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

0 2 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

0 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

0 5 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

0 7 Introduction of Portfolio Management EconomicSlowdown Bursting of Tel. & Tech Bubbles Political Events Operationalfrauds Accountingscandals Environmental Increase in loan losses and provisions BIS II Desire for pricingdiscipline Capital reduction in lending Understand true liabilities Better Credit Management

0 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

0 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

3. Position in the organisation

0 11 Positioning in the Organisation Wholesale Clients Product Business Units Financial Markets Global Transaction Services Private Equity Equities Client Business Units TMTACDECPFI&PS Corporate Finance Risk / Compliance / Legal / Audit / Human Resources / TOPS Change Management

0 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

4. Definition of the mandate

0 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:

0 15 PM Mandate PM mandate Portfolio Originator Hedging, selling and buying exposure, actively managing against portfolio parameters Portfolio Management Both Origination and PM Owner of Portfolio Owner of P&L Monitor Monitoring and reporting Origination Hedging and selling existing exposure to improve risk/improve diversification Origination Origination. PM has shadow P&L HedgerAsset Manager PM becomes a business on its own merits Portfolio Management Roles / Function

0 16 PM Mandate

0 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.

0 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.

5. Performance Measurement

0 20 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

0 22 Organisation Portfolio Management Portfolio Strategy/Execution Credit Portfolio Management Portfolio Analytics Asia Pacific Europe Benelux America South America (500) Amsterdam (20) Asia Pacific Europe America US (25)

0 23 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

0 24 PM Filter

0 25 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

0 26 Loan Pricing Tool

0 27 Loan Pricing Tool

0 28 Shortfall Compensation Credit Income vs Relationship income CPM receives compensation for Economic Loss from other product area in case of major cross sell

0 29 Managing the Portfolio Sales/Origination Risk Management CPM Investment Portfolio Economic Performance: Risk / Reward / Diversity MeasuringPredictingNegotiateBenchmark Industry/ Geography Rating / Tenor

0 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

0 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

0 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

0 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

8. Overcoming Challenges in Managing the Portfolio

0 35 The universe of Portfolio Management Credit Markets Other Product BU’s Risk Management Finance Credit Administration Audit & Compliance Relationship Banking Strategy Other Geographies Budget Execution Management PM Regulator Industry

0 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

0 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”

0 38 Change Management  Create buy – in / commitment  Communicate  Report  Success breeds ……………..  Strategy and Determination  Professionalism

0 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

0 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.

Thank you