Capital management and Basel II

Overview

Nedbank Group's aspiration of being a great place to invest requires best-practice capital management for our shareholders. In line with this objective and similar extensive efforts in risk management and the related Basel ll programme, Nedbank Group started to introduce worldclass capital management during 2005.

With Basel ll as the catalyst, the banking industry is transitioning to proper risk-based capital requirements (or economic capital). The risk profile of a bank will drive its capital requirements and hence fundamentally impact its core financial performance metrics. Additionally, there is increased competition in the industry and South Africa has entered what appears to be a new low inflationary environment.

Accordingly, the rules of the game of banking are changing and factors critical to achieving high performance will include:

• optimising the balance sheet risk profile;
  
• optimising capital levels;
  
• integrating risk and capital into strategy, and linking this to performance measurement; and, ultimately
  
• shareholder value-based management.

Nedbank Group's proactive response to this and its stages to worldclass risk and capital management, as well as performance measurement, are illustrated below:

Capital Management Framework

A comprehensive Capital Management Framework (CMF), illustrated below, has been approved by the board.

The new Group Capital Management Division (established in early-2005), which reports direct to the Chief Financial Officer, is mandated to champion the successful implementation of the CMF across the group.

The following is a brief outlay of the capital management governance in Nedbank Group:

The risk and capital management responsibilities of the board and Group Exco are incorporated in their respective terms of reference (charters) contained in the Enterprise-Wide Risk Management Framework (ERMF). They are assisted in this regard, and in the oversight of the group's capital risk (defined in the ERMF), by the board's Group Risk Committee and the ALCO and Executive Risk Committee (Group ALCO), respectively.

Group ALCO is in turn assisted by the Capital Management Committee (an interactive forum involving relevant senior management) and the Group Capital Management Division.

Risk-adjusted performance measurement

Risk-adjusted performance measurement (RAPM) is ultimately the essential component in Nedbank Group's capital management framework to achieving successful capital allocation, optimisation and integration into strategy.

There are two main measures implemented through the RAPM framework: risk-adjusted return on capital (RAROC), which expresses the risk-adjusted profit with respect to the capital necessary to generate the revenue, giving a relative measure of performance; and economic profit (EP), an absolute measure of shareholder value creation.

EP is being introduced as Nedbank Group's interpretation and measure for shareholder value creation, in conjunction with the existing traditional ROE measure, and from 2008 will become a key financial performance indicator for the Nedbank Group. This will ensure alignment with shareholders' interests.

The diagram below illustrates the adjustments made to the traditional income statement to arrive at Nedbank Group's risk-adjusted return measurement:

The group's cost of capital used for RAPM purposes at 31 December 2005 is calculated below.

Cost of capital is the weighted average of the cost (WACC) of the two equity components: ordinary and preference shares.

Strategic capital plan

The board has approved a comprehensive Strategic Capital Plan (SCP), which has been integrated into the group's 2006 to 2008 business plan.

Included in this plan is Nedbank Group's strategic and tactical response to Basel II, economic capital, risk appetite and RAROC targets, long-run (three-year) capital planning and various capital optimisation initiatives.

The current capital management strategy is summarised in five core objectives:

• fully implemented economic capital and RAPM to align with shareholder interests and value-add;
  
• capital mix and structure to be changed to optimise and lower the cost of capital within the board-approved risk appetite targets;
  
• Basel II, including the group's tactical response, to be successfully implemented;
  
• capital levels to be optimised to enhance ROE, while never compromising the group's targeted capital adequacy ratios; and
  
• risk and capital to be integrated into strategy and to be linked to performance measurement and incentives.

The group's capital position is now robust, with the Tier 1 group capital adequacy ratio increasing from 8,1% in December 2004 to 9,4% in December 2005. The total group capital adequacy ratio has improved from 12,1% in December 2004 to 12,9% in December 2005. This improvement was higher than management originally anticipated due largely to higher than expected non-core assets sales and a higher than expected acceptance of the group's 2005 interim capitalisation award. As a result, a share repurchase programme has been initiated to manage capital levels proactively. In addition to this, the group has changed its dividend cover ratio from 3,0 to 3,5 times headline earnings to 2,5 to 3,0 times headline earnings.

Nedbank Group's strategic capital plan is focused on optimising the level, mix and structure of the capital base. To achieve this the group commenced a share repurchase programme during the last quarter of 2005. The group purchased 1,02 million shares at an average price of R98, which are held as treasury shares in a group company.

