Overcoming Challenges To Active Portfolio Management

1. Overcoming Challenges To Active Portfolio Management PRIMA, Singapore Otbert de Jong Head PM AP / Global Head Risk Advisory May 14, 2004

2. 1. PM, Basle II, RAROC and Economic Capital 2. Introduction of Portfolio Management in ABN AMRO Bank 3. Position of PM in the Organisation 4. Definition of the PM Mandate 5. Performance Measurement 6. Organisation & Key Management Tools 7. Overcoming Challenges in Managing the Portfolio Contents

3. 1. PM, Basle II, RAROC and Economic Capital

4. Basle II, RAROC and Economic Capital How does it all fit? • Basle II will bind regulatory capital to credit quality • Regulatory/Economic capital will be measured on the basis of 3 main risk factors: market risk, credit risk and operational risk as the amount of capital that will be required to support these risks • RAROC: Risk Adjusted Return / Economic Capital • Economic Profit: expands RAROC by incorporating the cost of equity capital

5. Basle II, RAROC and Economic Capital Simply put, Economic Profit is: Revenue less: Cost (operating) Provisions Tax Cost of Capital

6. 2. Introduction of Portfolio Management in ABN AMRO Bank

7. Introduction of Portfolio Management Increase in loan losses and provisions Environmental Economic Slowdown BIS II Understand true liabilities Desire for pricing discipline Bursting of Tel. & Tech Bubbles Accounting scandals Capital reduction in lending Better Credit Management Political Events Operational frauds

8. Introduction of Portfolio Management The Loan Portfolio takes Centre Stage: • Need to better measure the quality and quantity of the portfolio • Need to better balance and “manage” the portfolio • Need to improve rating processes • Need to manage capital invested in lending business = leading to emphasis on economic capital vs regulatory capital Portfolio Management introduced as part of the credit and capital management architecture

9. Introduction of Portfolio Management Major steps: • Positioning of Portfolio Management in the organisation • Definition of the mandate of PM • Internal buy-in • Data and systems • Definition of portfolio parameters and performance measurement

10. 3. Position in the organisation

11. Positioning in the Organisation Wholesale Clients Risk / Compliance / Legal / Audit / Human Resources / TOPS Change Management Client Business Units TMT ACD ECP FI&PS Financial Markets Global Transaction Services Product Business Units Private Equity Equities Corporate Finance

12. Challenges • In the introduction of PM one faces 2 types of Challenges • 1. Self Made challenges as a consequence of • insufficient preparation or • definition of mandate => boundary battles • 2. Institutional challenges: inertia and change management

13. 4. Definition of the mandate

14. PM Mandate • Which portfolio? • Decision rights (and at which stage) ? • Client relationship implications of making PM a profit centre? • Format for compensation for loss making deals? • Allocation of capital for investment activities? • Product type (loan, CDs, bonds, …)? • Accounting implications? Just a few of the questions to be answered:

15. PM Mandate Portfolio Originator PM mandate Hedging, selling and buying exposure, actively managing against portfolio parameters Owner of Portfolio Portfolio Management Both Origination and Owner of P&L PM Roles / Function Hedger Asset Manager Monitor Hedging and selling existing exposure to improve risk/improve diversification PM becomes a business on its own merits Monitoring and reporting Origination Portfolio Management Origination Origination. PM has shadow P&L Portfolio Management Origination

16. PM Mandate

17. PM Mandate ABN AMRO Through: • Increased efficiency and a streamlined Credit Process • Attention to biggest value drivers: Provisions and Economic Capital Cost • Stronger pricing discipline by instilling a better appreciation of Economic Capital • More active management of the portfolio within enhanced Portfolio Parameters • Increased decision rights • Changes in the origination behaviour PM is responsible for managing the loan portfolio with an objective to maximise Economic Profit within a client driven wholesale bank strategy.

18. PM Mandate PMG : • Obtained full P&L responsibility for the Loan Portfolio • Obtained enhanced participation on Engagement and Credit Committees • Introduced Shortfall Compensation Payments • Obtained discretionary investment rights • Sole discretion over asset disposals or hedges • Developed tools to actively manage the portfolio PMG is responsible for managing the loan portfolio with an objective to maximise Economic Profit within a client driven wholesale bank strategy.

