Bancware Abn Amro Case Stud

8/11/2019 Bancware Abn Amro Case Stud

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The acronym AANA has a dual meaning tosome at the Chicago-based headquarters forABN AMROs North American operations. Whiletypically standing for ABN AMRO North America,it can also stand for ALCO Analytics for a NewAge. The latter embodies the notion thatleading-edge analytical tools are requisite forthe management of interest rate risk in abalance sheet with high levels of complexity.

ABN AMRO currently ranks as the 6thlargestmortgage originator and 9thlargest mortgageservicer in the world. In addition, its holdings ofmortgage loans and mortgage- backed securitiesare sizable. Its ability to monitor the liquidity,accounting, and option risk associated withthose mortgages is therefore crucial to thesuccess of its business.

ABN AMRO selected BancWares Convergencesolution to successfully capture and assessmany of those risks using advanced analytics.

At its Chicago headquarters, ABN AMRO NorthAmerica manages risk on approximately $90

billion in retail and commercial banking assetsthrough SunGard Trading and Risk SystemsBancWare solution. ABN AMRO, a long- time userof BancWare for asset/ liability management(ALM), added advanced analytics to the solutionearly in 1999. These include: option- adjustedvaluation (OAV) modeling through the Hull andWhite term- structure model, pre- paymentmodeling that incorporates the Andrew Davidson(ADCO) prepayment model, and commercialmortgage obligation (CMO) cash flows based onCMO data from Intex.

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As one of the top ten US banks in mortgageoriginations, ABN AMRO realized thatincorporating pre-payment modeling and thestochastic simulations of OAV were imperativefor deriving interest rate risk exposures of itsbalance sheet. BancWares advanced analyticalmodels more accurately capture interest raterisk because they consider optionalities inherentin mortgages, loans and other balance sheetitems. ABN AMRO worked closely with BancWareto direct the development of models such as OAVand the prepayment model.

The Importance of Product Scalability

ABN AMRO installed BancWares Convergence in1993. BancWare Convergence is an integratedplanning, reporting, and analysis tool that supportsasset/ liability management, forecasting, andbudgeting. As ABN AMROs modeling and businessrequirements grew, BancWares advanced analyticswere added. David Ide, first vice president anddeputy director of ABN AMRO North America,explained, We added to our base functionality asour needs changed. Our decision to purchase

Convergence pre-payment, term structure, andvaluation modules was driven by the long,successful relationship we have had withBancWare. These modules give us the capability tomodel the earnings and market value sensitivitiesassociated with a wide variety of highly complexfinancial instruments.

ABN AMRO North America was looking for a totalsoftware solution that had the ability to accuratelymodel the options embedded in its balance sheet.After careful evaluation, BancWare was selected.Some of the reasons ABN AMRO cites for choosingBancWare include its:

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ABN AMROs Addition of BancWare Advanced Analytics IncludingOAV Takes Interest Rate Risk Management at

ABN AMRO North America to New Heights.

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! Prepayment modeling capabilities whichinclude the four traditional factors aswell as up to four additional factors

! Overall scalability, flexibility and ease of

use

! Capability to easily customize reports tocurrent processes and managementrequirements

! Ability to integrate measurement of offbalance sheet risks into its ALM process

! Commitment to continual developmentof advanced analytics, complex scenariomodeling and risk management

Carl Tannenbaum, senior vice president anddirector of treasury research for ABN AMRO NorthAmerica, added, We are a huge mortgage bank.Without OAV for valuing assets with embeddedoptions we would have a blind spot that would be25 to 30 percent of total assetsour mort gageloan port f ol io alon e represent s roughly $10

bil l i on in assets we would not be accurat ely

valuing.

To take an accurate measure of interest rate riskin todays market, an institution requires theability to measure the impact of embeddedoptions. Tannenbaum noted that mortgagerefinancing, one example of an embedded

option, is beginning to take foot globally inEurope and also in Australia. Embeddedoptions, he said, are becoming moreimportant factors for the risk position of banksglobally.

BancWares combination of prepayment andterm structure modules evaluate the optionsembedded in ABN AMROs balance sheetcalibrated to market conditions for statisticallyrigorous option valuation.

Because our balance sheet is loaded withembedded options from mortgage- backedsecurities and a large mortgage origination

business, we are very risk sensit ive. OAV enablesus to actively manage the risks in our balancesheet, said Tannenbaum.

