	4,2	4,5
Interest rates	7,4	12,1	12,5
Equities	3,8	5,7	6,5
Credit	3,2	3,7	3,8
Commodities	1,2	1,3	1,6
Diversification	(6,0)	(10,8)	(9,5)
Total VaR exposure	13,3	16,2	19,4

Equity risk (investment risk) in the banking book

The total equity portfolio for investment risk is R3 901 million (2008: R3 779 million). R2 947 million (2008: R2 716 million) is held for capital gain, while the rest is mainly strategic investments.

Equity investments held for capital gain are generally classified as fair value through profit and loss, with fair-value gains and losses reported in non-interest revenue. Strategic investments are generally classified as available for sale, with fair-value gains and losses recognised directly in equity.

Investments	Publicly listed		Privately held		Total
Rm	2009	2008	2009	2008	2009	2008
Fair value disclosed in balance sheet (excluding associates and joint ventures)	485	525	2 491	2 087	2 976	2 612
Fair value disclosed in balance sheet (including associates and joint ventures)	485	525	3 416	3 254	3 901	3 779

Operational risk

Nedbank Group has approval from SARB to use the Standardised Approach for operational risk for Basel II regulatory capital. Nedbank Group has applied to SARB in January 2010 for the use of AMA. The AMA Operational Risk Management Framework was approved by the board’s Group Risk and Capital Management Committee in April 2009. The AMA methodologies are already rolled out and running in parallel in the businesses, and Nedbank Group will change to using AMA for economic capital purposes for 2010.

Major concentration risks and off-balance-sheet risks

Credit concentration risk is addressed here. Property concentration risk was discussed here, in particular the ‘deep dive’ into the Property Finance Division in 2008, and is incorporated in the quantification of credit economic capital. 

The one other potential major concentration risk in Nedbank Group is liquidity risk. The management of this, including diversification of the funding base, contingency planning of sources of funding, related governance, etc is covered here. 

Concentration risk is also a key feature of Nedbank Group’s Group Market Risk Framework. However, undue concentration risk is not considered to prevail in the group’s trading, interest rate risk in the banking book, forex and equity risk portfolios (evident in the low percentage contributions to group economic capital, see here), nor in assets and liabilities, subject to mark-to-market fair-value accounting.

As regard off-balance-sheet risks, there are only three ‘plain vanilla’ securitisation transactions, which have funding diversification rather than risk transfer objectives, as well as no ‘exotic’ credit derivative instruments or any risky off-balance-sheet special-purpose vehicles.

Economic capital

Economic capital is a sophisticated, consistent measurement and comparison of risk across business units, risk types and individual products or transactions. This enables a focus on both downside risk (risk protection) and upside potential (earnings growth). 

Nedbank Group assesses the internal requirements for capital using its proprietary economic capital methodology, which models and assigns economic capital within nine quantifiable risk categories.

The total average economic capital required by the group, as determined by the quantitative risk models and after incorporating the group’s estimated portfolio effects, is supplemented by a capital buffer of 10% to cater for any residual cyclicality and stressed scenarios. The total requirement is then compared with available financial resources.

 

Nedbank Group’s economic capital model and target capital adequacy (used for ICAAP)

Credit risks

Basel II AIRB credit methodology integrated with sophisticated credit portfolio modelling (incorporating credit concentration risk and intra-risk diversification, counterparty credit risk and securitisation risk)

+

Transfer risk (closely related to credit risk but arises due to sovereign default and so separately modelled and quantified)

Similar to AIRB credit methodology but dependent on probability and the extent of a transfer event (ie sovereign default)

+

Market risks

Trading (position) risk   IRRBB risk   Equity (investment) and property risks   Forex translation risks VaR scaled to one year using VaR limits (board-approved).   Simulated modelling of NII; economic value of equity (EVE) also done.   300% and 400% risk weightings in line with Basel II equity risk; PD/LGD Approach for Property Finance.   Multiple of exposure, based on rand volatility measures.

+

Operational risk

Basel II Standardised Approach used

+

Business risk

EaR methodology used

+

Other assets (100% risk-weighted)

=

Minimum economic capital requirement (after inter-risk diversification benefits)

+

Capital buffer (10% buffer for procyclicality, stressed scenarios, etc)

=

Total economic capital requirement

Measurement period/time horizon: one year (same as Basel II) Confidence interval (solvency standard): 99,93% (A) (ie more conservative than Basel II)

vs

Available financial resources

Comprises Tier A = core Tier 1 regulatory capital and qualifying reserves Tier B = perpetual preference shares and hybrid debt capital

Balance sheet management

Established as a separate cluster in 2009, the Balance Sheet Management (BSM) cluster helps to optimise the financial performance, strategy and sustainability of Nedbank Group through proactive management of all material components of the balance sheet.

Summary of perspectives on Nedbank Group’s balance sheet profile

The key highlights are as follows:

Capital adequacy overall

• Best-practice Internal Capital Adequacy Assessment Process (ICAAP) in place since 2008.
• Major focus over past 24 months, resulting in significantly strengthened capital levels, well above top end of the target ranges (in view of current external environment).
  • Successful execution of Risk-weighted Asset (RWA) Capital Optimisation Programme.

Regulatory capital adequacy (including unappropriated profits)

	Target (revised January 2009)	Nedbank Group	Nedbank Limited
Core Tier 1	7,5% to 9,0%	7,2% (Dec 2007) to 8,2% (Dec 2008) to 9,9% (Dec 2009)	6,8% (Dec 2007) to 8,0% (Dec 2008) to 9,6% (Dec 2009)
Tier 1	8,5% to 10,0%	8,2% (Dec 2007) to 9,6% (Dec 2008) to 11,5% (Dec 2009)	7,9% (Dec 2007) to 9,8% (Dec 2008) to 11,7% (Dec 2009)
Total	11,5% to 13,0%	11,4% (Dec 2007) to 12,4% (Dec 2008) to 14,9% (Dec 2009)	11,4% (Dec 2007) to 13,1% (Dec 2008) to 15,6% (Dec 2009)

Economic capital adequacy (used for ICAAP)

• In 2009 Nedbank Group increased (ie made more conservative) the group’s target solvency standard from A- (99,9%) to A (99,93%), while also introducing a more conservative definition of available financial resources (AFR), which covers the economic capital requirement.
• AFR surplus (after 10% capital buffer):
  • R16,1 billion for group; R13,5 billion for bank (based on old, less conservative basis).
  • R11,8 billion for group; R8,3 billion for bank (based on new, more conservative basis).

