Study and Analysis of Intesa Sanpaolo Bank Finance Essay

The purpose of Pillar 3 market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The Basel Committee on Banking Supervision (The Committee) aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. The Committee believes that such disclosures have particular relevance under the Framework, where reliance on internal methodologies gives banks more discretion in assessing capital requirements (BIS,2011).

The Committee is aware that supervisors have different powers available to them to achieve the disclosure requirements. Market discipline can contribute to a safe and sound banking environment, and supervisors require firms to operate in a safe and sound manner. Under safety and soundness grounds, supervisors could require banks to disclose information. Alternatively, supervisors have the authority to require banks to provide information in regulatory reports. Some supervisors could make some or all of the information in these reports publicly available. Further, there are a number of existing mechanisms by which supervisors may enforce requirements. These vary from country to country and range from "moral suasion" through dialogue with the bank's management (in order to change the latter's behavior), to reprimands or financial penalties. The nature of the exact measures used will depend on the legal powers of the supervisor and the seriousness of the disclosure deficiency. However, it is not intended that direct additional capital requirements would be a response to non-disclosure (BIS,2011).

Intesa Sanpaolo is an Italian bank that strictly adheres to the norms of transparency and has all its reports publicly disclosed. Therefore, this work is dedicated to the analysis of its risk profile using the documentation from the year 2010. Main calculations and figures were analyzed according to Basel 2 Pillar 3 requirements. In the end the summary of the risk profile is presented.

Background of the company

Intesa SanpaoloA is a banking group resulting from the merger betweenA Banca IntesaA andA Sanpaolo IMIA based inA Turin,A Italy. It has clear leadership in theA Italian marketA and a minor but growing international presence focused on Central-Eastern Europe and the Mediterranean basin (77% of the bank's revenue (97.7% from Europe) and 86% of all loans to customers come from business in Italy).A When it was formed in 2007 it overtookA Unicredit GroupA as the largest bank in Italy with 13 million customers andA $690 billion worth of assets.A By 2010 its assets had grown toA $877.66 billion 26th highest among all of the world's companies (Wikipedia, 2011).

Risk Management

In 2009 group acquisitions included a 30% interest in business info company MF Honyvem, and an increased stake inA AlitaliaA up to 33.3%. Even though the bank was rumored to have been working with the government to keep Air France from acquiring a stake in Alitalia Air France eventually acquired a 25% interest in Intesa Sanpaolo Group. Policies relating to risk acceptance are defined by the Parent Company's Management Bodies, Supervisory Board and Management Board, with support from specific Committees (particularly, the Group Risk Governance Committee), and the Chief Risk Officer, who reports directly to the Chief Executive Officer (Intesa Sanpaolo, 2010).

The Parent Company is in charge of overall direction, management and control of risks, whereas Group companies that generate credit and/or financial risks operate within the assigned autonomy limits and have their own control structures.

A service agreement governs the risk control activities performed by the Parent Company's functions on behalf of the main subsidiaries. These functions report directly to the subsidiary's Management Bodies.

The risk measurement and management tools together define a risk-monitoring framework at Group level, capable of assessing the risks assumed by the Group from a regulatory and economic point of view. The level of absorption of economic capital, defined as the maximum "unexpected" loss that could be borne by the Group over a period of one year, is a key measure for determining the Group's financial structure, risk appetite and for guiding operations, ensuring a balance between risks assumed and shareholder returns. It is estimated on the basis of the current situation and also as a forecast, based on the Budget assumptions and projected economic scenario under ordinary and stress conditions (Intesa Sanpaolo, 2010).

The capital position forms the basis for the business reporting and is submitted quarterly to the Group Risk Governance Committee, the Management Board and the Control Committee, as part of the Group's Risks Tableau de Bord.

Risk hedging, given the nature, frequency and potential impact of the risk, is based on a constant balance between mitigation/hedging action, control procedures/processes and capital protection measures (Saita, 2007).

Credit risk management

The Group's strategies, powers and rules for the granting and management of loans are aimed at:

- Achieving the goal of sustainable growth of lending operations consistent with the risk appetite and value creation;

- Diversifying the portfolio, limiting the concentration of exposures on single counterparties/groups, single economic sectors or geographical areas;

- Efficiently selecting economic groups and individual borrowers through a thorough analysis of their creditworthiness aimed at limiting the risk of insolvency;

- Privileging lending of a commercial nature or intended for new investments in production, provided that they are sustainable, over those of a merely financial nature;

- Constantly monitoring relationships, through the use of both T procedures and systematic surveillance of positions, that show irregularities with the aim of detecting any symptoms of performance deterioration in a timely manner.

The Intesa Sanpaolo Group has developed a set of techniques and tools for credit risk measurement and management which ensures analytical control over the quality of loans to customers and financial institutions, and loans subject to country risk.

In particular, with respect to loans to customers, risk is measured using internal rating models which change according to the segment to which the counterparty belongs (Intesa Sanpaolo, 2010).