BancWare Used to Manage Near-term BusinessPositionsABN AMRO uses the risk numbers derived fromBancWare Convergence to actively manage theinterest rate risk of its balance sheet, said Ide.ABN AMRO does this by closely examining its riskpositions. This extends to our risk managers,Ide explained, who tend to think in terms ofduration and market value sensitivity. ABNAMROs managers can get a better handle onduration and sensitivity through the risknumbers Convergence produces.

We are a huge mortgage bank.Without OAV for valuing assetswith embedded options we wouldhave a blind spot that would be 25to 30 percent of total assetsmort gage loan port f o l io alone

represent s roughly $10 bil l ion i n

asset s we would not be accurat ely

valu ing.

our

After determining duration, ABN AMRO also usesBancWare to examine how rate changes affectduration.

Ide explained, Curves of exposures generatedfor market value risks are just derivatives ofmarket value risk. So, we look at the marketvalue of the bank under these scenarios andcalculate a localized duration. Essentially, welook at the change in market value, up and down10 basis points, and then measure that up anddown the spectrum. Not only did BancWare allow

us to see the market value of the impact tochanges in interest rates, it has allowed us tocommunicate these changes, as well the rate ofchange, to our managers, noted Ide.This type of modeling indicates that as interestrates increase, the duration of equity increases,and assets extend. At the same time, liabilitiesshorten; and duration extends. For instance,when rates fall, the model shows a dramaticdecline in the duration of equity.

For the first t ime, our managers could

actually see that and use that to manage theirpositions, Ide said.

The risk managers requested modeling that wasoutside of the realm of standard policy andreporting functions. On a daily basis, themanagers think about near- term marketmovements and ask, What is my exposure for a10 or 25 basis point move, - - not 200 points.They wanted modeling that would help themmanage near- term positions, Ide said. To givethe managers the modeling they desired, ABNAMRO added BancWares OAV, Intex and Behaviormodules to Convergence in April of 1999.

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Convergence as a strategic planning tool inacquisitions

ABN AMRO also employs BancWare as a tool toevaluate acquisitions. It does not utilize

Convergence in every deal, but more often,BancWare is called upon to acquisitions where abalance sheet does not present neededgranularity.

In these cases, ABN AMRO uses BancWare to test:

1. Whether there is risk in the balance sheetthat it might not want to pay for, or thatmight be an issue for discussion.

2. Whether there would be costs to fix the

banks position or, conversely, money tobe made by adjusting the position.

Ide says that Convergence has become a realstrategic tool for acquisitions. It is such aneffective simulation tool that it can be used toeither confirm or produce run- rate net interestincome which can be useful for pricing decisions.Particularly useful [ for this kind of assignment]is the speed that comes with the Excel interface,which allows for a quick structuring of a newbalance sheet. For every prospect that weeventually acquire, the integration is very clean

because we have already done some initial set-up and analysis on BancWare, Ide said.

Also notable are the acquisitions that ABN AMROdid not make after an evaluation usingBancWare. Among these was a bank thatpresented a weak GAP report and a sizeableportfolio of purchased funds made up of callabledebt. We used Convergence and the(BancWare) behavior model to build a modelthat predicted the callable behavior of thoseadvances over different rate environments. We

ran the numbers and saw a horrendous riskposition, Ide said. These results convincedmanagement not to bid for the bank. AlthoughMr. Ide noted that the bank could have come tothis conclusion through a more arduous route,It was nice to have the ease and reliability ofConvergence for this evaluation.

Modeling Originations and ServicingRelationships

ABN AMRO also uses BancWare to rigorouslymodel the natural hedge between its mortgageorigination business and its mortgage servicingbusiness. ABN AMRO has a huge - - over $100

billion dollar - - mortgage servicing business.ABN AMRO pays up- front for the right to servicemortgages. These rights have a considerableadverse option position tied to mortgageprepayment. In particular, if the mortgages are

refinanced, the value of the servicing rightsevaporates. This business carries a substantialamount of financial risk. Ide noted. But at thesame time the value of the servicing rightsevaporates, income from the mortgageorigination business begins to pick up steam.Determining how much mortgage originationoffsets this risk exposure is extremely importantto the bank. Ide continued, We wanted thisrelationship to be part of our earnings riskanalysis. We also wanted it to be part of ourmarket value analysis. Although it does not

have a line on our balance sheet, it has a marketvalue. We had to determine the extent to whichbanks make a mistake if they assume thatoriginations and servicing are complete naturaloffsets to each other. The offset is there ineconomic terms but not entirely for reportedearnings. There is a timing problem andBancWare is crit ical to our measurement ofthese differences, said Ide.