Stress and scenario testing

• Best-practice framework and process followed to stress test and confirm the robustness of the group’s capital adequacy, including the capital buffers. Recent international developments incorporated.

Leverage ratio is low at 14,4 times, compared with international levels

Concentration risk is well-contained

• Large individual (single-name) credit exposure risk is low.
  • The credit economic capital of the top 20 exposures (excluding banks and SA government exposure) makes up only 3,19% of total group economic capital.
• Concerning geographic exposure, the significant focus on South Africa has been positive for Nedbank Group through the global financial crisis.
• Industry/Sector exposure is appropriately well-diversified.
• Property exposure is high but in line with our peer group and most large banks internationally.
  • ‘Deep dive’ done of commercial property exposure and home loans.
• Counterparty credit risk is almost exclusively restricted to non-complex, low-risk banking transactions.
• Strong and well-diversified funding deposit base exists and low reliance is placed on offshore funding.
• Low level of securitisation exposure and off-balance-sheet activities.
• Low risk of assets and liabilities exposed to the volatility of International Financial Reporting Standards (IFRS) fair-value mark-to-market accounting.
• Low equity (investment) risk exposure (0,7% of total assets), including private equity.
• Non-core asset disposal strategy successfully executed by 2007.
• Low foreign currency translation risk to the rand’s volatility.
• Well-diversified earnings streams across five major business clusters.
• Well-diversified subordinated-debt profile.

Liquidity risk

• Overall remains sound and has been a major focus over past two years through the global financial crisis.
  • Successfully lengthened the funding profile during 2009, including the successful (largest ever in South Africa) R5,4 billion issue of senior unsecured debt in September 2009.
• The R5,6 billion debt issue also positively contributed to diversify the funding base further.
• Nedbank Group’s funding mix remains sound (ie retail vs wholesale deposits reliance).
• Nedbank Group continues to maintain a dominant market share in household deposits.
• All liquidity risk measurement and management assumptions, principles and methodologies have been independently reviewed and align with best practice.
• Key areas of focus for 2010 – 2012:

  –	Continue to lengthen the funding profile.
  –	Continue to diversify Nedbank Group’s funding base in order to reduce reliance on wholesale funding.
  	°	Expanding domestic and international capital market issuance programmes, subject to price and appetite.
  	°	Continuing aggressively to pursue strong growth in retail and commercial deposits.
  –	Work with government, the SA Reserve Bank and the banking industry to address the financial services structural issues around funding and liquidity to facilitate positively positioning South Africa around the new Basel III liquidity proposals.

Interest rate risk in the banking book (IRRBB)

• Main components of IRRBB include endowment on equity and non-repricing transactional deposits, offset by the fixed-rate liquid asset hedge and working capital plus reset (basis) risk. 
  
  Reset risk is caused by advances pricing immediately for rate changes, due to being prime-rate-linked, versus term deposits repricing to three-month Johannesburg Interbank Agreed Rate (JIBAR), following hedging of IRRBB.
• Banking book interest rate sensitivity is currently 1,30% of total equity or R584 million (for a 1% move in rates).
• This is within the board-approved IRRBB limit of 2,5% of capital, with no limit breaches having been experienced in 2009.
• The strategic attention of the Group Asset and Liability Committee has shifted to positioning the balance sheet for the anticipated bottoming of the current interest rate cycle.

Asset and liability management

Asset and liability management addresses two of the 17 key risk types in the group’s Enterprisewide Risk Management Framework, namely liquidity risk and market risk in the banking book, which in turn includes interest rate risk in the banking book and foreign currency translation risk on foreign-based capital, investments, loans and/or borrowings.

Liquidity risk

There are two types of liquidity risk, namely funding liquidity risk and market liquidity risk. Funding liquidity risk is the risk that Nedbank Group is unable to meet its payment obligations as they fall due. These payment obligations could emanate from depositor withdrawals, the inability to roll over maturing debt or contractual commitments to lend. Market liquidity risk is the risk that the group will be unable to sell assets, without incurring an unacceptable loss, in order to generate cash required to meet payment obligations under a stress liquidity event.

Liquidity risk management is a vital risk management function in all entities across all jurisdictions and currencies, and is a key focus of the Nedbank Group.

The tables below show the expected profile of cashflows under a contractual and business-as-usual (BaU) scenario.

Nedbank Group contractual liquidity gap at year-end

		>3 months	>6 months	>1 year		Non-
Rm	<3 months	<6 months	<1 year	<5 months	>5 years	determined	Total
Cash and cash equivalents (including mandatory reserve deposits with central bank)	16 382			65		1 928	18 375
Other short-term securities	13 715	1 261	1 501	2 073			18 550
Derivative financial instruments	3 569	834	2 070	3 792	2 445		12 710
Government and other securities	537	2 020	7 607	18 660	7 159		35 983
Loans and advances	83 758	16 463	31 070	153 354	165 656		450 301
Other assets	2 261					32 523	34 784
Assets	120 222	20 578	42 248	177 944	175 260	34 451	570 703
Total equity						44 984	44 984
Derivative financial instruments	2 917	898	1 103	3 037	3 596		11 551
Amounts owed to depositors	338 632	50 084	57 810	19 888	2 941		469 355
Other liabilities	8 780					15 949	24 729
Long-term debt instruments			500	9 184	10 400		20 084
Liabilities and equity	350 329	50 982	59 413	32 109	16 937	60 933	570 703
Net liquidity gap	(230 107)	(30 404)	(17 165)	145 835	158 323	(26 482)

The contractual liquidity gap is adjusted with behavioural assumptions in order to determine the group’s BaU or anticipated liquidity risk profile. These adjustments result largely in a lengthening of deposit cashflows due to behavioural assumptions through which contractually maturing short-term deposits have longer profiles under normal market conditions.

