2018 Registration document and annual fi nancial report - BNP PARIBAS386

5 RISKS AND CAPITAL ADEQUACY PILLAR 3

5

Counterparty credit risk

If the counterparty defaults, all the trades are terminated at their current market value by the Bank. The initial guarantee deposit hedges the variation in transactions during this liquidation period. The initial deposit refl ects an extreme but plausible estimate of potential losses corresponding to an unilateral interval of confi dence of 99% over a ten - day period, based on historic data including an episode of signifi cant fi nancial tensions.

The initial deposit must be bilaterally traded on a gross basis between the Bank and the counterparty. It is kept by a third party so as to guarantee that the Bank immediately has access to the counterparty s deposit and that the Bank s deposit be protected in case the counterparty defaults.

CREDIT VALUATION ADJUSTMENTS (CVA) The valuation of fi nancial OTC-trades carried out by BNP Paribas as part of its trading activities (mainly Global Markets) includes Credit Valuation Adjustments (CVA). CVA is an adjustment of the trading portfolio valuation to take into account each counterparty s credit risk. It is the fair value on any expected loss arising from counterparty exposure based on the potential positive value of the contract, the counterparty default probability and the estimated recovery rate in case of default.

The majority of counterparty credit risk exposures on derivatives are related to the Group s interest rate, credit and foreign exchange activities, all underlying assets, and all business lines combined.

The credit valuation adjustment is not only a function of the expected exposure but also the credit risk level of the counterparty, which is linked to the level of the Credit Default Swaps (CDS) spreads used in the default probability calculation.

In order to reduce the risk associated with the credit quality deterioration embedded in a fi nancial operations portfolio, BNP Paribas uses a dynamic hedging strategy, involving the purchase of market instruments such as credit derivative instruments. (See CVA risk management in section Counterparty risk management).

Risk related to the volatility of CVAs (CVA risk)

To protect banks against the risk of losses due to CVA variations, Regulation (EU) No. 575/2013 introduced a dedicated capital charge, the CVA charge. This charge aims at capitalising the risk of loss caused by changes in the credit spread of a counterparty to which the BNP Paribas Group is exposed. The CVA charge is computed by the Group using mainly the advanced method and relies on the Bank s model on market risk (see section CVA Risk hereafter).

STRESS TESTS AND WRONG WAY RISK The BNP Paribas counterparty risk stress testing framework is consistent with the market risk framework (see section 5.7 Market risk related to trading activities). As such, the counterparty stress testing framework is implemented in conjunction with the market risk stress testing and employs consistent market shifts where scenarios are shared. Testing also comprises factors specifi c to counterparty risk such as deteriorations in counterparty credit quality.

Such risk analysis is present within the Executive Management reporting framework which shares some common forums with the market risk reporting set up such as the CMRC, core risk committee for market and counterparty credit risk. Both counterparty and market risk stress testing frameworks are governed by the Stress Testing Steering Committee.

Wrong Way Risk (or unfavourable correlation risk) is the case of exposure to a counterparty being inversely correlated with the counterparty s credit quality.

Such risk can be split in two parts:

■ General Wrong Way Risk (GWWR), which corresponds to the risk that the probability of default by counterparty is positively correlated with general market risk factors;

■ Specifi c Wrong Way Risk (SWWR), which corresponds to the risk arising when future exposure to a specifi c counterparty is positively correlated with the counterpart s probability of default due to the nature of the transactions with the counterparty or of the collateral received.

BNP Paribas monitoring and analysis of General Wrong Way Risk is performed through stress tests that highlight the risk factors negatively correlated with the counterparty s credit quality. It combines a top down approach and a bottom up approach:

■ for the top down approach, the GWWR policy defi nes the generic rules and criteria to be used to detect GWWR. These criteria are based on the countries of incorporation of the counterparties, the region of which they are part and the industries in which they are involved. Derivative positions, structured fi nancing, and collateral that counterparties may have with BNP Paribas have been defi ned as the situations where GWWR should be analysed and reported;

■ the GWWR framework relies upon a robust bottom up approach with the expertise of the counterparty credit analysts specifi cally needed to defi ne the most impacting scenarios at portfolio level (the approach consists of the use of stressed market parameters refl ecting extreme but realistic conditions).

When a legal link between the exposure underlyings and the counterparty is established, the SWWR is subject to prescribed regulatory capital treatment.