PRIMA-Presentation-14May04

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					Overcoming Challenges To Active Portfolio
Management

PRIMA, Singapore




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




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1. PM, Basle II, RAROC and Economic Capital
  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


                               0                               4
Basle II, RAROC and Economic Capital

Simply put, Economic Profit is:

    Revenue

less:Cost (operating)

    Provisions

    Tax

    Cost of Capital




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


                                       Increase in
                                     loan losses and
                                        provisions


   Environmental                                                              Economic
                                         BIS II                               Slowdown

                   Desire for                             Understand true
                    pricing                                  liabilities
                   discipline

                                                                               Bursting of Tel. &
Accounting               Capital reduction                                       Tech Bubbles
 scandals                   in lending            Better Credit
                                                  Management


                                                                  Political
                       Operational                                Events
                         frauds



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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



                                        0                              8
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




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3.
Position in the organisation
Positioning in the Organisation
          Wholesale Clients

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

          Change Management

                                                                       Client Business Units

                                                                 TMT      ACD       ECP        FI&PS
          Product Business Units




                                   Financial Markets

                                   Global Transaction Services

                                   Private Equity

                                   Equities

                                   Corporate Finance




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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




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4.
Definition of the mandate
PM Mandate

Just a few of the questions to be answered:
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?



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   PM Mandate
                                                                                      ?
Roles / Function
                       Monitor           Hedger          Portfolio Originator      Asset Manager




                                       Hedging and
                     Monitoring and   selling existing                            PM becomes a
PM mandate             reporting       exposure to       Hedging, selling and     business on its
                                          improve          buying exposure,         own merits
                                       risk/improve       actively managing
                                      diversification       against portfolio
                                                              parameters


Owner of Portfolio    Origination      Origination       Portfolio Management   Portfolio Management




                                       Origination. PM
Owner of P&L          Origination     has shadow P&L     Both Origination and   Portfolio Management
                                                                  PM




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           PM Mandate
                               “Origination Shop”           “Shadow Portfolio”              “Balanced Model”          “Portfolio Originator”            “Fund Manager”
Market Posture                      “Defend”                                      “Hedge”                                                    “Attack”
                                                           Portfolio optimisation       Active management (buy /       Active management of
Aim of Portfolio              Overview of portfolio to                                                                                              Asset management as
                                                          (sell / hedge) to improve     sell / hedge) as own value     risk and return as main
Management function          inform business decisions                                                                                              stand-alone business
                                                                  risk / return                  proposition              value proposition
Positioning of Portfolio
                                  None / Passive                  Reactive                      Proactive                     Leading                      In control
Management function
Formal split between
                                                                                          Informal arm’s length
Portfolio Management and              None                   Distinct functions                                                  Formal arm’s length relationship
                                                                                               relationship
Origination
Change to credit “business                                                                Reconstruct business              Fundamentally reconceive business model,
                                      None                Enhance business model
model”                                                                                          model                                 “no turning back”
Who takes credit                                                                          Origination, subject to      Origination, subject to
                                   Origination                  Origination                                                                         Portfolio Management
decisions?                                                                                   product design               product design
Who owns the credit                                            Origination or
                                   Origination                                           Portfolio Management          Portfolio Management         Portfolio Management
assets?                                                    Portfolio Management
                                                             Accepts all assets at        Accepts most assets at      Accepts assets at transfer
Portfolio Management
                                       N/A               transfer price, has no input   transfer price, has limited    price; has discretionary              N/A
input to asset selection
                                                                  on inflows                 input on inflows                    veto
                                                          Origination; Portfolio
Who owns the credit                                                                      Both Origination and
                                   Origination           Management has “shadow                                        Portfolio Management         Portfolio Management
P&L?                                                                                     Portfolio Management
                                                                 P&L”
Consistent with BIS II in
                                       Yes                          Yes                            Yes                           Yes                          Yes
long term?
                               Traditional universal          Abbey National,                                            HypoVereinsbank
Examples                                                                                UBS, Standard Chartered                                          [Freddie Mac]
                                       banks                    SE Banken                                                  (mortgage)




                                                                                   0                                                                             16
   PM Mandate ABN AMRO

PM is responsible for managing the loan portfolio with an objective to
maximise Economic Profit within a client driven wholesale bank strategy.