Market risks management

The quantification of trading risks is based on daily VaR of the trading portfolios of Intesa Sanpaolo and Banca IMI, which represent the main portion of the Group's market risks, to adverse market movements of the following risk factors:

- Interest rates;

- Equity and market indices;

- Investment funds;

- Foreign exchange rates;

- Implied volatilities;

- Spreads in credit default swaps (CDSs);

- Spreads in bond issues;

- Correlation instruments;

- Dividend derivatives;

- Asset-backed securities (ABSs);

- Commodities.

Some of the other Group subsidiaries hold smaller trading portfolios with a marginal risk (around 4% of the Group's overall risk). In particular, the risk factors of the international subsidiaries' trading books are interest rates and foreign exchange rates, both relating to linear pay-offs.

For some of the risk factors indicated above, the Supervisory Authority has validated the internal models for the reporting of the capital absorptions of both Intesa Sanpaolo and Banca IMI.

In particular, the validated risk profiles for market risks are: (i) generic on debt securities and generic/specific on equities for Intesa Sanpaolo and Banca IMI, (ii) position risk on quotas of funds underlying CPPI (Constant Proportion Portfolio Insurance) products for Banca IMI, (iii) optional risk and specific risk for the CDS portfolio for Intesa Sanpaolo, (iv) position risk on dividend derivatives (Intesa Sanpaolo 2010).

From the second quarter of 2010, the validated risk profiles were extended to commodity risk for Banca IMI, the only legal entity of the Group authorized to hold open positions in commodities.

The analysis of market risk profiles relative to the trading book uses various quantitative indicators and VaR is the most important. Since VaR is a synthetic indicator which does not fully identify all types of potential loss, risk management has been enriched with other measures, in particular simulation measures for the quantification of risks from illiquid parameters (dividends, correlation, ABS, hedge funds).VaR estimates are calculated daily based on simulations of historical time-series, a 99% confidence level and 1-day holding period.

The following paragraphs provide the estimates and evolution of VaR, defined as the sum of VaR and of the simulation on illiquid parameters, for the trading book of Intesa Sanpaolo and Banca IMI.

In the third quarter of 2010, market risks generated by Intesa Sanpaolo and Banca IMI increased with respect to the averages for the second quarter of 2010. The average VaR for the period totaled 43.4 million euro.

Daily VaR of the trading book for Intesa Sanpaolo and Banca IMI

Source: Intesa Sanpaolo, 2010

In the first nine months of 2010, market risks generated by Intesa Sanpaolo and Banca IMI decreased with respect to the averages for 2009. The average VaR for the period totaled 38.5 million euro.

Source: Intesa Sanpaolo, 2010

For Intesa Sanpaolo and Banca IMI, the breakdown of risk profile in the third quarter of 2010 with regard to the various factors shows the prevalence of the hedge fund risk, which accounted for 48% of total VaR; for Banca IMI, credit spread risk was the most significant, representing 50% of total VaR.

Contribution of risk factors to overall VaR

Source: Intesa Sanpaolo 2010

The level of risk remained high in the third quarter of 2010 due to the increased volatility of the spreads in government issues, following the worsening of the Greek crisis and the related contagion effect on Eurozone countries.

Source: Intesa Sanpaolo, 2010

Risk control with regard to the trading activity of Intesa Sanpaolo and Banca IMI also uses scenario analyses and stress tests. The impact on the income statement of selected scenarios relating to the evolution of stock prices, interest rates, credit spreads, foreign exchange rates and commodity prices at the end of September is summarized as follows:

- on stock market positions, a bullish scenario, that is a 5% increase in stock prices with a simultaneous 10% decrease in volatility would have led to a 17 million euro loss;

- on interest rate exposures, a parallel +25 basis point shift in the yield curve would have led to a 26 million euro loss, whereas a parallel -25 basis point shift would have led to a 33 million euro gain;

- on exposures sensitive to credit spread fluctuations, a 25 basis point widening in spreads would have led to an 85 million euro loss, 6 million euro of which due to structured credit products (SCP), whereas a 25 basis point tightening of the spreads would have led to an 86 million euro gain, 6 million euro of which due to SCPs;

- on foreign exchange exposures (main position on Euro/USD), the portfolio would have recorded a 4 million euro gain in the event of exchange depreciation (-10%). The loss in the event of foreign exchange appreciation (+10%) would have been 1 million euro;

- lastly, on commodity exposures a 6 million euro loss would have been recorded had there been a 50% increase in prices .

Source: Intesa Sanpaolo, 2010

Market risk originated by the banking book arises primarily in the Parent Company and in the other main Group companies that carry out retail and corporate banking. The banking book also includes exposure to market risks deriving from the equity investments in listed companies not fully consolidated, mostly held by the Parent Company and by Equiter, IMI Investimenti and Private Equity International.

