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
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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
Economic
Slowdown
Environmental
BIS II
Desire for
pricing
discipline
Accounting
scandals
Capital reduction
in lending
Understand true
liabilities
Bursting of Tel. &
Tech Bubbles
Better Credit
Management
Political
Events
Operational
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
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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
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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
Product Business Units
TMT
ACD
ECP
FI&PS
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
PM mandate
Monitoring and
reporting
Owner of Portfolio
Origination
Owner of P&L
Origination
Hedger
Hedging and
selling existing
exposure to
improve
risk/improve
diversification
Origination
Origination. PM
has shadow P&L
0
Portfolio Originator
Hedging, selling and
buying exposure,
actively managing
against portfolio
parameters
Asset Manager
PM becomes a
business on its
own merits
Portfolio Management
Portfolio Management
Both Origination and
PM
Portfolio Management
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PM Mandate
“Origination Shop”
Market Posture
“Shadow Portfolio”
“Defend”
“Balanced Model”
“Portfolio Originator”
“Hedge”
“Fund Manager”
“Attack”
Overview of portfolio to
inform business decisions
Portfolio optimisation
(sell / hedge) to improve
risk / return
Active management (buy /
sell / hedge) as own value
proposition
Active management of
risk and return as main
value proposition
Asset management as
stand-alone business
None / Passive
Reactive
Proactive
Leading
In control
Formal split between
Portfolio Management and
Origination
None
Distinct functions
Informal arm’s length
relationship
Formal arm’s length relationship
Change to credit “business
model”
None
Enhance business model
Reconstruct business
model
Fundamentally reconceive business model,
“no turning back”
Who takes credit
decisions?
Origination
Origination
Origination, subject to
product design
Origination, subject to
product design
Portfolio Management
Who owns the credit
assets?
Origination
Origination or
Portfolio Management
Portfolio Management
Portfolio Management
Portfolio Management
N/A
Accepts all assets at
transfer price, has no input
on inflows
Accepts most assets at
transfer price, has limited
input on inflows
Accepts assets at transfer
price; has discretionary
veto
N/A
Origination
Origination; Portfolio
Management has “shadow
P&L”
Both Origination and
Portfolio Management
Portfolio Management
Portfolio Management
Yes
Yes
Yes
Yes
Yes
Traditional universal
banks
Abbey National,
SE Banken
UBS, Standard Chartered
HypoVereinsbank
(mortgage)
[Freddie Mac]
Aim of Portfolio
Management function
Positioning of Portfolio
Management function
Portfolio Management
input to asset selection
Who owns the credit
P&L?
Consistent with BIS II in
long term?
Examples
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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
Strategy/Execution
Credit Portfolio
Management
Portfolio Analytics
Asia Pacific
Asia Pacific
Amsterdam
Europe
Europe
(20)
America
Benelux
US
America
(25)
South America
(500)
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Key Management Tools
Enlargement of PM’s Mandate required
enhancements to Key Management Tools
New In
WCS
Loan
Portfolio
PMG Filter
Portfolio Parameters
Old Out
Loan Pricing Tool
Shortfall Compensation Programme
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PM Filter
PMG Filter applies to all WCS credit applications
for new, renewal or extended credit facilities
Does Product Type relate to
PMG Portfolio
No
Yes
SCP Schedule
Produced
Y es
Does the facility generate an
EP Loss > EUR 50,000
SCP Program
Parameter
PMG Strategy to deliver
appropriate input for credit
application
Yes
Is the facility EC greater than EUR
[750k] and belon g to a Corporate
Industry Sector EC Con centration > 9%
and/or EC/Limits greater than [xx] bps
No
CPM & Client RM to review Action Plan prepared if EC > EUR
10 million
Yes
Does the facility or relationship
breach Obligor EC Concentration
limit of EUR 7 million
[or higher approved limit]
No
Facilities supported
by PMG
Portfolio Parameter
Proceed to GRM / GRC
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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
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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
Economic Performance:
Risk / Reward / Diversity
Measuring
Negotiate
Predicting
Benchmark
Industry/
Geography
Rating / Tenor
Risk
Sales/Origination
CPM
Management
Investment Portfolio
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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
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8.
Overcoming Challenges in Managing the Portfolio
The universe of Portfolio Management
Relationship
Banking
Industry
Regulator
Audit
&
Compliance
Credit Markets
Strategy
PM
Other
Geographies
Credit
Administration
Execution
Other
Product BU’s
Budget
Management
Risk Management
Finance
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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.
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Thank you