Otbert de Jong Head PM AP / Global Head Risk AdvisoryMay 14, 2004

Overcoming Challenges To Active Portfolio Management

PRIMA, Singapore

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Contents

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

1. PM, Basle II, RAROC and Economic Capital

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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

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Basle II, RAROC and Economic Capital

Simply put, Economic Profit is:

Revenue

less: Cost (operating)

Provisions

Tax

Cost of Capital

2. Introduction of Portfolio Management in ABN AMRO Bank

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Introduction of Portfolio Management

Economic Economic SlowdownSlowdown

Bursting of Tel. &Bursting of Tel. &Tech BubblesTech Bubbles

PoliticalEventsOperationalOperational

fraudsfrauds

AccountingAccountingscandalsscandals

Environmental

Increase in loan losses and

provisions

BIS IIBIS II

Desire for Desire for pricing pricing

disciplinediscipline

Capital reductionCapital reductionin lendingin lending

Understand true Understand true liabilitiesliabilities

Better Credit Management

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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

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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

3. Position in the organisation

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Positioning in the Organisation

Wholesale Clients

Pro

du

ct

Bu

sin

es

s U

nit

s

Financial Markets

Global Transaction Services

Private Equity

Equities

Client Business Units

TMT ACD ECP FI&PS

Corporate Finance

Risk / Compliance / Legal / Audit / Human Resources / TOPS

Change Management

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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

4. Definition of the mandate

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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:

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PM Mandate

PM mandate

Portfolio Originator

Hedging, selling andbuying exposure,actively managingagainst portfolio

parameters

Portfolio Management

Both Origination andPM

Owner of Portfolio

Owner of P&L

Monitor

Monitoring andreporting

Origination

Origination

Hedging and selling existing

exposure to improve

risk/improve diversification

Origination

Origination. PM has shadow P&L

Hedger Asset Manager

PM becomes a business on its

own merits

Portfolio Management

Portfolio Management

Roles / Function?

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PM Mandate“Origination Shop” “Shadow Portfolio” “Balanced Model” “Portfolio Originator” “Fund Manager”

Market Posture “Defend” “Hedge” “Attack”

Aim of PortfolioManagement function

Overview of portfolio toinform business decisions

Portfolio optimisation(sell / hedge) to improve

risk / return

Active management (buy /sell / hedge) as own value

proposition

Active management ofrisk and return as main

value proposition

Asset management asstand-alone business

Positioning of PortfolioManagement function

None / Passive Reactive Proactive Leading In control

Formal split betweenPortfolio Management andOrigination

None Distinct functionsInformal arm’s length

relationshipFormal arm’s length relationship

Change to credit “businessmodel”

None Enhance business modelReconstruct business

modelFundamentally reconceive business model,

“no turning back”

Who takes creditdecisions?

Origination OriginationOrigination, subject to

product designOrigination, subject to

product designPortfolio Management

Who owns the creditassets?

OriginationOrigination or

Portfolio ManagementPortfolio Management Portfolio Management Portfolio Management

Portfolio Managementinput to asset selection

N/AAccepts all assets at

transfer price, has no inputon inflows

Accepts most assets attransfer price, has limited

input on inflows

Accepts assets at transferprice; has discretionary

vetoN/A

Who owns the creditP&L?

OriginationOrigination; Portfolio

Management has “shadowP&L”

Both Origination andPortfolio Management

Portfolio Management Portfolio Management

Consistent with BIS II inlong term?

Yes Yes Yes Yes Yes

ExamplesTraditional universal

banksAbbey National,

SE BankenUBS, Standard Chartered

HypoVereinsbank(mortgage)

[Freddie Mac]

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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.

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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.

5. Performance Measurement

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Performance Contract

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

Performance Contracts Based on Economic Profit (“EP”) and RAROC

Alignment with other parts of the business is important !

6. Organisation & Key Management Tools

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Organisation Portfolio Management

Portfolio Strategy/Executi

on

Credit Portfolio Management

Portfolio Analytics

Asia Pacific

Europe

Benelux

America

South America

(500)

Amsterdam

(20)

Asia Pacific

Europe

America

US

(25)

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PMG Filter

Portfolio Parameters

Loan Pricing Tool

Shortfall Compensation Programme

Key Management Tools

New In

WCS Loan

Portfolio Old Out

Enlargement of PM’s Mandate required enhancements to Key Management Tools

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PM Filter

Is the facility EC greater than EUR[750k] and belong to a Corporate

Industry Sector EC Concentration > 9%and/or EC/Limits greater than [xx] bps

Does the facility or relationshipbreach Obligor EC Concentration

limit of EUR 7 million[or higher approved limit]

CPM & Client RM to review -Action Plan prepared if EC > EUR

10 million

Does Product Type relate toPMG Portfolio

Proceed to GRM / GRC

Does the facility generate anEP Loss > EUR 50,000

No

No

No

Yes

SCP ScheduleProduced

Yes

Yes

Yes

PMG Filter applies to all WCS credit applicationsfor new, renewal or extended credit facilities

PMG Strategy to deliverappropriate input for credit

application

Facilities supportedby PMG Portfolio Parameter

SCP ProgramParameter

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Loan Pricing Tool

Major Inputs:

Credit Rating => PD

T & C Risk

LGD

Legal Risk

Collateral

Tenor

Expected Utilisation

Industry

Revenue and Opex

Major Outputs:

Economic Profit

RAROC

Benchmark Pricing

ROS

Economic Capital

Regulatory Capital

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Loan Pricing Tool

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Loan Pricing Tool

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Shortfall Compensation

Credit Income vs Relationship income

CPM receives compensation for Economic Loss from other product area in case of major cross sell

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Managing the Portfolio

Sales/Origination

Risk

ManagementCPM

Investment Portfolio

Economic Performance:

Risk / Reward / Diversity

MeasuringMeasuring

PredictingPredicting

NegotiateNegotiate

BenchmarkBenchmark

Industry/ Industry/ GeographyGeography

Rating / TenorRating / Tenor

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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

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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

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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

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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

8. Overcoming Challenges in Managing the Portfolio

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The universe of Portfolio Management

Credit MarketsCredit Markets

Other Other Product BU’sProduct BU’s

Risk ManagementRisk ManagementFinanceFinance

CreditCreditAdministrationAdministration

AuditAudit & &

ComplianceCompliance

Relationship Relationship BankingBanking

StrategyStrategy

Other Other GeographiesGeographies

BudgetBudget

ExecutionExecution

Management

PM

RegulatorRegulatorIndustryIndustry

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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

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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”

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Change Management

Create buy – in / commitment

Communicate

Report

Success breeds ……………..

Strategy and Determination

Professionalism

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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

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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.

Thank you