The following methods are used to measure financial risks of the Group's banking book:

- Value at Risk (VaR);

- Sensitivity analysis.

Value at Risk is calculated as the maximum potential loss in the portfolio's market value that could be recorded over a 10-day holding period with a 99% confidence level (parametric VaR).

Shift sensitivity analysis quantifies the change in value of a financial portfolio resulting from adverse movements in the main risk factors (interest rate, foreign exchange, equity). For interest rate risk, an adverse movement is defined as a parallel and uniform shift of A±100 basis points of the interest rate curve. The measurements include an estimate of the prepayment effect and of the risk originated by customer demand loans and deposits.

Furthermore, sensitivity of the interest margin is measured by quantifying the impact on net interest income of a parallel and instantaneous shock in the interest rate curve of A±100 basis points, over a period of 12 months. This measure highlights the effect of variations in interest rates on the portfolio being measured, excluding assumptions on future changes in the mix of assets and liabilities and, therefore, it cannot be considered a predictor of the future levels of the interest margin (Galai, 1999).

Notes to the Basel 2 Pillar 3 disclosure

The regulations governing the drafting of the "Pillar 3 Basel 2

disclosure require credit institutions to adopt a formal policy to meet the minimum public disclosure requirements and to put procedures in place that enable them to assess its adequacy, also in terms of its verification and frequency. To this end, the Supervisory Board of the Parent Company Intesa Sanpaolo has approved a specific document "Guidelines on Pillar 3 disclosure". This document sets out the duties and responsibilities of the Corporate Bodies and the various Group departments involved in the different stages of the process governing this disclosure. Given its public importance, this document is for approval to the competent Corporate Bodies by the Manager responsible for preparing the Company's financial reports. This document is therefore subject to the related certification. As a consequence, the "pillar 3 Basel 2"disclosure is subject to the checks and controls established in the Group's "Guidelines for administrative and financial governance. In particular, the internal control system, for accounting and financial information is designed to ensure the ongoing verification of the adequacy and effective implementation of the administrative and accounting procedures at Group level (BIS,2011).

Capital Ratios as at 30 September 2010

Source: Intesa Sanpaolo, 2010

All capital ratios improved compared to 31 December 2009. The total capital ratio stood at 12.5%, while the Group's Tier 1 ratio was 8.9%. The ratio of Tier 1 capital net of preferred shares to risk-weighted assets (Core Tier 1) was 7.7%.

The improvement in ratios compared to 31 December 2009 was the result not only of ordinary operations, but also of the sale of the securities services business and the application of the internal approach to determine capital requirements for residential mortgages for private individuals following authorization from the Bank of Italy. The acquisition of the Monte dei Paschi di Siena branches and the purchase of 50% of Intesa Vita had a negative impact (Intesa Sanpaolo, 2010).

Capital Adequacy

In general terms, the group-level capital requirement is calculated as the sum of the individual requirements of the individual companies that make up the Banking group, net of exposures arising from intragroup relations included in the calculation of credit, counterparty and settlement risk.

In addition to the Total capital ratio referred to above, other more rigorous ratios are also used to assess capital base soundness: the Tier 1 capital ratio, represented by the ratio between Tier 1 capital and risk weighted assets.

Source: Intesa Sanpaolo

Summary

Operations in the first half of 2010 continued to be shaped by a focus on those factors that the market considers important in the current scenario of instability: solidity, liquidity and risk profile.

In terms of solidity, Intesa Sanpaolo - which has not turned to the market or government aid - is among those banking groups that best weathered the crisis of 2008 at the international level. Even in the current difficult scenario, the Group has an adequate capital base, and one of the lowest leverages when compared with the main international competitors: the ratio of total tangible shareholders' equity to total tangible assets was 4.4% at the end of June.

Considering the use, effective as of 30 June 2010, of the internal approach for determining the credit risk requirement relating to the regulatory segment of residential mortgages for private individuals, at the end of the first half of the year the Core Tier 1 ratio came to 7.7%, the Tier 1 ratio to 8.9% and the total capital ratio to 12.2%. Pursuant to the requirements of Pillar 2 of the Basel II Accord, capital adequacy has also been measured from the management perspective.

The results of the ICAAP (internal capital adequacy assessment) process confirm the Group's sound capital base: the financial resources available ensure, with adequate margins, coverage of all current and prospective risks, also in stress conditions.

The business model adopted by Intesa Sanpaolo also continues to ensure strong control of liquidity risk, largely thanks to the high contribution of retail funding to total funding sources. The stability of this source of funding, especially in the form of demand deposits and bonds, continues to represent one of the Group's main strengths. Intesa Sanpaolo has adequate liquidity reserves, consisting of a high amount of eligible assets - a large proportion also being highly liquid - and overnight loans through repurchase agreements renewed continuously, financed through short-term liabilities in the money market. The amount of these funds is established to cover the Bank's full operational requirements for a long period, also in the event of a sudden crisis in the wholesale market (money market and bond market).

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