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2. Introduction of Portfolio Management in ABN AMRO Bank ... Portfolio Management introduced as part of the credit and capital management architecture ...

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overcoming challenges to active portfolio management

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

Contents
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
basle ii raroc and economic capital5
Basle II, RAROC and Economic Capital

Simply put, Economic Profit is:

Revenue

less: Cost (operating)

Provisions

Tax

Cost of Capital

introduction of portfolio management
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

introduction of portfolio management8
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

introduction of portfolio management9
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
positioning 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

Financial Markets

Global Transaction Services

Product Business Units

Private Equity

Equities

Corporate Finance

challenges
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
pm mandate
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:

pm mandate15
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

pm mandate abn amro
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.

pm mandate18
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.

performance contract
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 !

organisation portfolio management
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)

key management tools
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
loan pricing tool
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
shortfall compensation
Shortfall Compensation

Credit Income vs Relationship income

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

managing the portfolio
Managing the Portfolio

Economic Performance:

Risk / Reward / Diversity

Industry/ Geography

Rating / Tenor

Measuring

Predicting

Negotiate

Benchmark

Risk

Management

CPM

Sales/Origination

Investment Portfolio

minimising provisions
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
cost of capital
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
portfolio management instruments
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

monitoring
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
the universe of portfolio management
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

sources of problems
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
technical challenges
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”
change management
Change Management
  • Create buy – in / commitment
  • Communicate
  • Report
  • Success breeds ……………..
  • Strategy and Determination
  • Professionalism
results to date
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
risk advisory service
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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