Nedbank Group BaU liquidity gap at year-end

		>3 months	>6 months	>1 year		Non-
Rm	<3 months	<6 months	<1 year	<5 months	>5 years	determined	Total
Cash and cash equivalents (including mandatory reserve deposits with central bank)					18 375		18 375
Other short-term securities	13 715	1 261	1 501	2 073			18 550
Derivative financial instruments	3 569	834	2 070	3 792	2 445		12 710
Government and other securities					35 983		35 983
Loans and advances	35 575	23 867	45 677	296 872	48 310		450 301
Other assets						34 784	34 784
Assets	52 859	25 962	49 248	302 737	105 113	34 784	570 703
Total equity						44 984	44 984
Derivative financial instruments	2 917	898	1 103	3 037	3 596		11 551
Amounts owed to depositors	87 915	64 499	79 712	235 676	1 553		469 355
Other liabilities						24 729	24 729
Long-term debt instruments			500	9 401	10 183		20 084
Liabilities and equity	90 832	65 397	81 315	248 114	15 332	69 713	570 703
Net liquidity gap	(37 973)	(39 435)	(32 067)	54 623	89 781	(34 929)

Note: BaU assumptions include rollover assumptions on term maturities. No management actions are assumed in terms of realising cash through the sale of liquid assets or other marketable securities.

The additional disclosure below depicts the contractual and BaU liquidity mismatches in respect of Nedbank Limited, and highlights the split of total deposits into stable and more volatile. Based on the behaviour of the bank’s clients, it is estimated that in excess of 83% of the total deposit base is stable in nature.

Nedbank Limited* contractual balance sheet mismatch at year-end

Rm	Total	Next day	2 to 7 days	8 days to 1 month	More than 1 month to 2 months
Contractual maturity of assets	509 150	47 759	5 921	31 156	11 496
Loans and advances	398 899	29 810	2 445	18 590	6 682
Trading, hedging and other investment instruments	71 295	4 930	3 243	11 011	4 542
Other assets	38 956	13 019	233	1 555	272
Contractual maturity of liabilities	509 150	161 943	19 629	74 292	29 018
Stable deposits	348 378	139 898	10 470	55 617	22 474
Volatile deposits	72 197	14 982	1 537	9 236	5 575
Trading and hedging instruments	50 240	7 063	7 622	9 439	969
Other liabilities	38 335
On-balance-sheet contractual mismatch		(114 184)	(13 708)	(43 136)	(17 522)
Cumulative on-balance-sheet contractual mismatch		(114 184)	(127 892)	(171 028)	(188 550)

The BaU table below shows the expected liquidity mismatch under normal market conditions after taking into account the behavioural attributes of Nedbank Limited’s stable deposits, savings and investment products.

Nedbank Limited* BaU balance sheet mismatch at year-end

Rm	Total	Next day	2 to 7 days	8 days to 1 month	More than 1 month to 2 months
BaU maturity of assets	509 150	27 358	2 667	14 263	10 031
Loans and advances	398 899	6 861	2 327	9 299	8 365
Trading, hedging and other investment instruments	71 295	20 497	340	3 410	1 394
Other assets	38 956			1 554	272
BaU maturity of liabilities	509 150	17 788	10 813	31 567	20 900
Stable deposits	348 378	444	1 158	7 989	14 356
Volatile deposits	72 197	1 705	5 030	19 083	5 575
Trading and hedging instruments	50 240	15 639	4 625	4 495	969
Other liabilities	38 335
On-balance-sheet BaU mismatch		9 570	(8 146)	(17 304)	(10 869)
Cumulative on-balance-sheet BaU mismatch		9 570	1 424	(15 880)	(26 749)

* Nedbank Limited refers to the SA reporting entity in terms of Regulation 38 (BA700) of the SA banking regulations.

As per the table above Nedbank Limited’s BaU inflows exceed outflows overnight to one week, taking into account behavioural assumptions, including rollover assumptions associated with term deals and excluding BaU management actions.

As per the graph below the improved BaU maturity mismatch in 2009, when compared with 2008, can be attributed to the following: Previously Nedbank Limited adopted a very conservative approach when estimating the BaU mismatch, which means that Nedbank Limited previously assumed that no term deposits were refinanced and that they resulted in a cash outflow on maturity of the deposit. As this does not reflect reality under normal market conditions, refinancing assumptions (having been statistically derived) have now been applied to term funding, thus yielding a more realistic BaU mismatch.

(Expressed on total assets and based on maturity assumptions before rollovers and risk management) 

Note: The improvement in the 2009 profile is mainly due to refinements to the refinancing assumptions as detailed above.

Interest rate risk in the banking book
Nedbank Group is exposed to IRRBB primarily because:

• the bank writes a quantum of prime-linked advances;
• funding is prudently raised across the curve at fixed-term deposit rates that reprice only on maturity;
• three-month JIBAR-linked swaps and forward rate agreements are typically used in the risk management of term deposits and fixed-rate advances;
• short-term demand funding products reprice to different short-end base rates;
• certain non-repricing transactional deposit accounts are non-rate-sensitive; and
• the bank has a mismatch in net non-rate-sensitive balances, including shareholders’ funds that do not reprice for interest rate changes.

IRRBB comprises:

• Repricing risk (mismatch risk) – timing difference in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet positions.
• Reset or basis risk – imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics.
• Yield curve risk – changes in the shape and slope of the yield curve.
• Embedded optionality – the risk pertaining to interest-related options embedded in bank products.

Nedbank Group interest rate repricing profile at year-end

Rm	Within 3 months	Between 3 and 6 months	Between 6 and 12 months	> 1 year	Non-rate- sensitive
Net repricing profile before hedging	65 358	(27 622)	(32 210)	31 335	(36 861)
Net repricing profile after hedging	33 999	(1 017)	(2 726)	6 605	(36 861)
Cumulative repricing gap after hedging	33 999	32 982	30 256	36 861

At 2009 the group’s earnings-at-risk sensitivity of the banking book for a 1% parallel reduction in interest rates was 1,30% of total group equity (2008: 1,25%), well within the approved risk limit of 2,5%. This exposes the group to a decrease in net interest income (NII) of R584 million should interest rates fall by 1%, measured over a 12-month period, which translates into an approximate reduction in margin of 12 basis points or an absolute reduction of approximately 3,6% of this year’s NII.