    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




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    PM Mandate

PMG is responsible for managing the loan portfolio with an objective to
maximise Economic Profit within a client driven wholesale bank strategy.

    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




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5.
Performance Measurement
  Performance Contract

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



                   Alignment with other parts of the business is important !



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6.
Organisation & Key Management Tools
Organisation Portfolio Management



    Portfolio        Credit Portfolio
                                        Portfolio Analytics
Strategy/Execution    Management


     Asia Pacific       Asia Pacific          Amsterdam
       Europe             Europe                 (20)
      America            Benelux
         US              America
        (25)           South America
                           (500)




                               0                              22
Key Management Tools

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


                                   New In


                                             WCS
PMG Filter
                                             Loan
Portfolio Parameters                        Portfolio
                                                        Old Out
Loan Pricing Tool

Shortfall Compensation Programme




                                   0                              23
PM Filter

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



                                                   Does Product Type relate to             No
                                                         PMG Portfolio

                                                                        Yes
             SCP Schedule                Y es
               Produced                            Does the facility generate an
                                                     EP Loss > EUR 50,000
                                                                                   SCP Program
                                                                                   Parameter
       PMG Strategy to deliver                      Is the facility EC greater than EUR
                                         Yes
                                                     [750k] and belong to a Corporate
      appropriate input for credit               Industry Sector EC Concentration > 9%
             application                          and/or EC/Limits greater than [xx] bps

                                                                         No
                                                 Does the facility or relationship
       CPM & Client RM to review -       Yes
                                                breach Obligor EC Concentration
      Action Plan prepared if EC > EUR
                 10 million                           limit of EUR 7 million
                                                    [or higher approved limit]

                                                                       No
          Facilities supported
                by PMG
                                                                         Portfolio Parameter

                                 Proceed to GRM / GRC




                                                  0                                              24
Loan Pricing Tool
   Major Inputs:               Major Outputs:
   Credit Rating => PD        Economic Profit
   T & C Risk                 RAROC
   LGD                        Benchmark Pricing
   Legal Risk                 ROS
   Collateral                 Economic Capital
   Tenor                      Regulatory Capital
   Expected Utilisation
   Industry
   Revenue and Opex



                           0                         25
Loan Pricing Tool




                    0   26
Loan Pricing Tool




                    0   27
Shortfall Compensation


Credit Income vs Relationship income


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




                            0                            28
Managing the Portfolio
                     Economic Performance:
                     Risk / Reward / Diversity
                                                    Industry/
  Measuring                   Negotiate
                                                   Geography
  Predicting                Benchmark
                                                  Rating / Tenor

                                                       Risk
 Sales/Origination                CPM               Management




                           Investment Portfolio


                                     0                             29
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



                             0                    30
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


                                0                  31
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


                             0               32
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




                                  0                                  33
8.
Overcoming Challenges in Managing the Portfolio
     The universe of Portfolio Management

                                               Relationship                                  Regulator
Industry
                                                 Banking

             Audit
              &                                                                   Credit Markets
           Compliance
                                                              Strategy

                          Other
                        Geographies
                                                 PM                   Execution
                                                                                          Other
     Credit
                                      Budget                                           Product BU’s
  Administration                                         Management




                                                                 Risk Management
                              Finance




                                                     0                                             35
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




                            0                       36
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”




                              0                               37
Change Management

 Create buy – in / commitment
 Communicate
 Report
 Success breeds ……………..
 Strategy and Determination
 Professionalism




                           0     38
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




                            0                              39
 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.




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Thank you

				
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