FINA/022

IBS Center for Management Research

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Market Risk Management at ABN AMRO O
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This case was written by Arun Khan, IBS Center for Management Research. It was compiled from published sources, and is
intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a
management situation.
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 2005, IBS Center for Management Research. All rights reserved.

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 FINA/022

Market Risk Management at ABN AMRO1

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Introduction

Holland’s leading bank, ABN AMRO operated more than 800 offices at home and another 2,600 in 75

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other countries. In the US, ABN owned Chicago-based LaSalle Bank and Standard Federal Bank, one
of Michigan's largest banks. ABN also had a large presence in Brazil (through its ownership of Banco
Real and Paraiban) and Malaysia (where it had operated for more than 100 years). The bank was
expanding its presence in the Philippines, India, Singapore, Taiwan, and Thailand.
ABN had three major business segments: private clients & asset management, consumer and

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commercial clients, and wholesale clients, but its strategic focus was on the mid-market segment.
The bank believed it had a strong and distinctive competitive advantage in this segment, where it
felt it could be most profitable in the future.

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Market risk referred to the risk that movements in financial market prices, such as foreign
exchange, interest rates, credit spread, equities and commodities, would change the value of the
bank’s portfolios. ABN was exposed to market risk through its trading activities, which were
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carried out both for customers and on its own account.
In trading activities, risk arose both from open positions and from imperfect correlation between
market positions that were intended to offset one another. Effective and efficient management of
market risk was essential for both the competitiveness and profitability of the bank.
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There were several major types of market risk: interest rate risk, foreign exchange risk, equity
price risk, commodity price risk, credit spread risk, and volatility and correlation risks. For each
risk type there were specific risk factors. Market risk exposure was quantified by identifying
relevant risk factors and calculating appropriate risk measures. The risk measures for each risk
factor were then used to set market risk limits, to run scenario and sensitivity analyses, and as
inputs to various risk measurement models, such as Value-at-Risk (VaR).
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Market Risk Management

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Market Risk contained three major functions: Market Risk Management, Market Risk Policy, and
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Market Risk Reporting & Control. Market Risk Management (MRM) ensured that the authority
delegated by the Group Asset Management and Liability Committee (ALCO) and Group Risk
Committee (GRC) with regard to market risk resulting from the bank’s trading activities was
exercised effectively, and that exposures were efficiently monitored and managed.
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MRM limited and monitored the potential impact of specific pre-defined market movements on the
profit & loss of trading positions. MRM also monitored the market risk of ALCO portfolios
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maintained by Group functions. Market Risk Policy was responsible for developing policy and
establishing and maintaining a market risk framework within the organization. Market Risk
Reporting & Control strived to optimize both the reporting process and the content of the market
risk reports.

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This case draws heavily from ABN AMRO’s Annual Reports. The information has been compiled in the
form of a case study for the purpose of discussion by MBA students.

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 Market Risk Management at ABN AMRO

Value-at-Risk

VaR was the primary tool for the day-to-day monitoring of trading-related market risks. VaR was
defined as the loss that might be caused by changes in risk factors under normal circumstances,
over a specified period of time in the future and at a specific level of statistical confidence. ABN
used a proprietary VaR model that had been approved by the Dutch central bank.
The specific method used by ABN for calculating VaR was Historical Simulation, using four years

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of equally weighted historical data. The VaR was calculated at a 99% confidence level for a one-
day holding period, using relative changes in historical rates and prices. The positions captured by
VaR calculations included derivative and cash positions that were reported as trading assets and
liabilities. The VaR was reported on a daily basis per trading portfolio, per product line and for the

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bank as a whole, and was reported daily to the senior management of the business units, GRM and
the responsible members of the Managing Board.
The effectiveness of VaR was validated by back testing, which counted the number of days where
the losses were bigger than the estimated VaR figures for those days. Statistically, with a 99%
confidence level, it might be expected that on one out of every 100 trading days, a loss exceeding

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the VaR occurred. The back testing was performed both on the actual profit and loss (P&L) and on
a hypothetical P&L, which measured a P&L excluding the effect of commissions, origination fees
and intra-day trading. The results of the back testing were reported to the Dutch central bank on a
regular basis.