The group’s level of interest rate sensitivity is managed in conjunction with credit impairment sensitivity and is benchmarked regularly against the peer group.

Nedbank Limited’s economic value of equity, measured for a 1% parallel decrease in interest rates, is a loss of R225 million (2008: gain of R155 million).

The table below highlights the group’s and bank’s exposure to IRRBB measured for normal and stressed interest rate changes:

2009		Nedbank	Other group	Nedbank
Rm	Note	Limited	companies	Group
Net interest income sensitivity	1
1% instantaneous decline in interest rates		(444)	(140)	(584)
2% instantaneous decline in interest rates		(887)	(281)	(1 168)
Linear path space	2
Lognormal interest rate sensitivity		(273)
Basis interest rate risk sensitivity	3
0,25% narrowing of prime/call differential		(168)	(51)	(219)
Economic value of equity sensitivity	4
1% instantaneous decline in interest rates		(225)
2% instantaneous decline in interest rates		(461)
Stress testing
Net interest income sensitivity
Instantaneous stress shock	5	(1 996)
Linear path space	2
Absolute-return interest rate sensitivity		(1 386)

Notes
1.	Net interest income sensitivity, as currently modelled, exhibits very little convexity. In certain cases the comparative figures have been estimated assuming a linear risk relationship to the interest rate moves.
2.	Linear path space is a stochastic method used to generate random interest rate paths. These paths are then modelled and a probabilistic impact of interest rate changes on NII is derived. The ‘Lognormal interest rate sensitivity’ uses two years of interest rate movements to derive interest rate volatility. The stress scenario ‘Absolute-return interest rate sensitivity’ is based on the volatility of interest rates over nine years.
3.	Basis interest rate risk sensitivity is quantified using a narrowing in the prime/call interest rate differential of 0,25% and is an indication of the sensitivity of the margin to a squeeze in short-term interest rates.
4.	Economic value of equity sensitivity is calculated as the net present value of asset cashflows less the net present value of liability cashflows.
5.	The instantaneous stress shock is derived from the principles espoused in the Basel Committee paper Principles for the Management and Supervision of Interest Rate Risk.

Foreign currency translation risk in the banking book
Foreign currency translation risk arises as a result of Nedbank Group’s investments in foreign companies that have issued foreign equity. This foreign equity is translated into rand for domestic reporting purposes, recording a profit where the rand exchange rate has deteriorated between periods and a loss where the rand exchange rate has strengthened between periods.

Foreign currency translation risk remains relatively low and currently aligns with an appropriate offshore capital structure. Risk limits are based on the expected level of currency-sensitive foreign capital and the exposure was approximately US$241 million at year-end.

Offshore capital split by functional currency

	US dollar equivalent ($ millions)			Total
$m	Equity	Forex-sensitive	Non-forex-sensitive	2009	2008
US dollar	108	108		108	88
Pound sterling	113	113		113	94
Swiss franc	13	13		13	6
Malawi kwatcha	7	7		7	5
Other			436	436	391
Total	241	241	436	677	584

Forex-sensitive portion of offshore capital

$m	2009
Forex-sensitive portion of offshore capital	241
Limit	250

The effective average capitalisation rate of the foreign-denominated business is 26% (2008: 25%). The total foreign RWA as a percentage of the Nedbank Group total is low at 2% (R5,7 billion out of the total group RWA of R326 billion). Therefore, any foreign exchange rate movement will have a minimal effect on Nedbank Group’s capital adequacy ratio.

High rand volatility has a minimal effect on capital adequacy as a 10% depreciation in the rand, for example, will only decrease capital adequacy by 0,02%.

Capital management 
Nedbank Group's Capital Management Frame the integration of risk, capital, strategy and performance measurement (and incentives) across the group. This contributes significantly to successful enterprisewide risk management.

The board-approved Solvency and Capital Management policy document requires Nedbank Group to be capitalised at the greater of Basel II regulatory capital and economic capital.

Importantly though, one should not see Nedbank Group’s economic capital as divorced from Basel II regulatory capital – quite the contrary, since our economic capital is an extension of the Basel II Pillar 1 requirements to incorporate Pillar 2, together with a few other key refinements tailored to Nedbank Group and South Africa, and to incorporate the Rating Agency perspective (eg Tier 2 regulatory capital does not qualify for our economic capital definition of AFR).

Regulatory capital adequacy

Nedbank Group Limited has again strengthened its regulatory capital ratios in 2009, with a Tier 1 capital adequacy ratio of 11,5% (2008: 9,6%) and a total capital adequacy ratio of 14,9% (2008: 12,4%). The core Tier 1 capital adequacy ratio was 9,9% (2008: 8,2%).

Nedbank Limited has also strengthened regulatory capital ratios, with a Tier 1 capital adequacy ratio of 11,7% (2008: 9,8%) and a total capital adequacy ratio of 15,6% (2008: 13,1%). The core Tier 1 capital adequacy ratio was 9,6% (2008: 8,0%).

All capital adequacy ratios are now well above the group’s target ranges, including core Tier 1. They include unappropriated profits at the year-end to the extent that these are not expected to reverse and are expected to be appropriated subsequent to the year-end.

Nedbank Group’s capital adequacy ratios increased significantly over the past two years due to a strong focus on the optimisation of risk-weighted assets (capital), enabled by enhancing data quality and more selective asset growth using our economic-profit based philosophy of managing for value, the retention of earnings, the profits made on the disposal of Visa shares in 2008 and the issuing of some non-core Tier 1 capital instruments.

The group’s leverage ratio (total assets to ordinary shareholders’ equity, excluding off-balance-sheet items) at 14,4 times is also conservative by international standards and in line with the local peer group.

