Management, measurement and control systems

Starting in 2008, statistical models aimed at creating the Internal Rating Model and rating assignment processes were authorised by the Supervisory Authority for the calculation of capital requirements using the Advanced IRB approach (AIRB).

Basel 2 requires the Group to adopt the following credit risk measures needed to calculate regulatory capital (AIRB approach): Probability of Default (PD), Loss Given Default (LGD), and Exposure At Default (EAD). The new methodology with the greatest impact on risk measurements is "Probability of Default”, which is a reflection of the borrower’s rating and expresses its ability to meet obligations assumed over a time horizon of one year. Thus, a rating is a probability-based approach to risk assessment representing a projection of portfolio quality that becomes part of daily processes for: credit facility assessment, loan management, pricing, allocation to reserves and management reporting.

The statutory adoption of risk criteria has made it possible for the Bank to obtain significant operational advantages, both in terms of higher accuracy in credit budgeting forecasts and in terms of a more effective monitoring of credit aggregates: based on risk criteria, the Group sets the process for the yearly budgeting of credit items and makes accurate and sustainable forecasts in relation to the loan book, substandard and doubtful loan flows and loan-loss provisions.

Forecast sustainability is ensured by the definition of concrete loan book actions which are communicated to the outlying networks through an internal regulatory document as well as by amending the credit disbursement and management processes and criteria.

All credit processes use the borrower rating as a decision-making driver and are conceived of as a function of the specific nature of the various customer segments in order to optimise the use of resources employed in loan management/monitoring and to achieve the right balance between the push for sales and effective loan management. The internal rating system, which affects the Corporate and Retail portfolios, is based on the development of several statistical models specialised by customer type with the aim of assigning a solvency rating for both prospective borrowers (first-time lending models based on financial and demographic information taken from outside databases) and existing borrowers (for which behavioural models have also been used, which incorporate internal performance data).

With a view to increasing the levels of efficiency in managing internal ratings, the current scope of activity of the Rating Agencies has been reviewed for them to become a single point of reference for all units on rating issues. The new role of the [internal] Rating Agencies will allow for a closer interaction with the Network to make assistance more effective, generate more synergies and enable a more efficient transfer of knowledge.

In September, the operating scope of [internal] Rating Agencies was limited to companies with revenues exceeding EUR 5 mln (the previous limit was EUR 2,5 mln). Portfolio reduction will enhance the rating maintenance efficiency, while improving rating quality for the counterparties within the new scope.

2.2.1 Credit policies

Since 2008, the credit policy definition process, fed with data input from the metrics described above, has been based on analytical portfolio estimates and has continuously been optimised and finetuned.

The model adopted, which is integrated in the Group's budgeting process, has among its main objectives the re- qualification of the loan book and containment of the cost of credit. Furthermore, the model provides guidance for loan book management and growth, by setting out criteria for customer selection and approaches for the identification of portfolios to be re-qualified/run off in different ways depending on customer segment, business sector, geographic area, quality of counterparties, form of lending and collateral pledged.

In 2013, the document describing 'credit policy guidelines” by geo-sectoral clusters of business has been updated. In particular, it sets out strategies for the growth and requalification of lending.

In 2013, the following loan book requalification initiatives launched in 2012 have been maintained as structural:

 Credit scoring and rating review, attaching priority to high-risk positions with a view to identifying those

accounts which, despite signs of risk, have the fundamentals for a renewal of credit lines and financial support.

 'Requalification' / downsizing of loans to riskier counterparties when the credit scoring and rating review

makes it advisable to proceed with a reduction in exposure.

 Increased credit assessment intervention on past due positions, by activating a “Problem Loan Front End”

task force to support the Network;

 Screening of new loans disbursed for net growth objectives to be achieved consistently with the need to

safeguard the prospective quality of the loan book.

