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2010

Matthieu Royer

January 19, 2009

The Year of the Regulator,

The Year of Metamorphosis

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Disclaimer:

The remarks I'm about to make are my own, and do not necessarily reflect the views of CALYON, by

hierarchy, staff or HO colleagues.

If this was on the Internet, I bet you'd scroll down through that disclaimer to click “whatever”. Believe

me, I would.

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Some Signs that the Crisis is Behind (1/2)

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USD 2 year swap ratess USD 30 year swap rates

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USD Libor 3 mois OIS 3 mois

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Libor-OIS Spread

Spread between Libor 3m and OIS is back to « pre-crisis » levels (~11 bp vs 364 in oct 08)

Increase in the slopes US & Euro rates, and Markets « normalisation »

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Market Trends (Cont’d)

Default expectations increased dramatically earlier in the year and recently started to reduce, and is reflected in the “Distress” ratio (i.e. >10% Bond-yield or <80% bid for loan), as well as in CDS prices – some stabilization seems to have been reached though we believe that it may re-spike in the ST to then resettle to lower levels during the 2 nd half of 2010.

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S&P LSTA Index Distress Ratio Merrill Lynch High Yield Index Distress Ratio

Distress Ratio by Number of Issuers vs. Merrill Lynch High-Yield Distress RatioSource: Standard and Poor’s LCD and S&P/LSTA Leveraged Loan Index & Merrill Lynch

January 1997 – November 2009

Note: In October the S&P/LSTA Leverage Loan Index began tracking thinly marked loans.Distress Ratio is the percent of performing loans trading below 80. Merrill Lynch High Index Distress Ratio is the percent of performing high-yield bonds outyielding Treasuries by 1,000 basis points or more.

A, BBB, BB and B widely syndicated medium term margin spreadsSource: Loan Pricing Corporation (Gold Sheets) and S&P's Leverage Commentary and Data (LCD)

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Trailing 12m Speculative Grade default history and "base line" forecast

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US Spot (Actual) US baseline forecast

EU Spot (Actual) EU baseline forecastsource: Moody's, PBSM

Forecasts

CDX North America Investment Grade and Non-Investment Grade Series5 years - Spread History

source: MarkIt

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Risk: it’s in the definition…

An absolute level or an “anticipated” absolute level or a guideline

Should the definition be consistent across all Business Lines and Product Type

…. Really… no exceptions?

Some Caricatures

Typical Front-Office View

• must be sufficiently large so that market or risk fluctuation and migration do not immediately create a breach

• Above limit = stop business… endanger client relationship, destroys lucrative product placement, missed opportunities, bad for the P&L, constraint I have little control over if worldwide relationship, etc.

• Just a model with lack of flexibility… assumes homogenous risk metrics, doesn’t reflect market reality, doesn’t take into account factor X or Y, etc.

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It’s in the definition…

Typical Credit Risk Professional view

• I have no upside and only downside risk: make the limit as small as possible without been stricken down by the FO sword

• Believer / Not Believer

• View the world in term of specific risk: hands-on analysis, local view, independence between factors

• The worse may happen: “do you remember company X…”

• Quantitative tools = administrative task: “I have 20 years of experience!”

• Correlation is always positive

Typical Quant View

• You just don’t understand!

• I need more research, systems, budget, resources…

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Assumptions

Observations

• most people (FO, Credit Risk) remain uncomfortable with concepts such as Economic Capital, Regulatory Capital, the interaction between the drivers or their relative impacts

• And… they typically want to simplify every problem impose on them into a one variable or at best a two dimensional problem

Education at all level is Key

• model transparency

• output visualization dashboards must remain simple yet informative: a graphic explains a lot, but it needs explanation

• Ongoing dialogue with the different actors

• Help identify key variable so that structures (or pricing) can better match risk-views

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Focus ‘risk culture’? Why (1)

Corporate & Investment Bank : a multiplicity of Businesses & Products

complex

evolutionary

Client diversity

Product multiplicity

Regulation complexity

Geographical contrast

Specificity of quantitative techniques

Markets fluctuations, modifications of « demand »

Environment changes (macro, political,…)

Strategic objectives

Piling-up of constraints (regulatory, accounting, « prudential »,…)

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Risk : an evolutionary challenge

perimeter

expertise v. transverse

coordination

Expanding scope (permanent controls,…)

Increased responsibilities (capital, ROE, financial communication, compensation policy,…)

Experts must be more-and-more « technical »

Transverse approach required (but delicate)

Numerous : regulators (CB, AMF, CEBS, Basle Committee, FED, SEC, etc.), rating agencies, analysts / investors, internal audit, CAC / auditors, front office, compliance, Credit Agricole Group & sister / affiliates,…

High expectations (information quantity and quality)

Focus ‘risk culture’? Why (2)

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Seeking harmonization to enhance quality work in efficient manner

knowledge

understanding

attitudes

Risk appetite, strategy (Calyon and CA group)

Written rules (procedures) and non-written (practices)

Organization and interactions between teams

Useful information to perform efficiently

Appropriate interpretation of laws & regulations

Integration of bank’s policy (ies)

Confronted to a new problem, homogeneity of reaction (decision, alert, initiatives,...)

Focus ‘risk culture’? Objectives

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Typical Variation Risk measure (95% percentile)

This approach « measures » the statistical risk of a maximum loss within a 95% confidence interval for 1 day

Approach raises many questions: time horizon, can it happen 3 days in a row, what happen in the 5% cases, compounding impact, stress, etc.

10 yrs bullet TL

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Credit Risk

Risk is “known” and equal to 100% of notional throughout life.