Consolidation of entities for regulatory purposes is performed in accordance with the requirements of Basel II, the Banks Act and accompanying regulations. Some differences exist in the basis of consolidation for accounting and regulatory purposes. These include the exclusion of certain accounting reserves [eg the foreign currency translation (FCT) reserve, share-based payments (SBP) reserve and available-for-sale (AFS) reserve], the deduction of insurance entities and the exclusion of trusts that are consolidated in terms of IFRS but are not subject to regulatory consolidation.

The FCT, SBP and AFS reserves that arise in the consolidation of entities in terms of IFRS amounted to R1,2 billion at year-end and are excluded from qualifying regulatory capital. Restrictions on the transfer of funds and regulatory capital within the group are not a material factor. These restrictions mainly relate to those entities that operate in countries other than South Africa where there are exchange control restrictions in place.

Against the background of the group’s conservative risk appetite and sound risk management discussed earlier, the group believes that its capital levels (both regulatory capital and its internal capital assessment, economic capital) and provisioning for credit impairments are appropriate and conservative, and that the group and its subsidiaries are strongly capitalised relative to our business activities, strategy, risk appetite, risk profile and the external environment in which we operate. Additionally, the group is currently not holding excess capital for major acquisitions.

Summary of risk-weighted assets (by risk type and business cluster)

	2009 Rm	Mix %	2008 Rm	Mix %
Credit risk	246 099	75,4	285 457	80,4
Nedbank Corporate	67 427	20,7	75 887*	21,4
Nedbank Business Banking	33 616	10,3	44 467	12,4
Nedbank Capital	25 389	7,8	34 672*	9,8
Nedbank Retail (including Bancassurance and Wealth)	78 958	24,2	94 138*	26,5
Imperial Bank	39 914	12,2	35 377	10,0
Central Management and Shared Services	795	0,2	916*	0,3
Equity risk	13 396	4,1	13 035	3,7
Market risk	5 718	1,8	7 049	2,0
Operational risk	47 222	14,4	36 497	10,2
Other assets	14 031	4,3	13 197	3,7
Total risk-weighted assets	326 466	100	355 235	100

* 2008 restated to include Africa and the United Kingdom in appropriate business clusters and to separate Nedbank Business Banking from the Nedbank Corporate cluster.

Total risk-weighted assets decreased by R28,8 billion during 2009. The decrease was largely due to credit risk, which decreased by R39,4 billion as a result of the optimisation of risk-weighted assets, enabled by data quality enhancements and the reduction of excess conservatism, and selective asset growth under the group’s managing for value strategic theme.

These decreases were offset by an increase in operational-risk-weighted assets of R8 billion due to the inclusion of the ‘most recent year of gross income’ data in the calculation under the Standardised Approach (TSA).

Summary of risk-weighted assets (by risk type) and capital adequacy position

	Nedbank Group		Nedbank Limited***
	2009 Rm	2008 Rm	2009 Rm	2008 Rm
Credit risk	246 099	285 457	184 472	221 969
Credit portfolios subject to Advanced Internal Ratings-based Approach (ie Nedbank Limited)	192 842	238 480	180 968	218 142
Corporate, sovereign, bank (including small and medium enterprises)	105 669	131 955	95 274	114 050
Residential mortgage	51 023	70 401	49 543	67 968
Qualifying revolving retail	7 385	6 554	7 386	6 554
Other retail	28 765	29 570	28 765	29 570
Credit portfolios subject to Standardised Approach	49 344	42 829
Corporate, sovereign, bank	19 534	16 849
Retail exposures	29 810	25 980
Counterparty credit risk	3 057	3 169	2 908	3 109
Securitisation exposures (Internal Ratings-based Approach)	856	979	596	718
Equity risk (market-based Simple Risk Weight Approach)	13 396	13 035	10 781	10 190
– Listed (300% risk weighting)	1 447	1 574	1 447	1 471
– Unlisted (400% risk weighting)	11 949	11 461	9 334	8 719
Market risk (Standardised Approach)	5 718	7 049	4 455	5 445
Operational risk (Standardised Approach)	47 222	36 497	39 025	30 559
Other assets (100% risk weighting)	14 031	13 197	10 429	10 170
Total risk-weighted assets	326 466	355 235	249 162	278 333
Total minimum regulatory capital requirements*	35 097	34 635	27 560	27 137
Qualifying capital and reserves**	48 584	44 119	38 939	36 577
Total surplus capital over minimum requirements	13 487	9 484	11 379	9 440
Analysis of total surplus capital**
Core Tier 1 capital	15 296	10 285	10 816	7 695
Tier 1 capital	14 820	9 100	11 691	7 699
Total capital	13 487	9 484	11 379	9 440

*	Includes Basel II capital floor since February 2009.
**	Includes unappropriated profits.
***	Nedbank Limited refers to the SA reporting entity in terms of Regulation 38 (BA700) of the SA banking regulations.

Summary of qualifying capital and reserves
Excluding unappropriated profits

		Nedbank Group		Nedbank Limited
Rm		2009	2008	2009	2008
Tier 1 capital (primary)		36 627	33 458	28 600	27 031
Core Tier 1 capital		31 389	28 427	23 365	22 156
Ordinary share capital		436	410	27	27
Ordinary share premium		13 728	11 370	14 434	14 434
Reserves		25 485	23 133	15 610	14 298
Minority interest: ordinary shareholders		1 849	1 881
Deductions		(10 109)	(8 367)	(6 706)	(6 602)
	Impairments	(8)	(6)	(3 430)	(3 608)
	Goodwill	(4 981)	(3 894)	(1 126)	(1 126)
	Excess of expected loss over eligible provisions (50%)	(780)	(588)	(861)	(588)
	Unappropriated profits	(1 312)	(658)	(798)	(300)
	Foreign currency translation reserves	(223)	(545)	(9)	(9)
	Share-based payment reserves	(875)	(949)	206	(281)
	Property revaluation reserves	(1002)	(951)	(666)	(668)
	Surplus capital held in insurance entities (50%)	(489)	(387)
	Other regulatory differences	(439)	(389)	(22)	(22)
Non-core Tier 1 capital		5 238	5 031	5 235	4 874
Preference share capital and premium		3 486	3 279	3 483	3 122
Hybrid debt capital instruments		1 752	1 752	1 752	1 752
Tier 2 capital (secondary)		10 911	10 153	9 807	9 395
Long-term debt instruments		11 500	10 464	10 848	9 812
Revaluation reserves (50%)		501	476	333	334
Deductions		(1 090)	(787)	(1 374)	(751)
	Surplus capital held in insurance and financial entities (50%)	(489)	(387)
	Excess of expected loss over eligible provisions (50%)	(780)	(588)	(861)	(588)
	General allowance for credit impairment	212	212
	Other regulatory differences	(33)	(24)	(513)	(163)
Tier 3 capital (tertiary)		–	–	–	–
Total		47 538	43 611	38 407	36 426

