Definition of Internal Capital Requirement
– on group and subsidiary level
Andreas Green
January 27, 2011
Agenda
2

Internal Capital Requirement
– Definition
– Group vs. subsidiary level

Stress tests
– Purpose
– Methodology
– Group vs. subsidiary level
Internal Capital Requirement
3
Definition of the internal capital requirement (ICR)
ICR
Additional Capital Constraints
Economic Capital, exc NLP
2
3
4
1
Pillar 1 risks
Adj P1 credit
risk
Credit Risk
Pillar 2 risks
Market Risk
Add'l Capital Internal Capital
Buffer
Requirement
Operational Risk
Large
Exposures
Core Tier 1 capital
Transition
Rules
Financial
Actual Capital
Conglomerate
Base
Tier 1 Hybrid
A key component of the ICR is the stress buffer
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Tier 2 capital
Group vs. subsidiary level

Nordea’s policy has so far been to not include stress test
buffers in the definition of Internal Capital Requirement on
subsidiary level
– The rationale has been to maximize capital transferability within the Group
– The capital adequacy has thus been assessed based on a comparison of
the actual capital and the ICR excluding stress test buffers
This position has been challenged during the financial crisis and will be further
challenged due to the crisis management framework being developed
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Stress tests
6
The role of stress testing

Stress testing is primarily a
component of capital forecasting
and requires a holistic
perspective on risks
Capital requirements during
economic cycle
Economic
Cycle
– Does the bank have enough capital
Available capital
(Tier 1/ capital
base)
given a serious economic downturn?

Given the process of stressing
capital requirements, the bank is
forced to consider mitigating
actions
– How can the bank maintain capital
targets and/or requirements in periods
of stress?
– Where might the bank consider
reducing exposures? Reducing
growth?
– Where will the bank find additional
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capital in periods of economic stress?
Capital surplus
Required capital
(Regulatory/
Internal)
Stress test methodology
Capital Requirements
Financial Statements

Financial statements – stressed income
statements and balance sheets

Probability of default – stressed to reflect
increases in defaults.
Growth – stressed growth rates are
applied to P&L and lending.

Collateral coverage – stressed by moving
exposures from secured to unsecured.
Loan losses – derived using a historical
regression analysis applied to scenarios.

Funding costs – increase in the cost of
long- and short-term funding
Exemplified by Credit risk
 Rating migration – all customers are
migrated according to scenarios.


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GDP
Credit Risk
Unemployment
Market Risk
Inflation
Other Risks
Stock prices
Income
Property prices
Expenses
Interest rates
Loan losses
Capital
Requirements
Capital
Ratios
Capital Base
Group vs. subsidiary level

On group level Nordea defines the (ICR) stress test
buffer based on the ambition to not fall below a
certain threshold
– Should the definition be consistent across entities?
– Should the severity of the stress scenarios be the same on
subsidiary level as on group level?
– The stress test methodology needs in general to be adapted to
Basel III and the group vs. subsidiary level issue will be impacted
by the crisis management framework
A requirement to maintain stress test buffers on subsidiary level will most likely mean
that the sum of the stress test buffers on subsidiary level exceeds the buffer on group
level
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