Reducing economic capital through securitisation

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Reducing economic capital through securitisation
ISDA-PRMIA Michael Dickinson 13th April 2004
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How liquid is a Banks 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?

• Regulators 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
• Markets 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
• Issuers 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
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
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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 lt 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
BNPP Portfolio
BNPP
Equity
?EC
Final EC Saving
?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 CDOs downgrades by the Rating
  Agencies
• Source Moodys
• 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.
• 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.