Including unappropriated profits

	Nedbank Group		Nedbank Limited
Rm	2009	2008	2009	2008
Core Tier 1 capital	32 435	28 935	23 897	22 307
Tier 1 capital	37 673	33 966	29 132	27 182
Total capital	48 584	44 119	38 939	36 577

Dividend cover
The group has a dividend cover policy range of 2,25 to 2,75, covered by headline earnings per share. Historically the effective cover has been higher as a result of takeup under a scrip dividend alternative and also the reinvestment of dividend proceeds by black economic empowerment (BEE) shareholder trusts.

Summary of regulatory capital adequacy of all banking subsidiaries of Nedbank Group 
A summary of all the group’s banking subsidiaries’ Basel II regulatory capital positions is provided below:

	2009		2008
Bank	Risk-weighted assets Rm	Basel II capital ratio %	Risk-weighted assets Rm	Basel II capital ratio %
Nedbank Limited	249 162	15,6*	278 333	13,1*
Imperial Bank Limited	43 887	11,2	38 074	11,1
Nedbank (Namibia) Limited	3 864	14,6	3 264	13,9
Fairbairn Private Bank (IOM) Limited	2 327	15,9	2 526	16,1
Fairbairn Private Bank Limited	1 697	14,2	1 722	14,5
Nedbank (Swaziland) Limited	1 374	15,7	619	17,4
Nedbank (Lesotho) Limited	905	18,8	320	23,3
Nedbank (Malawi) Limited	98	50,1	80	23,0

Note: The capital ratios for the African subsidiaries shown above are on a pro forma basis and contribute to Nedbank Group ratios, as Basel II is still to be implemented in these jurisdictions.
* Includes unappropriated profit.

We conclude that the capitalisation of all these banking entities is adequate, all with conservative risk profiles and being well-managed and monitored within the group’s enterprisewide risk management and the ICAAP. Nedbank Group has approval to acquire 100% of Imperial Bank’s shares and plans to integrate it fully into Nedbank Group in 2010, subject only to regulatory approval in terms of section 54.

Capital impact of Nedbank Group’s outright purchase of joint ventures with Old Mutual and 100% Imperial Bank Limited buyout
The capital impact on Nedbank Group of these transactions is not material. The transaction with Old Mutual was effective 1 June 2009 and is included in these results. The transaction with Imperial Holdings was still pesnding at 31 December 2009. During February 2010 final regulatory approvals were received and Nedbank Limited acquired 100% of the ordinary and preference shares in Imperial Bank.

Economic capital adequacy
Nedbank Group’s economic capital methodology has been summarised here. Set out below is a summary of the group’s economic capital adequacy and capital allocation to the business clusters:

The following changes were made to the group’s 2008 economic capital model (used for ICAAP), which introduce even more conservatism around the group’s target solvency standard:

• Increased the target debt solvency standard from A- (99,9%) (same as Basel II) to A (99,93%).
• Excluded ‘50% of next year’s earnings’ from the definition of AFR (even though business risk economic capital is still included).
• Created a Tier A and Tier B category for AFR, with Tier A having to cover at least the minimum economic capital requirement at an A rating.

Definitions:
Tier A = core Tier 1 regulatory capital and qualifying reserves*
Tier B = perpetual preference shares and hybrid debt capital
(* In Tier A we include SBP, FCT and AFS reserves, as we deem this as correct and appropriate.)

The effect of the changes on required economic capital and AFR for 2009 is shown by comparing it with the required and available capital prior to and after these changes.

The impact of these changes at 2009 (with pro forma data) is highlighted in the tables below:

Available surplus at year-end

	New basis	Old basis
Rm	(99,93%)	(99,90%)
Economic capital requirement	25 785	24 251
10% capital buffer	2 579	2 425
Economic capital requirement including capital buffer	28 364	26 676
AFR	40 147	42 780
Available surplus (after 10% capital buffer)	11 783	16 104

Economic capital by risk type at year-end

	New basis	Old basis
Rm	(99,93%)	(99,90%)
Credit risk	14 515	13 541
Transfer risk	142	134
Trading risk	442	428
IRRBB risk	39	39
Business risk	4 254	4 133
Operational risk	2 855	2 548
Property risk	1 158	1 121
Investment risk	1 734	1 679
Forex translation risk	33	33
Other assets risk	613	595
Total economic capital requirement	25 785	24 251
10% capital buffer	2 579	2 425
Economic capital requirement including 10% capital buffer	28 364	26 676

Economic capital available financial resources at year-end

	New	Old
Rm	definition	definition
Tier A capital	34 909	33 735
Ordinary share capital and premiums	14 164	14 164
Minority interest: ordinary shareholders	1 849	1 849
Reserves	25 485	24 311
Retained income (excluding unappropriated profits)	14 130	14 130
Unappropriated profits	1 309	1 309
Distributable reserves	7 697	7 697
Non-distributable reserves	173	173
Foreign currency translation reserves	224	Not In
Share-based payment reserves	875	Not In
Available-for-sale reserves	76	Not In
Property revaluation reserves	1 002	1 002
Deductions	(7 827)	(7 827)
Impairments	(8)	(8)
Goodwill	(4 981)	(4 981)
Subordinated-debt portion of unappropriated profits	(266)	(266)
First loss credit enhancement iro securitisation scheme (50%)	(33)	(33)
Surplus capital held in insurance entities (50%)	(489)	(489)
Holsboer and Chairman’s Fund	(330)	(330)
Minority interest in Imperial Bank	(1 720)	(1 720)
Excess of IFRS provisions over expected loss (100%)	1 238	1 238
Tier B capital*	5 238	9 045
Total AFR	40 147	42 780

* Includes preference shares, hybrid debt capital instruments and other.