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VaR, a good estimate under normal market circumstances, was supplemented by a series of stress
test scenarios and sensitivity stress tests that examined the behavior of a portfolio under extreme
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market movements. Sensitivity stress tests and stress test scenarios had been developed internally
to reflect specific characteristics of the bank’s portfolios. The stress test scenarios and sensitivity
stress tests were performed daily for each trading portfolio and at several levels of aggregation.
Sensitivity stress tests: This category of stress tests was based on parallel movements either in one
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particular risk factor or simultaneously in a number of risk factors. The tests were applied to each
trading portfolio. The following stress tests had been developed and implemented:
 Stressed Delta: This test calculated the potential loss (profit) that might be incurred by the
portfolio as a result of a large parallel move in the respective risk factor. For the interest
rate sensitive portfolios, this test was calculated by applying a series of parallel shifts in
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the yield curve.

 Stress Matrices: These tests aimed at analyzing the potential loss (profit) as a result of
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simultaneous movements in the underlying market price (stock price or FX rate) and
volatility of this risk factor, and were designed in the form of scenario matrices.
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 Curvature stress: This test analysed the potential change in the value of interest rate
sensitive portfolios due to convexity effects embedded in these portfolios. It was measured
by calculating differences between the linearly extrapolated delta (through a series of
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shifts in the interest rate) and the results of the full revaluation of the portfolio, assuming
parallel shifts in the yield curve.
 Czech Koruna scenario: This analyzed the potential change in the value of interest rate-
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sensitive portfolios in emerging market currencies due to an extreme nonparallel move

(inverted curve) as a result of a liquidity crisis, as was seen in 1997 in the Czech Koruna
market.
 Limits were in place for each of the stress tests listed above. The stress test calculations
and the limit monitoring were performed on a daily basis.

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Stress Test Scenarios

ABN used two types of scenario analysis:

1. Historical scenarios. In this category, bank-wide stress test scenarios were created based
on events of significant disturbance in financial markets that actually took place in the
past. Some of the scenarios which had been used were the stock market crash (1987), bond
market crash (1994), emerging markets crisis (1997), financial market crisis (1998) and
WTC attacks (2001). For each of the scenarios, a checkpoint level was put in place,

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serving as a trigger for discussions and/or actions in cases where this checkpoint level was
exceeded. The scenario calculations and monitoring of checkpoint levels were performed
on a daily basis.
2. Hypothetical scenarios. In this category, the bank constructed shocks that were deemed

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plausible in the future. Examples of scenarios calculated in the past were ‘Euro blow-up’
and ‘Y2K’.
Given its worldwide coverage and diversified overall portfolio, ABN believed overall it was not
very sensitive to sudden sharp market movements.

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Asset and Liability Management

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Interest Rate Risk

One of GALM’s core objectives was to manage the sensitivity of the bank’s net interest revenue to
changes in market interest rates. Group ALCO set limits to ensure that the potential adverse impact
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of market movements on trading and non-trading earning was closely controlled.
Several measures were used to monitor and limit non-trading interest rate risk - scenario analysis,
interest rate gap analysis and market value limits. Model-based scenario analysis was used to
monitor the interest rate risk positions denominated in euros, Brazilian reals and US dollars in
Europe, Brazil and the US respectively. Interest rate risk positions in other currencies and other
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countries were managed by gap analysis and/or market value limits, as these positions were
typically less complex.
The bank used simulation models and estimation techniques to assess the sensitivity of the net
interest revenue stream (interest received less interest paid) to movements in the shape and level of
the yield curve. Assumptions about client behavior played an important role in these calculations.
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This was particularly relevant for loans such as mortgages where the client had the right, but not
the obligation, to repay before the scheduled maturity.
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On the liability side, the repricing characteristics of savings and deposits were based on estimates,
since the rates attached to these products were not coupled to a specified market rate. The bank
used a statistical approach for forecasting and sensitivity analyses because it was best suited to
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these products. Although comparable in many ways with macroeconomic forecasting, this
approach was based on the information in individual client contracts.
The sensitivity of net interest revenue to interest rate changes was assessed by assuming a gradual
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parallel shift in the term structure of interest rates during a period of 12 months. Sensitivity
analysis indicated that such a movement would lead to a reduction of the net interest revenue. This
analysis was based on the positions as on 31st December 2004, and was subject to various
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assumptions, including one on expected client behavior under these changing circumstances.