10 yrs IRD Swap

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Credit Risk

Retained risk measure is max

of profil

Within 95% interval risk should notbe above profile

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Tail Credit Risk: a « visualization »

• Vanilla 10 years USD Interest Rate Swap – receive fix rate / pays floating• Q95% = 8% du nominal, TCR= 11% = 1.35xQ95%

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Tail Credit Risk: results

• About 25% larger than « MPE » measure at 95% confidence interval for a Vanilla operation

• Can be significantly larger for exotic products

CDS 3 yrs TCR/Q95 = 1,25 Ratchet 4yrs TCR/Q95 = 2,1

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BIS 2 Recent Evolution for Market Operations

• Capital mesure for « specific risks »: enhancement to Jump-to-Default and Default Likelihood Migration Incremental Risk Charge (Bonds, CDS, Options on Bonds): 1 year loss @ 99.9%, time horizon min. 3

mths (fonction of Product, Rating, Size) in-between year rebalancing = potential capital saving Comprehensive Risk (CDO, Nth to Default and related CDS hedging): VaR Monte-Carlo (99.9%, 1 yr)

but floored to Stress Scenarii imposed by Regulator Standard Method (Securitizations, CDO^2, etc.): applied to Net Long and Net Short. Two specific

cases: Negative Basis Trades (NBT) likely to be moved to « Banking Book »; and Leveraged Super Senior (LSS) risk & pricing consistent to CDO, so likely to be computed « deleveraged » in CR

• Stressed VaR Move from pro-cyclical VaR calculation to a « lagged » VaR by adding to Current VaR the Stressed VaR

(1yr horizon) Addition of antithetical paths and use of Absolute Chocks vs. Relative

• Evolution of current VaR Reiterate wish for 10 days horizon instead of Var 1 day * √10 (Banks remaining in current approach will

need to justify regularily « conservativeness » and « appropriateness ») Addition of Basis Risk (especially Bonds and CDS typically not included in VaR)

Anticipate a significant increase in the risk measure

especially for books heavy on “Exotic” and “SCM”

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BIS 2 Recent Evolution for Market Operations

« today »Capital = (f + c) * VaR (99%, 10 days) + s * VaR (99%, 10 days) specific

« tomorrow » Dec.2010Capital = (f + c) * VaR (99%, 10 days) + s * VaR (99%, 10 days) specific Equities

+ f * VaR (99%, 10 days) stressed + (IRC + Comprehensive Risk + Standard*)

* Standard method for non-eligible products to IRC and to CR

IRC Comprehensive

Risk

Standard Method

Securitization (excl. CDO corp.)

CDO

Others

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A Revolution in Conventional Wisdom (if memory is « short », Regulator will remind us)• « Too big to fail » has been tested

• Giant bankruptcies / systemic threshold « jumped »: Lehman, GM, Chrysler,…• Banks too large for their country (Island ; Switzerland ?)

• Reduced forward view of legal aspect on Developed Countries• Selective defaults / organized / blessed by political & Legal authorities

• Kazakhstan, USA, Bahrain

• Split of Groups in difficulty (Parent/Holding, subsidiaries, etc.)• Bernanke / Geithner on very large groups, « testament » in UK, etc.• Sacrifices / Forced conversions without disappearance of equity holder (Kaufman, Sanitec, Monier,…)

• Middle-East : the impossible happens (also applicable to other geographical zone…)• name lending based on pre-supposed infinite wealth; price of pride / reputation has a limit

• Erratic market movements or with multiple sigma possible• Liquidity is not a certainty; temporary positions can become permanent

• Bank’s responsibilities: distribution is not immune to risks• Advise provided or that should have been provided, due-diligence (Munis, Pension Funds)• Products complexity and client’s capacity to « appropriate » (suitability)• Products implied risks (2nd and 3rd order) and client’s absorption capacity (economically)

Post-Crisis and Future Themes for Risk Managers and Leaders

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Organizational view

Client risk grouping

Product 1 RisksProduct 2 Product 3 (type/duration)

Counterparty Counterparty

1st level grouping

Product 1 (type/duration)

Counterparty

Product 1 (type/duration)Product 2Potential product 3

Region / Geographic view

World View

Cou

1st lev

Nth level grouping

Where do you set Limits / Monitor Risk?

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• From one excess to another (at least temporarily) ?• Significant tightening of credit spreads over the last 6 months; widening risk (« W »)?• Increase of equity markets ; mutliples anticipate significant 2011 profits which remains a big assumption.

• Defiance• Economic expansion : to take with realism and “cold-blood”

• True recovery, but slow and may be chocked by public aid withdrawal• Lagging effect on negative impacts (few quarters still)• Difficult dialogue with Front Office (who has an ability to forget rapidly)

• Industrialization of Vanilla products: not as easy as it seems• Behind technological subjects, there are economic and operational risks to identify

• Some guiding lights• Since Lehman, market participants (and Regulators) rediscover the virtue of Clearing houses• ISDA are not anymore “accessory” or optional, and not “taboo” for corporate counterparties• Stress Tests : assumptions and the “moment” in the cycle (difference between now and most stressed to

assess)• Today: not to take into account the crisis twice (in the “current” and in the “stress”)• Tomorrow: it is in the hight of the cycle that one must consider extreme movements

• Tail Risks• Relative Contribution (direct and indirect concentrations i.e. underlyings)• Common sens (do not forget Gross Nominal Exposure, knowledge of underlyings, etc.)

Post-Crisis and Future Themes for Risk Managers and Leaders