Nedbank Group’s ICAAP confirms that the group is capitalised above its new, more conservative A or 99,93% target debt rating (solvency standard) in terms of its proprietary economic capital methodology set out on page 165. This includes a 10% capital buffer, the incorporation of the group’s risk appetite approved by the board and the application of comprehensive stress and scenario testing.

Economic capital requirements and available financial resources (by risk type)

	2009		2008
Rm	New basis	Old basis	Old basis
Credit risk*	14 515	13 541	15 605
Transfer risk	142	134	166
Market risk	3 406	3 300	3 066
Trading risk	442	428	352
IRRBB risk	39	39	33
Property risk	1 158	1 121	1 019
Investment risk	1 734	1 679	1 635
Forex translation risk	33	33	27
Operational risk	2 855	2 548	1 682
Business risk	4 254	4 133	4 798
Other assets risk	613	595	689
Minimum economic capital requirement	25 785	24 251	26 005
+ Capital buffer (10%)	2 579	2 425	2 601
= Total economic capital requirement	28 364	26 676	28 606
vs AFR	40 147	42 780	38 216
Tier A capital (shareholders’ equity)	34 909	33 735	28 336
Tier B capital (non-core Tier 1-type capital)	5 238	9 045	9 880
= Surplus available after capital buffer	11 783	16 104	9 610

*	Credit risk economic capital incorporates counterparty credit risk and securitisation risk.
**	New basis includes the new solvency standard (99,93%) and the new definition of AFR.

The total economic capital (including 10% buffer) decreased by R1,9 billion from R28,6 billion in 2008 to R26,7 billion in 2009 (old basis), owing mainly to a decrease in credit risk economic capital and business risk economic capital. The decrease in business risk is as a result of parameter updates as well as the lower projected growth, compared with the previous year.

Credit risk economic capital decreased from R15,6 billion to R13,5 billion (old basis) over the period. Both credit risk economic and regulatory capital decreased as a result of the optimisation of risk-weighted assets.

These decreases were offset by increases in property and operational risk. Property risk has increased as a result of the increase in properties in possession due to the worsening economic conditions. Operational risk increased due to the inclusion of the ‘most recent year of gross income’ data in the calculation under TSA.

In conclusion, Nedbank Group’s economic capital adequacy is strong at its new A (99,93%) target debt rating (solvency standard), with surpluses at group level of R11,8 billion (R16,1 billion on the old basis at an A- target rating). This is after providing for a 10% economic capital buffer, which is subject to sophisticated stress testing.

• Capital allocation (risk-based) to business clusters
  
  A summary of economic capital requirement at year-end by business cluster (on the old basis)* is presented below:
  
  
  
  Click to enlarge
  * (On old economic capital basis, as the new basis is effective for capital allocation purposes only from 2010.)
  
  The target debt solvency change will be effective for risk-adjusted performance measurement from 2010 and, as a result, is not effective in the business cluster results above. In addition, there are a number of economic capital allocation methodology enhancements that will be implemented for 2010, which are expected to have a significant impact on the allocation of capital across the group’s business clusters. The impact of the changes by business cluster will be disclosed with the 2010 interim results. The following is a summary of the key enhancements being implemented for 2010:
  
  • Full alignment of the group’s actual book capital, with the aggregate amount allocated to the various business clusters using bottomup economic capital.
  • Updating of the credit portfolio modelling correlations and revising the credit economic capital allocation methodology taking into account recent global developments (including downturn years) and the new regulatory thinking in line with the new Basel III proposals discussed earlier.
  • Measurement of operational risk for economic capital purposes using the Advanced MeasurementApproach instead of TSA.
  
  Cost of equity
  
  Following a shift in the constituents of the cost of equity calculated using the Capital Asset Pricing Model, Nedbank Group revised its cost of equity up to 14,15% at the beginning of 2010. The main driver of the increase in the cost of equity was an increase in the 10-year risk-free rate, which resulted from a change in expectations for the 10-year RSA government yield on the back of global and local economic developments. The cost-of-equity figure of 14,15% is roughly in line with analyst expectations and peer group comparatives.
  
  Capital Asset Pricing Model
   

  	Risk-free rate (R157) %	Beta	Equity risk premium %	After-tax cost of ordinary shares %
  2007	7,73	1,02	5,30	13,14
  2008	8,43	1,00	5,44	13,87
  2009	7,75	1,00	5,50	13,25
  2010	9,17	0,90	5,50	14,15

  
  External credit ratings
  External credit ratings across the banking industry were moved downwards, reflecting the effect of the global financial crisis on the banking sector. Notwithstanding strengthened capital and liquidity positions, and the much less significant impact of the global financial crisis on South Africa, local banks were all generally downgraded by the rating agencies.

  • Moody’s Investors Service
    In November 2009 Moody’s Investors Service (Moody’s) took a number of rating actions on the major SA banks, including the ratings of Nedbank Limited, the 100%-owned subsidiary of Nedbank Group Limited (Nedbank Group).
    
    According to Moody’s these rating actions were triggered by the following factors:
     
    • The deteriorating operating and macroeconomic conditions and the resultant challenges for the SA banking sector that has led to Moody’s downgrading the bank financial strength rating (BFSR) by one notch to C-, while changing the outlook on the BFSR from negative to stable.
    • At the same time the Global Local Currency (GLC) deposit rating was also downgraded one notch toA2, with an associated change in outlook from negative to stable.

    The specific impact on Nedbank Group’s ratings is as follows:
    
    Nedbank Limited
    The foreign currency deposit ratings: remain unchanged at A3/P-2.