Interest Rate Risk Associated with US Residential Mortgage Business

ABN was among the top 15 residential mortgage originators and the top 10 residential mortgage
servicers in the US. The bank sold most of the mortgage loans it originated and retained a majority
of the rights to service the residential mortgage loans it sold. The bank recognized a Mortgage

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 Market Risk Management at ABN AMRO

Servicing Right (MSR) upon sale of the loan. MSR represented the present value of the estimated
future net servicing cash flows realized over the estimated life of the loan. The sensitivity of
origination income and MSR valued to changes in interest rates might have a significant impact on
earnings.
In general, mortgage origination and mortgage servicing businesses provided a partial natural
offset. But, the timing of income recognition could impact earnings. If interest rates were high or
rising, residential mortgage loan demand might decline, leading to a fall in origination income.

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However, high or rising interest rates might lead to lower servicing prepayments and a
corresponding reduction in servicing amortization costs and, therefore, an increase in servicing
income.
Conversely, if interest rates were low or falling, as in 2002 and 2003, residential mortgage loan

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demand might increase and origination income might go up. However, it was likely that low or
declining interest rates would increase servicing portfolio prepayments and related servicing
amortization costs and decrease servicing income.
If declines in interest rates were enough, accelerated mortgage loan refinancing and related
increases in prepayments might cause declines in the value of existing mortgage servicing rights

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and lead to provisions for impairment. These provisions might be offset by higher future
origination income, but the magnitude of the impairment provision and the higher origination

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income might differ. In addition, the timing of income recognition might not exactly match the
servicing provision. The provision was charged to net income immediately upon a rate change, but
the higher origination income would occur over time. As a result, the size of any provision could
be material to earnings in any one quarter, even if there were other offsetting sources of earnings
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over a full 12-month period.
ABN employed various strategies to manage the risk to net mortgage revenue over time from all
sources and to manage the risk to an immediate reduction in the fair value of its mortgage
servicing rights. The main hedge instruments used were interest rate swaps and forward sales
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contracts. From time to time, other derivative instruments such as interest rate futures, caps, floors
or purchased options to enter interest rate swaps might be employed.
Occasionally cash instruments such as mortgage-backed securities were utilized as hedges for
MSR assets. As part of the overall management of interest rate risk, ABN took into account the
modulations in mortgage origination income that resulted from changes in interest rates. The
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origination side of the business, from interest rate lock commitment to loan sale, was hedged on an
economic basis. MSRs were also hedged under a programme designed to limit exposure to the
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impact which interest rate volatility might have on the fair value of the MSR assets.
The valuation of MSRs was important to the North America’s business unit’s results. This
valuation was complicated because of the inherent uncertainties. Economic factors considered in
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estimating the fair value of MSRs included interest rates, discount rates, prepayment speeds,
geographic characteristics, servicing costs and ancillary income. Mortgage loan prepayment rates
were revised monthly, and were derived from a third party model. In addition, management used
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the sale of MSRs and regular valuations by various third party brokers to compare its valuation
assessments with market data.
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Currency Risk

ABN had put in place a comprehensive framework to manage and limit currency risk. Group
ALCO was responsible for the coordination of its currency risk policies. In trading portfolios,
exposure to exchange rate movements was managed through market risk limits based on VaR. Any
short or long positions were monitored to ensure compliance with the limits established by GRC.

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Non-Trading Currency Risk

Various hedging strategies were applied to net investments in its overseas operations and to their
profits in order to minimize any adverse effects from translating the relevant foreign currency into
euro.
 Ratio hedge The bank’s BIS-ratios (tier 1 and total capital as a portion of Risk weighted
assets, RWA) were protected against fluctuations in the EUR/USD rate. As both capital

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and RWA were subject to foreign currency translation, this was done by maintaining the
BIS ratios for US dollar elements at a level close to the overall BIS ratios.
 Capital hedge Investments in overseas operations in currencies other than US dollar were
hedged selectively. The bank considered using hedging in cases where the expected

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currency loss was larger than the interest differential between the two currencies.
Gains and losses on these capital exposures were taken through equity, as was the cost of hedging.
The position as on 31st December 2004 implied that a hypothetical increase in the value of the
euro against all other currencies would have led to a reduction in reserves, and vice versa. On this
basis, there would have been no material impact on the bank’s BIS-ratios, as the ratios were

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hedged against changes in the EUR/USD exchange rate.

