Risk Report 2008 - Dexia

1 Risk Report2008 PILLAR III OF BASEL IIContactDexia SADexia Tower Place Rogier 11 1210 Brussels BelgiumTour Dexia 1, passerelle des Refl ets La D fense 2 TSA 12203 92919 La D fense Cedex FranceIBAN BE61-0682-1136-2017 BIC GKCCBEBB RPM Brussels VAT BE RelationsE-mail: Brussels: (32) 2 213 57 49 Phone Paris: (33) 1 58 58 85 97 Contents 3 1. Risk Management Objectives and 6 Mission and 6 Risk Governance and 6 Dexia Risk 10 2. Own Funds and Capital 11 Own 11 Capital Requirements by Type of 12 Capital 14 Significant Banking 15 3. Credit 16 Credit Risk Management and 16 Credit Risk 20 Impairment, Past-Due and Related 22 Credit Risk Mitigation 24 AIRB 27 Standardized 43 Counterpart Risk on 44 Pillar II Credit 45 4. Market and ALM 48 Market 48 ALM 5. Operational 56 Operational Risk Management and 56 Basel II 57 6. Other 59 Behavioural 59 Business 59 Strategic 60 Reputation 60 Model 61 Pension 61 Specific Insurance 62 7.

2 Focus on Equity 63 Basel II Treatment and Accounting 63 Equity 63 Dexia Risk Report 2008 Pillar III of Basel II Page 1/72 Gains or 64 8. Focus on Securitization 65 Objectives and Roles of 65 Basel II Treatment and Accounting 65 Securitization Activity as 66 Securitization Activity as 69 Dexia Risk Report 2008 Pillar III of Basel II Page 2/72 Appendix List of 71 Introduction Basel II Framework Basel II refers to the revision of the 1988 regulatory framework defining the capital requirements for banking institutions. The main objectives of the new capital agreement ( Basel II framework ) put in place by the Basel Committee on Banking Supervision are to improve the regulatory framework in order i) to further strengthen the soundness and stability of the international banking system ii) to promote the adoption of stronger risk management practices by the banking industry and iii) to prevent any competitive regulatory inequality among internationally active banks.

3 In order to achieve these objectives, the Basel II framework is based on three pillars: The first pillar minimum capital requirements defines the way banking institutions calculate their regulatory capital requirements in order to cover credit risk, market risk and operational risk. The revised framework provides different approaches for calculating credit risk (3 approaches: Standardized, Foundation Internal Rating-Based and Advanced Internal Rating-Based), market risk (2 approaches: Standardized Approach and Internal Model Approach) and operational risk (3 approaches: Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach). The second pillar supervisory review provides the national regulators with a framework to help them in assessing the adequacy of banks internal capital to be used to cover credit risk, market risk and operational risk but also other risks not identified in the first pillar such as concentration risk.

4 The third pillar market discipline encourages market discipline by developing a set of qualitative and quantitative disclosures which will allow market participants to make a better assessment of capital, risk exposure, risk assessment processes, and hence the capital adequacy of the institution. The requirements of the third pillar are fulfilled by this publication. Dexia is closely involved in the consultations at national and international level on the amendments to the Capital Requirement Directive, in particular with respect to the reinforcement of European supervision. Basel II Implementation Pillar I Credit Risk AIRB Approach approval The Dexia homologation application file was successfully presented for final decision to the Management Board of the Banking, Finance and Insurance Commission by December 18, 2007. Consequently, since January 1, 2008, Dexia has been authorized to use the Advanced Internal Rating-Based Approach (AIRB Approach) for the determination of its regulatory capital requirements under Basel II Pillar I for credit risk and for the calculation of its solvency ratios.

5 This acceptance is applicable to all entities and subsidiaries consolidated within the Dexia Group, which are established in a Member State of the European Union and subject to the Capital Requirement Directive. This approval was obtained after some efforts both on methodological aspects internal models were largely redesigned in order to make them Basel II compliant and on IT systems which also had to be improved in order to cope with the entire series of Basel II requirements relating to data collection, consolidation and calculation. Dexia Risk Report 2008 Pillar III of Basel II Page 3/72 Dexia has also decided to maintain a Standardized Approach for some portfolios for which this approach is specifically authorized by the Basel II framework, such as small business units, non-material portfolios, portfolios corresponding to activities in run-off or to be sold or portfolios and entities for which Dexia has adopted a phased rollout of the AIRB Approach.