2.2.2 Disbursement processes

Loan disbursement processes are aimed at improving the effectiveness, efficiency and level of service in loan management with the goal of:

 standardising and automating loan proposals and risk assessment to the extent possible;

 adapting processes to the branch network’s organisational and operational requirements;

 assessing creditworthiness, also through the assignment of internal ratings to individual borrowers;

 improving customer response time.

The procedure available to the branch network and the Head Office for managing all phases of the loan approval process, consists in the Electronic Loan File (it. Pratica Elettronica di Fido or P.E.F.). This tool is continually optimised with the aim of improving both response time and the selection of acceptable risk.

The assessment and approval methods implemented in the ‘P.E.F.’ reflect the principles and rules of the internal rating system. Thus, methods differ depending on whether the customer is an individual/consumer (retail) or a

EXPLANATORY NOTES- Part E – Risks and hedging policies

business (a corporation with revenues under EUR 5 million, or a corporation with revenues over EUR 5 million) and on whether the customer is a prospect or existing customer.

In keeping with the regulatory provisions issued by the Supervisory Authority, the ‘P.E.F.’ was designed to use one single rating when borrowers have relationships with several MPS Group banks. In terms of activities aimed at complying with AIRB requirements, the assignment of decision-making authorities in the loan disbursement process based on risk-based approaches is one of the key elements in meeting the expertise requirements mandated by the Bank of Italy. These approaches, which escalate to decision-making bodies having higher levels of power in the event of higher levels of risk underlying the credit facility, made it possible to achieve regulatory and operational advantages.

In 2013, modifications were made to the loan assessment and approval processes for Retail customers:

 a new Retail customer assessment module was released, which is based on an estimate of the sustainable

instalment amount

 a module was introduced to verify the consistency of proposed facilities with the credit policy guidelines

issued by the Parent Company

 credit approval processes and related decision-making powers were reviewed to reflect the organisational

changes in head office and network units.

2.2.3 Monitoring processes

The Credit Monitoring process introduced in 2012 as a single tool for the management of post-disbursement activities, is an effective aid to obtain credit cost reduction by leveraging two main factors: .

 identification of high insolvency risk positions ('screening');

 'customer-type differentiated' treatment of positions (dedicated 'routing').

Identification of high insolvency risk positions

Ordinary-risk positions are scanned by a 'screening' engine which selects the highest-risk positions on a weekly basis, so as to identify the counterparties bound to become insolvent at a sufficiently early stage. Screening is based on a 'performance risk indicator' (it.: "indicatore di rischio andamentale", IRA) which factors in -and is reflective of- a set of critical elements including the worsening of leading indicators, ratings, information on related counterparties and days past due (with thresholds differentiated by customer segments and amounts used). "Customised" parameters make it possible to diversify the screening criteria for risk positions by type of customer with respect to the criteria used by the "Loan Performance Management" system.

'Customer-type differentiated' treatment of positions

This choice was based on the need for differentiating the treatment of positions by customer segments, in the conviction that a corporate client cannot be treated in the same way as a retail client and that specific client management needs should be met with 'ad hoc' processes. Ordinary-risk positions, reported as higher risk by the 'screening' engine, are routed to specific processing queues depending on the type of customer and credit facility involved:

1. a 'Mass Retail' procedure for 'Retail Family' clients;

2. a 'Standard Retail' procedure for Retail, Affluent and Private customers, as well as small-sized businesses with limited exposure;

3. a dedicated Corporate procedure for corporate customers.

In 2013, Credit Monitoring witnessed the introduction of the following innovations:

 release of new operating events in the process flow, that allow for the detection of positions in a 'pre-

bankruptcy agreement’ phase;

 shortening of the time for activation of collection initiatives on mortgage loan instalments in arrears;

 wider scope for possible routing of low-amount positions to amicable debt collection processes (outsourced

Moreover, another function is due for release shortly. Known as the "Action Report", this function allows for the creation of a virtual dossier in which to enter and track the most important operating actions carried out on positions monitored over time.