Risk Culture Transformation Strategies for Financial Institutions

1. 2010 The Year of the Regulator,The Year of Metamorphosis • Matthieu Royer • January 19, 2009

2. 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.

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

4. 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 2nd half of 2010.

5. 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.

6. 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…

7. 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

8. 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 »,…)

9. Focus ‘risk culture’? Why (2) 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)

10. Focus ‘risk culture’? Objectives 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,...)

11. 95% percentile 10 yrs bullet TL 10 yrs IRD Swap Credit Risk Credit Risk 120.0% 14.0% 12.0% 100.0% 10.0% 80.0% Retained risk measure is max 8.0% % of notional % of notional 60.0% of profil Risk is “known” and equal to 100% of 6.0% notional throughout life. 40.0% Within 95% interval risk should not 4.0% be above profile 20.0% 2.0% 0.0% 0.0% 0 1 2 3 3 4 5 6 7 8 8 9 10 0 1 2 3 3 4 5 6 7 8 8 9 10 Time Time 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.

12. 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%

13. 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

14. 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”

15. BIS 2 Recent Evolution for Market Operations • « today » Capital = (f + c) * VaR (99%, 10 days) + s * VaR (99%, 10 days) specific • « tomorrow »  Dec.2010 Capital = (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

16. Post-Crisis and Future Themes for Risk Managers and Leaders • 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)

17. Organizational view Where do you set Limits / Monitor Risk? World View Region / Geographic view Client risk grouping Nth level grouping 1st level grouping 1st lev Counterparty Counterparty Counterparty Cou Product 2 Product 3 (type/duration) Product 1 Risks Product 1 (type/duration) Product 1 (type/duration) Product 2 Potential product 3

18. Post-Crisis and Future Themes for Risk Managers and Leaders • 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.)