6 Market Risk In terms of market risk, Dexia calculates its capital requirements on the basis of the Internal Model Approach for general interest rate risk and foreign exchange risk and the Standardized Approach for specific interest rate risk and equity risk (general as well as specific risk). In the future, Dexia intends to switch to the Internal Model Approach for equity risk. Operational Risk For operational risk, Dexia applies the Standardized Approach. In this regard, an information file was submitted to the Regulator in June 2007. Incident reporting is now at cruising speed and the Risk and Control Self-Assessment (RCSA) process covers the entire bank, including foreign subsidiaries and branches. COREP The COREP (COmmon solvency ratio REPorting European Basel II reporting which includes prudential information on credit risk, market risk and operational risk quantitative disclosures) is produced thanks to close collaboration between the various entities of the Group.

7 Its implementation implied important improvements in terms of data quality and technical resources due to the variety of national formats. Deadlines for producing the data were gradually reduced over the year; a further shortening of these deadlines in line with the European harmonization is to be considered as a major challenge in 2009. Pillar II The Basel II reform is not limited to the calculation of the statutory capital in relation to credit risk, market risk and operational risk. Pillar II requires banks to demonstrate an appropriate capital adequacy process ensuring the risk profile is matched by adequate capital. An inter-Group project team was set up to ensure compliance with Pillar II requirements. The Pillar II application file required by Circular PPB-2007-15-CPB-CPA was submitted to the Belgian Banking, Finance and Insurance Commission. The Pillar II Approach is integrated in the management of the bank (and more particularly in the decision-taking process on risks, the reporting, the commercial strategy and financial plans).

8 Pillar III Frequency of Disclosure Following the application of Basel II as of January 1, 2008 Dexia decided proactively to publish the qualitative part of the requirements at the beginning of 2008. The publication was released on May 14, 2008. The complete third pillar (including both the qualitative and the quantitative disclosures) is published each year, as from 2009, together with publication of the annual Report . Nevertheless, a subsequent release may be published if considered relevant by Dexia due to significant changes in its risk profile. Support Dexia will release the Pillar III document on its website ( ). Currency The figures in the following tables are given in millions of euro (EUR) unless otherwise stated. Scope of Application The Pillar III disclosure requirements under the new Basel II capital framework are applicable to the upper level of consolidation, the Dexia Group. This consolidation is realized at Dexia SA, based at 11 Place Rogier, B-11210 Brussels, Belgium.

9 Dexia Risk Report 2008 Pillar III of Basel II Page 4/72 In line with regulatory capital, Dexia has chosen to link the scope of Pillar III to banking institutions (for further information see part ). Financial Crisis The Pillar III disclosure reflects the organization of Dexia prior to the financial crisis. Major changes recently occurred in the Dexia organization. Early in November 2008, Dexia launched a transformation plan. In light of the new market context and substantial changes in the banking landscape, a review of Dexia s business model, strategy and risk profile was initiated. On November 14, 2008, Dexia entered into a sale and purchase agreement with Assured Guaranty Ltd relative to the sale of FSA Holdings. The Financial Products portfolio, which primarily comprises the guaranteed investment contract business and the net interest margin of Global Funding, is excluded from the scope of the sale of FSA Holdings.

10 This activity will thus be carved out of the transaction and be put into run-off, under the responsibility of Dexia . The Belgian and French States have agreed to provide a guarantee on the Financial Products assets. Detailed figures on the Financial Products portfolio are currently not available and are therefore not included in the Pillar III disclosure, except for regulatory capital and capital adequacy ratio figures (refer to part 2). Banking Portfolio Valuation Given the illiquidity of markets and the reduced observability of prices/spreads in the valuation process, IASB has amended IAS 39 and IFRS 7, allowing entities to reclassify securities out of the trading or AFS books. Dexia developed mark-to-model valuations which were performed for end-of-year 2008. Bonds Reclassified in Loans and Receivables The amortized AFS reserve based on September 30, 2008 is used for AFS reserve calculation. However the Mark-to-Model used for loans and receivables in French local GAAP and IFRS notes to the financial statements is based on an adjusted market price methodology with different parameters depending on the type of asset class and market sector.