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 Profit hedge Profits were also hedged on a selective basis to lessen the impact of currency
movements on the profit and loss account. The criteria for deciding on profit hedging were
similar to those for capital hedging. In August 2004 an additional 17% of the expected net
USD profit for 2004 was hedged, thereby increasing the average rate of the hedges from
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USD 0.9563 to USD 0.9929 per Euro. The expected US dollar profit for 2005 had been
hedged at a rate of USD 1.1625 by using a combination of forwards, options and a collar.
The expected US dollar profit for 2006 had been hedged for 80% at a rate of 1.2130 by
call options.
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Liquidity Risk

A bank might be unable to fund its portfolio of assets at appropriate maturities and rates, or might
find itself unable to liquidate a position in a timely manner at a reasonable price. The bank held
capital to absorb unexpected losses, and managed liquidity to ensure that sufficient funds were
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available to meet not only known cash funding requirements, but also any unanticipated ones that
might arise. Adequate levels of liquidity were maintained to meet deposit withdrawals, repay
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borrowings and fund new loans, even under stressed conditions. To increase liquidity, the bank
securitised its Dutch home mortgages and retained most of the resulting notes. As a result, ABN
owned additional securities that were eligible as collateral for the Dutch central bank, resulting in a
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direct improvement of some EUR 13 billion in its liquidity. Unlike the US federal banking
authorities, the Dutch central bank did not directly accept mortgages as collateral. The
securitisation did not have an impact on its solvency or on the balance sheet presentation of the
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underlying securitised mortgages. If and when required, these notes could be sold in the market.
The bank managed liquidity on a daily basis in all the countries in which it operated taking into
account the unique circumstances of each national market. So the local line management was
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responsible for managing its local liquidity requirements under the supervision of Group ALCO.
On a day-to-day basis, the bank’s liquidity management depended on, among other things, the
effective functioning of local and international financial markets. As these conditions did not
always apply, the bank had Group-wide contingency funding plans. These plans were implemented
if there was a dramatic change in its normal business activities or in the stability of the local or
international financial markets. The Group Strategic Funding Committee had full authority to

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manage such a crisis. As part of contingency planning, the bank assessed potential trends,
demands, commitments, events and uncertainties that might affect liquidity. More specifically, the
bank considered the impact of these potential changes on its sources of short term funding and
long-term liquidity planning. As the bank had entered into committed credit facilities, its liquidity
management process also involved assessing the contingencies inherent in these types of
transactions, in terms of their potential impact on the normal sources of liquidity and finance.

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 Market Risk Management at ABN AMRO

Exhibit 1

Revenues in 2004 per SBU in %

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Note: C&CC - Consumer & Commercial Clients.
WCS – Wholesale Clients
PC – Private Clients
AM – Asset Management O
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LPC – Lease Plan Corporation
GF – Group Functions
Source: Annual Report 2004.
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Exhibit 2

Total Revenue
(in millions of Euros)
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Source: Annual Report 2004.

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Exhibit 3
Financial Highlights
(in millions of euros) 2004 2003 2002
Total revenue 19,793 18,793 18,280
Operating expenses 13,687 12,585 13,148

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Operating result 6,106 6,208 5,132
Provisioning for loan losses 653 1,274 1,695

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Value adjustments to financial fixed assets 2 16 49
Operating profit before taxes 5,451 4,918 3,388
Source: Annual Report 2004.

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Exhibit 4

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Risk Governance Organizational Structure
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Source: Annual Report 2004.

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Exhibit 5
VaR per Risk Category
(99% confidence level, 1 day holding period)

(In millions of euros) 2004 2003 2004 2003 2004 2003 2004 2003

Year- Year Average Average maxim Maxim Minim Minim

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end -end -um -um -um -um

Total per risk type

Interest rate risk 18.7 13.5 21.6 17.5 49.5 40.4 10.4 11.0

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Equity price risk 15.6 11.0 14.9 11.4 25.9 18.9 8.8 3.8
Foreign exchange risk 3.7 2.1 3.0 3.3 7.7 11.0 1.0 0.6
Commodity price risk 0.8 0.2 0.4 0.3 2.5 2.5 0.1 0.1
Diversification effect (8.3) (8.0)

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Aggregate VaR1 30.5 18.8 26.4 21.7 42.2 34.3 17.1 14.1

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The minimum and maximum for each risk category occurred on different days and therefore is not
meaningful to the aggregate VaR. The Aggregate VaR includes the diversification effect that is caused
by imperfect or negative correlations between certain risk types and may therefore be low than the
sum of the individual risk types on the same day (year-end)
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Source: Annual Report 2004.

Exhibit 6
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VaR V/s Hypothetical Profit & Loss for Trading Portfolios for 2004
(in millions of Euros)
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Source: Annual Report 2004.

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20. www.hoovers.com
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