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Reducing economic capital through securitisation

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

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Reducing economic capital through securitisation

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  1. Reducing economic capital through securitisation ISDA-PRMIA Michael Dickinson 13th April2004

  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 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. 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 Assuming same loss distribution, CLO Equity should be lower than economic capital { Internal Model Risk transfer Securitisation tranching model 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 Securitised Portfolio Investors BNPP Portfolio Equity BNPP EC Final EC Saving EC i Run EC Calculations with full portfolio effects New Exposure Expo i

  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.

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