Between the economics and the accounting, ABNAMRO discovered this difference throughinnovative modeling within BancWare,

particularly the behavior and ADCO prepaymentmodels. Through the BancWare platform andpre- payment modeling, ABN AMRO modeled aninterest rate exposure for the entire bank anddetermined the worth of mortgage originationswhen interest rates dropped. The modelingshowed that the bank could make significantlymore income in a falling rate environment thanpreviously estimated.

To arrive at the mortgage originationsensitivities ABN AMRO easily built a model into

Convergence. First Mr. Tannenbaums group builta summarized database in Convergence of the $5trillion mortgage market in the US and called thisthe mortgage universe. Due to the flexibilityand ease of Convergence we can use pre-payment modeling to project the behavior of themortgage universe. The adds in the modelrepresent the production volume for the entireindustry, said Ide.

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Market Value of Origination Business

-300 -200 -100 0 100 200 300Rate movements (bps)

$millions


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Next, working with assumptions on ABN AMROsmarket share and profit spreads (which isrelated to volume because of fixed costs), themodel projects the fee income the bank expectsto earn. This fee income stream can be

calculated under numerous alternative interestrate scenarios and incorporated into the banksearnings- at- risk and market value riskpositions. Because the model is so fast- - ittakes just seconds to run each deterministicrate scenario- - we could actually go in and runscenarios in 10 basis point increments, from up300 basis points, to down 300 basis points, saidIde. The result was a graph with a lot of detailand some intuitive results.

The shape of the market value sensitivity, not

coincidentally, closely resembles the typicalshape of a prepayment curve. The slope of thecurve flattens both when the refinance incentiveis significantly out- of- the- money and when itis significantly in- the- money. When therefinance incentive is at- the- money ormodestly in- the- money, the slope becomesvery steep, implying a large positive duration forthe origination business.

Streamlined ALM Process

At about the same time that ABN AMROimplemented BancWares advanced modules thebank also consolidated the ALCO committeesfrom its three major US banks. Now it has oneconsolidated ALCO and its entire interest- raterisk modeling is loaded onto one BancWareplatform. This streamlined ALM process yieldedimmediate benefits. We saw significant time

savings, To run stochastic scenarios, with 20starting points and 200 paths, it takes just a fewhours for each of the banks, Ide noted.

Mr. Tannenbaum zeroed in on two factors thathave positively impacted turn- around time:

1. BancWares incorporation of ADCOprepayment assumptions data,eliminating the need for the bank todevelop its own set of prepaymentassumptions

2. BancWares ability to run deterministicvaluations for simple assets and themore complex OAV simulations for assetswith embedded options

We can run one scenario right after another,without a hitch. The process is streamlined,commented Mr. Tannenbaum.

Convergence, along with the behavior, term

structure and valuation models, gives us thecapability to model the earnings and marketvalue sensitivities associated with a wide varietyof highly complex financial instruments.Convergence is an extremely effective simulationtool in conjunction with OAV to manage marketrate risk, commented Ide. The flexiblearchitecture of Convergence loaded with theadvanced analytics of OAV, Intex, ADCO and theBancWare behavior model, enables ABN AMRO toanalyze market values and income simulationswithin an integrated and consistent framework.

This allows ABN AMRO to deliver the marketvalues that it uses to manage its complexbalance sheet. Ide concluded: We are alwaystrying to posit ion ourselves based on the risknumbers we get from the model. Whether thattranslates into a hedge or position adjustment,BancWare modeling impacts the decision. In anage where markets are volatile, consumers aresavvy, and the demand for up- to- date riskanalytics is never ending, BancWaresConvergence software has played an invaluablerole.

We saw significant time savings.To run stochastic scenarios, with20 starting points and 200 paths,

it takes just a few hours for eachof the banks. SunGard Trading and Risk Systems

Contact: Kim Ferranti, Marketing DirectorPhone: 617-542- 2800 x 337Fax: [email protected]:/ / www.risk.sungard.com

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http://www.risk.sungard.com/http://www.risk.sungard.com/

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Bancware Abn Amro Case Stud