1 Risk Management Wholesale Collateralization and the EU Collateral landscape: a legal update Budapest - September 26, 2002 David Suetens Senior Vice President, Risk Management Wholesale Tel

2 Risk Management Wholesale Agenda What is collateralization - Business perspective Identifying collateral law issues in Europe Collateral Directive Way forward

3 Risk Management Wholesale Definition of Collateralisation a form of credit enhancement where cash and securities are exchanged against the value of a derivatives portfolio

4 Risk Management Wholesale For Example ABN AMRO Net Exposure Collateral Counterparty Interest Rate Swap - 5 mln (CP owes AAB) Cross Currency Swap15 mln (AAB owes CP) Net exposure10 mln (AAB owes CP) So CP calls for collateral from AAB to cover this net exposure of 10 mln

5 Risk Management Wholesale Collateralization Business Drivers Collateralization Creating Business Opportunities Tool for Risk Management Revenue Generator

6 Risk Management Wholesale  Market Access  Larger Transactions & Longer Maturities  More Volatile Transactions  European Debt Market - Sovereign to sub-sovereign debt issuance weaker credits increased solvency costs for banks - Growth in corporate debt – More non-European borrowers issuing in euros  Deeper and More Liquid Derivatives Market Collateralization Collateral as a creator of business opportunities for you...

7 Risk Management Wholesale Collateralization Collateral as a tool for risk management…credit risk is being transferred into legal, operational and market risk  Legal Risk  Approved Netting Opinions  Enforceable Collateral Opinions  Operational Risk  Trade Matching identifies mis-booking of a trade  Market Risk  Reconciliation identifies mis-pricing of a trade

8 Risk Management Wholesale Example 1: Standard 5 Year Interest Rate Swap UncollateralisedCollateralised PFELow6%0.75% Medium8%2% High15%3% Low = EUROMedium = USDHigh = Emerging markets Example 2: Standard 5 Year Cross Currency Swap UncollateralisedCollateralised PFELow30%3% Medium55%5% High108%10% Low = EURMedium = AUDHigh = Emerging Markets Risk Management Impact on credit add-ons

9 Risk Management Wholesale Legal and Documentation Requirements ISDA 1992 Master Agreement : covers the trading relationship ISDA Confirmation each transaction will be confirmed each confirmation will refer to the ISDA Master ISDA Credit Support Annex (English Law - Transfer of Title) describes the collateralised trading relationship

10 Risk Management Wholesale Operational Requirements Value derivatives portfolio Value collateral portfolio Highlight margin call Notify and agree collateral movement Settle collateral Custodian for securities and cash Manage coupons and interest payments Resolve portfolio differences Reconcile derivatives portfolio from time to time

11 Risk Management Wholesale New Basle Capital Framework “ The Committee acknowledges the benefits that can accrue from the use of credit risk mitigation techniques and the key role they can play in prudent risk management. Accordingly, the committee believes it is important that the capital framework should provide a better recognition of mitigation techniques.”

12 Risk Management Wholesale Identifying collateral law issues 1999: ECB establishes the European Financial Markets Lawyers Group, discussing possibilities that would lead to a harmonisation in EU Financial markets activity, focusing a.o. on collateral. 2000: ISDA’s Collateral Law Reform Group publishes a paper ‘The Need for National Law Reform’ : EU Commission establishes a Forum Group on Collateral Conclusion: a complex and fundamental diversity of European national laws dealing with creditor rights, property, contract and insolvency laws.

13 Risk Management Wholesale Creating a Pledge  Cumbersome and impractical rules for creating, perfecting, maintaining and enforcing pledge collateral: England, France, Greece, Ireland, Netherlands, Portugal and Spain 1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

14 Risk Management Wholesale Use of Pledge  Legal restrictions on use of pledge collateral: all jurisdictions, except England, Greece and Ireland (most positive view) 1. 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

15 Risk Management Wholesale Enforceability of title transfer  Uncertainty regarding the enforceability of title transfer collateral:Denmark, Finland, Greece, Italy, Netherlands, Spain, Luxemburg 1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

16 Risk Management Wholesale Title transfer versus 3th parties  Uncertainty regarding the vulnerability of title transfer collateral arrangements against third parties: Spain, Finland, France, Germany, Italy, Portugal 1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

17 Risk Management Wholesale MTM collateral arrangements  Material risk that top-up collateral may be vulnerable as a preference during a suspect period: Denmark, France, Greece, Italy and Spain 1 1: Based on ISDA’s Paper: The Need for National Law Reform Paper

18 Risk Management Wholesale Why change collateral laws? As collateral managers we want ….  Effective and simple regime for pledge and title transfer  Simplify creation, perfection and enforcement  Confirm efficacy of title transfer collateral throughout Europe  Clarify conflict of laws rules  Confirm top-up and substitution  Right of use (‘rehypothecation’) üPart of Financial Services Action Plan

19 Risk Management Wholesale Collateral Directive: first Commission’s proposal  all financial collateral  pledge and title transfer agreements covered No recharacterisation for title transfer arrangements  both provider and taker must be either:- 1.public authority/central bank or 2.financial institution. under prudential supervision or 3.legal person of capital base exceed. EUR 100 million/gross assets exceed.EUR 1000 million )

20 Risk Management Wholesale Collateral Directive: first Commission’s proposal  Limit rules on creation/enforce  Re-use of pledge?  Recognition of substitution/top-up  Recognition of close-out netting  Recognition of the PRIMA principle (‘place of the relevant intermediary approach’) - EU (15) and Hague (53)

21 Risk Management Wholesale Collateral Directive: issues  Scope the capital/gross assets test? apply test to one party only? Collateralized business among corporates?  Result: Financial institutions (including a.o. Sicav’s, Insurance companies) Central Banks (including a.o. EIB, IMF, ECB) Public Authorities Central counterparty or clearing house A person other than a natural person, including partnerships, provided that the other party is one of the above. But: OPT-OUT

22 Risk Management Wholesale Collateral Directive: issues  Creation of a pledge/title transfer Occurs often through formal acts, such as: Filing with an official body Registration in a public register Advertisement in a journal or newspaper  Result: Creation/validity not to be dependent on a formal act if: The financial collateral arrangement provides for dispossession, ie the provision of the financial collateral The provision of collateral must be evidenced in writing

23 Risk Management Wholesale Collateral Directive: issues  Realization: if the Collateral Taker cannot realise collateral quickly, then Increased funding cost from re-hedging Additional collateral required to cover close out period  Increased transaction costs Additional risk for Collateral Provider  Result: No restrictions on realization such as: Time period Official/Court Approval Public Auction or other prescribed sale procedure Appropriation: only if agreed by the parties in the collateral agreement and its valuation. BUT: OPT-OUT

24 Risk Management Wholesale Lifecycle of the directive The way forward  13/12/2001: political orientation agreed by ECOFIN on compromise text under the Belgian presidency  March till June: Second reading by the European Parliament  6/06/2002: Voting by European Parliament in a plenary session  Publication: 27/06/2002  Implementation: 18 months after publication,ie 27/12/2003  Conclusion: focus on local implementations, avoid carve outs, discuss and convince your legislator of a broad scope