19. 5. Performance Measurement

20. Performance Contract Performance Contracts Based on Economic Profit (“EP”) and RAROC Old P&L: +/+ Credit Revenue -/- Operating Expenses (direct + indirect costs) -/- Provisions Budget -/- Tax -/- Capital Charge (BIS 1) Performance EP (stand-alone basis): +/+ Credit revenue -/- Direct costs -/- Provisions based on Expected Loss -/- Tax based on a global average -/- Capital Charge based on Econ. Capital Alignment with other parts of the business is important !

21. 6. Organisation & Key Management Tools

22. Organisation Portfolio Management Portfolio Strategy/Execution Credit Portfolio Management Portfolio Analytics Asia Pacific Europe America US (25) Asia Pacific Europe Benelux America South America (500) Amsterdam (20)

23. Key Management Tools New In WCS Loan Portfolio Old Out Enlargement of PM’s Mandate required enhancements to Key Management Tools PMG FilterPortfolio Parameters Loan Pricing Tool • Shortfall Compensation Programme

24. PM Filter

25. Loan Pricing Tool • Major Outputs: • Economic Profit • RAROC • Benchmark Pricing • ROS • Economic Capital • Regulatory Capital • Major Inputs: • Credit Rating => PD • T & C Risk • LGD • Legal Risk • Collateral • Tenor • Expected Utilisation • Industry • Revenue and Opex

26. Loan Pricing Tool

27. Loan Pricing Tool

28. Shortfall Compensation Credit Income vs Relationship income CPM receives compensation for Economic Loss from other product area in case of major cross sell

29. Managing the Portfolio Economic Performance: Risk / Reward / Diversity Industry/ Geography Rating / Tenor Measuring Predicting Negotiate Benchmark Risk Management CPM Sales/Origination Investment Portfolio

30. Minimising Provisions (Important Value Driver) • move away from higher risk categories • historical and forward looking analysis • diversity: geography / industry matrix • use of KMV • active portfolio management incl. timely exit

31. Cost of Capital (Next Important Value Driver) • Only Economic Profit positive or min. RAROC % transactions • Portfolio Optimisation • Exit low yielding relationships • Augment primary business with secondary market opportunities

32. Portfolio Management Instruments Primary Origination Purchase/Sale in Secondary Loan Markets Hedge (insurance or credit derivative) Selling Credit Protection Buying /selling in bond market Exercising put options Risk Distribution e.g. CLO /Securitisation Portfolio Trades

33. Monitoring • Real time review and update of obligor credit ratings • Forward looking ratings, detect credit migration, perform stress testing • Model calibrations • Sector and geographical reviews and concentration • Monitoring of RAROC and EC/limits and EL/limits (monthly) • Data accuracy and procedure improvements • Early involvement in potential transactions

34. 8.Overcoming Challenges in Managing the Portfolio

35. The universe of Portfolio Management Regulator Industry Relationship Banking Audit & Compliance Credit Markets Strategy Other Geographies PM Execution Other Product BU’s CreditAdministration Budget Management Risk Management Finance

36. Sources of problems • No buy-in / commitment by all stakeholders (see universe of PM on previous slide) • Incoherent formulation of mandate of PM • Poor execution • Poor or lack of supporting systems • Poor data quality and/or maintenance • Most of all: Poor communication

37. Technical challenges • Tools: start simple and build it up. Don’t run if you can not walk • Measuring: quality over quantity • P & L : solve boundary issues quickly • Centralise and have specialists and “champions”

38. Change Management • Create buy – in / commitment • Communicate • Report • Success breeds …………….. • Strategy and Determination • Professionalism

39. Results to date Very encouraging: • Marked improvement of RAROC • Reduction of RWA by 30+% at equal revenues • Big change in origination behaviour • Catalyst for better credit assessment and better measurement • Further upside in portfolio optimisation and arbitrage

40. Risk Advisory Service • Risk Management strategic and implementation advice for Financial Institutions: • BIS II, ORM, CRM, MRM, ERM, • Support on strategic issues such as capital budgeting, capital allocation, strategic choices, systems selection, organisational change, RM implementation programs, coaching and specialist services.

41. Thank you