The group will continue with the dynamic management of its capital with a view to managing Tier 1 capital and the overall capital mix more efficiently, subject to the appropriate shareholder and regulatory approvals.

The group is also restructuring its subordinated (Tier 2) debt profile. The group currently plans to call the R2 billion NED 1 bond during 2006 and issue two new bonds of approximately R1,5 billion each, the first of which will be issued in April 2006, with a second issue around September 2006. The group also proposes to enhance its subordinated debt profile further in 2007, when the R4 billion NED 2 bond will in all likelihood be called and replaced with a series of smaller bonds. This will lower the cost of the Tier 2 capital, as the NED 1 and NED 2 bonds are relatively expensive, with an annual coupon rate of 11,3% and 13,15% respectively.

There are a number of items of national discretion that are in the process of being resolved between the South African Reserve Bank (SARB) and the industry, which could impact on Nedbank Group's capital planning.

These include:

• decision on the pillar 1 capital ratio;
  
• approach to the pillar 2 capital buffer;
  
• foundation internal-ratings-based (FIRB) versus advanced internal-ratings-based (AIRB) credit risk approach accreditation;
  
• qualifying capital and hybrid capital instruments;
  
• alternative standardised approach versus standardised approach qualification requirements for operational risk;
  
• other areas of national discretion; and
  
• final Basel II calibration.

In line with the key milestones for Basel II implementation in South Africa, the final draft of the new banking regulations is due in the second half of 2006, at which point these items of national discretion are expected to be largely resolved and Nedbank Group's capital planning may then be refined. The group will update its capital planning and communicate further details at the time of its 2006 interim results.

Capital adequacy

From an internal capital adequacy assessment perspective, Nedbank Group is adequately capitalised in relation to its current target debt (solvency) rating of Ain terms of its board-approved economic capital framework.

In respect of the current regulatory (Basel I) standard the group and Nedbank Limited's capital adequacy positions are also strong and, for the reasons set out earlier, well above our current target ratios of 12% (total) and 8% (Tier 1) for both Nedbank Group and Nedbank Limited:

Further information on the capital adequacy positions of the group and Nedbank Limited may be found under Capital adequacy.

Basel II update

Overview

The SARB has confirmed a common implementation date of 1 January 2008 for Basel II in South Africa. It is pleasing to note the resourcing for Basel II that has taken place at SARB during 2005 and the significant progress made with the drafting of the new regulations and Banks Act returns, which has had significant input from the major South African banks.

As reported previously, Nedbank Group has been following a strategic-based approach to its Basel II implementation since 2003, not only to comply with Basel II, but also to elevate the group's risk management, capital management and performance measurement to worldclass standards.

Nedbank Group's Basel II programme is summarised in four main components, as illustrated on the following page, and is on track with considerable implementation and use already in place.

Nedbank Group's targeted approaches for day-one implementation (ie 1 January 2008) of Basel II remain as follows:

• AIRB approach for credit risk;
  
• standardised approach for operational risk, but with worldclass operational risk management. A plan and roadmap have been finalised, and workstreams are under way for the advanced measurement approach (AMA), but target implementation of this is 2010;
  
• internal model approach for market trading risk; and
  
• worldclass capital management and ALM.

Cost of Basel II implementation

The once-off costs associated with implementing the outlined target Basel II approaches, and elevating risk and capital management in the Nedbank Group to worldclass standards, is approximately R250 million.

This total estimated cost is spread over four years (2003 to 2006), with the major portion having been incurred by end-2005.

Basel II capital impact

Since 2004 capital reporting and projections to senior management and the board have included estimation of requirements under economic capital, Basel II regulatory capital and the current Basel I regulatory capital. In the first half of 2005 Nedbank Group reported to SARB via the Quantitative Impact Study (QIS) 4 on the preliminary estimated capital impacts of Basel II. SARB has indicated a requirement for banks to conduct a QIS 5 in 2006.

As noted earlier, there are a number of items of national discretion pertaining to the pending new regulations under Basel II that require resolution prior to the group being in a position to determine the finalised impact of Basel II on capital levels.

Nedbank Group has made various assumptions regarding these uncertainties and, based on these, our capital projections reflect a favourable position under Basel II at the end of 2007 (Basel II is effective in South Africa from 1 January 2008).