1. Reducing economic capital through securitisation ISDA-PRMIA Michael Dickinson 13th April 2004

2. 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. 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 constraints  banking 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. 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. 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. 6 Option 1 : Comparing UL & Equity 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. 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. 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. 9 Option 2 : Another approach of risk transfer  EC  EC i  Expo i BNPP Portfolio Securitised Portfolio Investors BNPPEquity New Exposure Run EC Calculations with full portfolio effects Final EC Saving

10. 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. 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. 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.