Transcript Reducing economic capital through securitisation ISDA-PRMIA

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
- 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
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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
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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
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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 ?
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Option 1 : Comparing UL & Equity
Assuming same loss distribution, CLO Equity
should be lower than economic capital
Internal Model
Economic
Capital
{
Risk transfer
EL
Equity of the CLO
BB BBB
Investor's
appetite
Securitisation tranching model
Bank's risk
appetite
A AA
AAA
The lower the rating of the most junior
sold tranche, the higher the risk
transfer as a proportion of total risk
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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)
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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
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Option 2 : Another approach of risk
transfer
Securitised
Portfolio
Investors
Economic
Capital
Bank's risk
appetite
BNPP Portfolio
EL
Equity
BNPP
appetite
risk
Investor's
Equity
Final EC
Saving
BB
BBB
A
AA
AAA
EC
EC i
Run EC Calculations
with full portfolio
effects
New
Exposure
Expo i
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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
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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
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In managing economic capital why is
regulatory capital important?

Shareholders work on the basis of return on regulatory capital.
-

Portfolio managers must optimise portfolio risk and return.
-


Given costs of securitisation, shareholders would expect to see some capital
benefit.
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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