    Nedbank Limited’s euro medium-term note programme: rating for senior unsecured debt downgraded to A2 (stable outlook) from A1 (negative outlook) and rating for subordinated notes downgraded to A3 (stable outlook) from A2 (negative outlook).
    
    Nedbank Limited’s BFSR rating: downgraded to C-; outlook revised from negative to stable.
    
    Nedbank Limited’s GLC deposit rating: downgraded 1 notch to A2; outlook changed from negative to stable.
    
    Nedbank Limited’s national scale debt ratings (relating to the domestic medium-term note programme): downgraded to Aa2.za (stable outlook) from Aa1.za for senior unsecured debt and to Aa3.za (stable outlook) from Aa2.za for subordinated notes.
    
    Nedbank Limited’s national scale rating: downgraded to Aa2.za; outlook revised from negative to stable.
    
    

    Moody’s current ratings for Nedbank Limited after the ratings actions:

    	Nedbank Limited
    	2009
    BFSR	C-
    Outlook – financial-strength rating	Stable
    Global local currency – long-term deposits	A2
    Global local currency – short-term deposits	Prime-1
    Foreign currency – long-term bank deposits	A3
    Foreign currency – short-term bank deposits	Prime-2
    Outlook – foreign current deposit rating	Stable
    National scale rating – long-term deposits	Aa2.za
    National scale rating – short-term deposits	Prime-1.za
    Outlook – national scale rating	Stable
    Definitions:
    BFSR

    C =

    Banks rated C possess good intrinsic financial strength. Typically, they will be institutions with valuable and defensible business franchises. These banks will demonstrate either acceptable financial fundamentals within a stable operating environment, or better-than-average financial fundamentals within an unstable operating environment.

    Where appropriate, a ‘+’ modifier is appended to ratings below the ‘A’ category and a ‘-’ modifier will be appended to ratings above the ‘E’ category to distinguish those banks that fall in intermediate categories.

    Long-term (capped by sovereign rating)

    A =	Obligations rated A are subject to low credit risk and considered upper-medium grade.
    Aa =	Obligations rated Aa are subject to very low credit risk and considered high-quality grade.

    Moody’s appends numerical modifiers 1, 2 and 3 to each generic rating classification from m Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category.

    Short-term

    P-1 =	Issuers rated Prime-1 have a superior ability to repay short-term debt obligations.
    P-2 =	Issuers rated Prime-2 have a strong ability to repay short-term debt obligations.

    • Fitch Ratingss

      Fitch Ratings (Fitch) also revised its ratings for Nedbank Group in July 2009.

      Fitch affirmed Nedbank Group’s long-term foreign and local currency Issuer Default Rating (IDR) at BBB and national long-term rating at AA-(zaf) respectively. The short-term foreign currency IDR was upgraded to F2 from F3. The outlook for all three ratings was revised to stable from negative.

      Fitch downgraded Nedbank Limited’s long-term foreign and local currency IDR to BBB from BBB+ and the national long-term rating to AA-(zaf) from AA(zaf) respectively. The outlook for the three ratings was revised upward to stable from negative. In aligning Nedbank Limited’s ratings with those of Nedbank Group, Fitch also reviewed the level of integration between the holding company and its bank subsidiary, and believes there is very little difference between the credit quality of the two entities. The agency considers the overall levels of integration between the two entities to be high, with insignificant external obligations within the holding company and intergroup obligations interest-free and without repayment dates.

    The rating actions are summarised as follows:

    Nedbank Group
    Long-term foreign currency IDR: affirmed at BBB; outlook revised to stable from negative. 

    Long-term local currency IDR: affirmed at BBB; outlook revised to stable from negative. 

    Short-term foreign currency IDR: upgraded to F2 from F3
    
    National long-term rating: affirmed at AA-(zaf); outlook revised to stable from negative. 

    National short-term rating: affirmed at F1+(zaf).
    Individual rating: affirmed at C. 

    Support rating: affirmed at 2.

    Nedbank Limited
    Long-term foreign currency IDR: downgraded to BBB from BBB+; outlook revised to stable from negative.
    
    Long-term local currency IDR: downgraded to BBB from BBB+; outlook revised to stable from negative.

    Short-term foreign currency IDR: affirmed at F2.

    National long-term rating: downgraded to AA-(zaf) from AA(zaf); outlook revised to stable from negative.

    National short-term rating: affirmed at F1+(zaf).
    Individual rating: affirmed at C. 

    Support rating: affirmed at 2.

    Latest Fitch ratings for Nedbank Group companies:

    Fitch ratings	Nedbank Group December 2009	Nedbank Limited December 2009	Imperial Bank Limited December 2009
    Individual	C	C
    Support	2	2	2
    Foreign currency
    Short-term	F2	F2
    Long-term	BBB	BBB
    Long-term rating outlook	Stable	Stable
    Local currency
    Long-term senior	BBB	BBB
    Long-term rating outlook	Stable	Stable
    National
    Short-term	F1+ (zaf)	F1+ (zaf)	F1 (zaf)
    Long-term	AA- (zaf)	AA- (zaf)	A+ (zaf)
    Long-term rating outlook	Stable	Stable	Positive

    Definitions:
    Individual and support

    C =

    An adequate bank that, however, possesses one or more troublesome aspects.

    2 =

    A bank for which there is a high probability of external support and the potential provider of support is highly rated in its own right.

    Foreign and local currency (capped by sovereign risk limits of BBB+ for foreign long-term, F2 for foreign short-term and A for local long-term)

    F2 =

    Good credit quality. The capacity for timely payment of financial commitments is satisfactory.

    BBB =

    Good credit quality. Indicates that there is currently a low expectation of credit risk. The capacity for timely payment of financial commitments is considered adequate.

    The modifiers ‘+’ or ‘-’ denote relative status within major categories.

    National

    F1 =

    Indicates the strongest capacity for timely payment of financial commitments relative to other issuers or issues in the same country.

    A =

    Denotes a strong credit risk relative to other issuers or issues in the same country.

    AA =

    Denotes a very strong credit risk relative to other issuers or issues in the same country.

    The modifiers ‘+’ or ‘-’ denote relative status within major categories.