Reducing economic capital through securitisation

ISDA-PRMIAMichael Dickinson

13th April 2004

2

How liquid is a Bank’s portfolio

BNP Paribas Corporate & Investment Banking portfolio :- 225.3 bn euros (Source : Balance sheet 31/12/02)- Around 18.000 Corporate Clients- 41 countries (Booking countries)

Liquidity can be found on - 500 names on the secondary loan market- 1200 names on the CDS market- Typical size 5 to 20 M.

Most of the portfolio is illiquid

3

Offer and demand requirements

From the Portfolio Management side:- Sizeable transaction to obtain a visible impact on RAROC and ROE

- Keep the first loss and the corresponding return due to our credit expertise

- Shift the unexpected losses which are not covered by profitability

- Comply with compliance and legal constraintsbanking secrecy

Chinese wall

From the investor side:- Access to credit exposure not readily available in the market- At the desired risk rating and spread- Diversified/diversifying pool of assets (with / without due

diligence)- Alignment of interest with issuer

4

Potential Structures Guarantees

- Non standard

- Clear regulatory capital treatment

- May develop under IAS ?

Credit Insurance- Theoretically appropriate (franchise, …)

- Policy restrictions / approval process

- Capital treatment?

- Concentration of exposure to insurance companies

Securitisation- Access to bond market

- With/without funding component

- Only structure available for undisclosed pool

Securitisation still the main technique for illiquid portfolios

5

Does Securitization really transfer risk?

Regulator’s view : NO- Only a few transactions have seen second losses

- The issuing bank has an incentive to provide implicit support

- The real objective of securitisation is capital arbitrage

Market’s perception : YES- Significant downgrades have occurred in the CLO/CDO market, leaving

investors with actual losses (either in MtM terms or in RAROC/EVA terms)

- Primary and secondary spreads have followed underlying credit spreads

Issuer’s view : YES- Sold tranches reduce the risk for the issuer

- Issuer can benefit from MtM gain or improved RAROC/EVA

How to quantify risk transfer ?

6

Option 1 : Comparing UL & Equity

EL

Bank's riskappetite

Econom icCapital

Equity o f the CLO

Investor'sappetite

BB BBBA AA AAA

Internal Model

Securitisation tranching model

Assuming same loss distribution, CLO Equity should be lower than economic capital

{Risk transfer

The lower the rating of the most junior sold tranche, the higher the risk transfer as a proportion of total risk

7

Option 1 : Benefits & Drawbacks

Benefits :- Simplicity- Correlations between securitised & unsecuritised assets can still be

captured

Drawbacks : - Risk transfer is underestimated

-Internal credit risk data stressed for tranching (PD/LGD)

-Diversity of CLO < Bank ’s diversity

-Equity calibrated on the final maturity of the structure whereas Economic Capital is calculated on a 1 year horizon

- Risk transfer cannot be reallocated at asset level- Not applicable from an investor point of view (especially for senior

tranches)

8

Option 2 : Principles

Securitised assets are isolated

Their risk contribution to the CLO equity piece, and other tranches is calculated

The risk portion kept is reallocated to each asset through the equivalent exposure

Securitised assets with the new equivalent exposure are re-introduced into the portfolio

EC with equivalent exposure compared to EC with previous exposure : the risk transfer measure

9

Option 2 : Another approach of risk transfer

EL

B ank's riskappetite

Econom icC ap ita l

Equity

Investor'srisk

appetite

BBBBBAAA AAA

ECEC

EC iEC i

Expo iExpo i

BN

PP P

ort

folio

Securitised Portfolio

Investors

BNPPEquity

New Exposure

Run EC Calculations Run EC Calculations with full portfolio with full portfolio

effectseffects

Final EC

Saving

10

Option 2 : Benefits /Drawbacks

Benefits- Properly captures the behaviour of the CLO portfolio on a stand

alone basis- Still allows to capture correlation between securitised and

unsecuritised assets- Allows a better understanding of securitisation benefits

- Credit lines freed up

- Cost reallocation

- Same methodology can be applied to purchased tranches in 3rd party securitisations

Drawbacks- Difficult to implement- Still does not capture the MtM impact of defaults/migrations

11

Risk Transfer : from theory to reality

Assuming initial Economic Capital broadly in line with initial equity

Risk transfer changes through time as :- downward migration in the portfolio increases the economic capital- first losses deducted from the equity reduce the available cushion- upward migration and shortening term have a positive effect

Effect depends on point in the credit cycle

As evidenced by CDO’s downgrades by the Rating Agencies

Source: Moody’s

A hedge against future portfolio downgrade

12

In managing economic capital why is regulatory capital important?

Shareholders work on the basis of return on regulatory capital. - Given costs of securitisation, shareholders would expect to see some capital

benefit. Portfolio managers must optimise portfolio risk and return.

- Capital (both economic and regulatory) needs to be deployed:- In optimising assets / businesses.- Back to shareholders.

Need to develop an investor base.- Therefore appropriate capital charge for investors is needed.

Alignment of economic and regulatory capital removes opportunity for regulatory capital arbitrage.