INNOVEST’S GLOBAL BANKING REPORT COVERS 263 BANKS Global Banking Report AND DIVERSIFIED FINANCIALS Overview IN THE AMERICAS, THE UK, ASIA, AND EUROPE. November 2006 THE REPORT IS DIVIDED INTO FOUR SECTIONS: Lead Author: Gregory Larkin, Analyst, Email: [email protected]. Section 1 Contributing Authors: Amy-Lyn Hall, Analyst; Tomoko Smidt-Olsen, Analyst; Key Environmental, Social and Elizabeth Lipton, Analyst. Governance Threats and Opportunities The chart below examines the one year stock performance of the 60 largest banks in The Global Banking Sector, categorized by their Innovest Overall Rating. In it, we can see that Innovest’s Best Retail Banking, In Class banks more consistently posted strong returns relative to their competitors. For further explanation please turn to page 8. Corporate Finance, and One Year Total ROI vs. Innovest Ratings 60 Asset Management and Investment Banking 50 Section 2 40 Best Practice in the Global Banking Sector 30 20 Section 3 Innovest’s EV21, Intangible Value 1yr. ROI total 10 Assessment and Overall Ratings for the 0 263 companies analyzed in the sector. -10 See appendix for full list of companies. -20 Section 4 AAA1AAA AA2AA A3A BBB4BBB BB5BB B6B Innovest Overall Ratings Key Predictions for 2007, and Changes in Innovest’s coverage of the No part of this report may be reproduced in any manner without the written permission of Innovest Strategic financial sector in 2007 Value Advisors, Inc. The information herein has been obtained from sources which we believe to be reliable, but we do not guarantee its accuracy or completeness. All opinions expressed herein are subject to change without notice. Innovest Strategic Value Advisors, Inc., its affiliated companies, or their respective shareholders, directors, officers and/or employees, may have a position in the securities discussed herein. The securities mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates. © 2006 Innovest Strategic Value Advisors, Inc. All rights reserved. New York Toronto San Francisco Tokyo Mr. Peter Wilkes Ms. Susan McGeachie Mr. Pierre Trevet Mr. Hiromichi Soma Managing Director Director Managing Director Director +1 212 421 2000 ext. 216 +1 905 707 0876 ext. 217 +1 415 332 3506 +81 3 5976 8337 [email protected] [email protected] [email protected] [email protected] Paris London Sydney Innovest Uncovering Hidden Value Perrine Dutronc Mr. Andy White Mr. Bill Hartnett for Strategic Investors Managing Director Managing Director Managing Director +33 (0)1 44 54 04 89 +44 (0) 20 7073 0469 +61 2 9940 2688 [email protected] [email protected] [email protected] www.innovestgroup.com Innovest Strategic Value Advisors Global Banking Sector Report, Overview www.innovestgroup.com November 2006 Introduction: Environmental, Social, and Governance (ESG) factors in the banking sector have been gathering momentum for a number of years and with growing consistency impact a bank’s credit quality, reputation, and regulatory vulnerability. Increasingly, banks which incorporate ESG factors into their lending and investment decisions enjoy a “sustainability premium” which helps drive outperformance. Innovest analysis continues to demonstrate that superior ESG performance can result in superior share price performance as well. Figure 1 below shows the max, min and median one year total return on investment (capital growth and dividend) for the 60 largest banks categorized by Innovest Overall ratings (a seven tier scale where AAA=Best, BBB= average, and CCC=worst).1 In it we can see that banks with strong Innovest ratings have less volatility and higher average performance compared with their competitors rated BBB and below. The performance of BBs over the past year also shows that extra-financial research is an overlay - not a substitute - for quantitative analysis. A bank which takes risks out of its ESG comfort zone may still win on the bets that it placed. However, this chart shows that banks rated A and above more consistently do well. The Innovest ratings used are those as of 30th September 2005 and the stock price change is in local currency over a one-year period to September 30 2006. One Year Total ROI vs. Innovest Ratings One Year Total ROI vs. Innovest Ratings 60 50 40 30 20 1yr. total ROI 1yr. 10 0 -10 -20 AAA1AAA AA2AA A3A BBB4BBB BB5BB B6B Innovest Overall Ratings 1 There was only one CCC within the 60 largest banks, and we therefore removed it from this study. 2 Innovest Strategic Value Advisors Global Banking Sector Report, Overview www.innovestgroup.com November 2006 Section 1 KEY ENVIRONMENTAL, SOCIAL AND GOVERNANCE THREATS AND OPPORTUNITIES IN THE GLOBAL BANKING SECTOR. 1.1 Retail Banking Banks with strong ESG management systems understand their customers’ needs and risks better and design products specifically tailored to capitalize on undervalued high risk/high reward customer demographics. This section specifically addresses banks’ strategies to deal with: The Growth of the Sub Prime Market American and UK banks have aggressively pursued the estimated $1.4trillion of income held by customers with impaired, or no credit, and have also targeted the immigrant population. Stakeholder Engagement and Credit Quality There is growing evidence that Banks with strong stakeholder engagement, widely implemented financial education initiatives and an adaptive product portfolio are outperforming in the lucrative sub-prime market. The Decline of the US Housing Market Between 2002 and 2005 the percentage of bank loans allocated to residential real estate shot up from 23%to 32.5% as banks lowered their risk threshold to throw more money into the booming housing market. We examine strategies to weather the downturn. The Global Thrift Shift As household savings rates deteriorate in the US, UK, and Australia, in much of the developing world households save between 20 and 40% of their disposable income. 1.2 Corporate Lending and Project Finance Banks which are not able to incorporate ESG risk into their corporate lending operations are more vulnerable to exogenous shocks. Conversely, banks which understand ESG risks are able to more effectively navigate complicated risk landscapes and spot opportunities that less sustainable banks overlook. This section looks at: Key ESG Risks Confronting Corporate Lending Divisions In this section we analyze how Greenhouse gas Regulation, extreme weather patterns associated with climate change, environmental degradation in high gorwth emerging market and emerging market instabilty factor into corporate lending performance. 3 Innovest Strategic Value Advisors Global Banking Sector Report, Overview www.innovestgroup.com November 2006 Environmental, Social and Governance Upside In this section we look at how new opportunities in renewable energy and clean technology, sustainable growth in emerging market economies, and stronger credit risk management are driving outperformance. Corpoprate Lending In China In this section we analyze China’s rapidly evolving political economy and how it impacts new entrants into the Chinese banking sector. 1.3 Asset Management and Investment Banking There is a growing body of research which shows that incorporating ESG factors into equity valuations can lead to decreased volatility and increased performance. Obviously, this depends on the strategy deployed, and the time horizon. Investors and traders with a short time horizon, however, can use ESG factors to predict binary events. This section discusses: The Sustainability Premium in Asset Management Research shows that by incorporating ESG factors, valuation models used by asset management divisions can add outperformance. Emissions Trading Transnational regulation limiting toxic emissions has created fast growing cap and trade markets. The financial sector plays a critical role in financing companies’ emissions compliance and developing the emissions trading market. Governance Challenges in China Throughout the financial sector banks have been scrambling for positions in China’s capital and corporate lending markets, even though the country has not entirely shed its command economy past. We zero in on political reforms in China’s markets and focus on which banks are best positioned to navigate China’s political economy. Stable, Sustainable Development in Emerging Markets Banks play a critical role in capitalizing emerging market growth. Banks whose lending and investment decisions can foster strong, sustainable long term growth are better positioned to outperform in the long term. 4 Innovest Strategic Value Advisors Global Banking Sector Report, Overview www.innovestgroup.com November 2006 Section 2 BEST PRACTICE IN THE GLOBAL BANKING SECTOR Executive Summary In Section 3 of the Global Banking Report, Innovest analyzes the best ESG practices in the sector and zeros in on the four pillars that underpin a bank’s Innovest rating. Section 3 provides best practice in the global banking sector Breifly, these pillars are: Strategic Governance This assesses how the mangement, and executive level of a bank assesses, adapts to and manages environmental, social, and governance risk and opportunity. Key Section include: » Strategy » Strategic Capability » Traditional Governance » Risks and Strategic Profit Opportunities Human Capital This pillar examines how effectively a bank recruits, develops, and retains