Driven by Basel II capital requirements and a demand for sophisticated capital markets products, portfolio managers now sit at the centre of their respective financial organisations. Alexandre Santos explains.

During the past decade, portfolio management units have been at the forefront of the scene in providing solutions to revive the stagnating debate about value creation and the risk/return trade-off. From a few desks in the basement where modellers struggled to price risk into capital decisions, portfolio management units (PMUs) have quickly progressed to the top floors of organisations, becoming the main reference point for ensuring capital optimisation by increasing velocity and reducing risk concentration.

This transition has been fuelled by changes in the regulatory framework (Basel II) and the sheer volume of sophisticated products that are being developed by capital markets desks. As a result, portfolio managers sit at the core of financial organisations and are no longer perceived as experimental or advisory functionaries.

Emerging markets portfolio

Many global financial institutions have been aggressively breaking into emerging markets in recent years, which has meant a dedicated capital management focus is needed to promote liquidity where markets are still underdeveloped.

Opportunities for asset disposals are still restricted as volumes of secondary loan sales are small and credit default swap markets in emerging countries only account for a small portion of the global market. Even though collateralised loan obligations, collateralised debt obligations and small portfolio/basket sales at the back-end offer some capital churning possibilities, asset quality is a primary focus for portfolio managers.

Given the differences and structural characteristics of these markets (cyclicality, lack of liquidity, high premiums to offload assets) companies have established teams in these markets that actively participate in the origination process through capital allocation committees. These committees judge the merits of transactions based on relative value considerations, cross-selling potential and portfolio concentration, always aiming to deploy capital in value-enhancing assets.

Commercial banks are facing unusual earnings volatility as a result of the introduction of IAS 39. The ‘new’ accounting regime, when applied to an ever-growing volume of hedges, has led to an accounting imbalance because loans on the banking books continue, by and large, to be subject to accrual accounting.

De-levering, improved corporate earnings, a low interest rate environment, significant liquidity levels and strong global growth have provided the impetus for the tightening credit trend witnessed over the past three years, leading to significant losses in short (hedge) books.

While it can be argued that any improvement in the credit environment is positive for the underlying loan book, the increased volatility of earnings is not a welcome side-effect of prudential portfolio/risk management. Further work is needed to explain to outsiders that this volatility reflects pro-active prudential management of risk, which in the long term is repaid in the form of lower credit losses and provisions.

Higher costs

The market has been responding to increased demands needs from portfolio managers by offering ever more sophisticated risk management products, including credit options, index products and other credit exotics. This puts increasing pressure on the operational/ risk/modelling infrastructure adding to the cost base.

Some of the more advanced banks are addressing P&L volatility by creating long credit books of highly liquid positions that overlay the hedge book and therefore act as a counterbalance. Within these books, basis plays, capital structure arbitrage, loan and curve plays are all traded to reduce exposure to volatility and improve hedge portfolio management, with the optimisation of capital consumption remaining the ultimate goal.

Focus on distribution

Basel II will again change the rules of the game, and, as a consequence, capital requirements will become more closely linked to credit risk.

Well diversified portfolios of sub-investment grade names are the optimal assets to securitise. Banks will be encouraged to retain super senior risk on their balance sheet as this will absorb a lower capital charge (only 7% under Basel II versus 100% under Basel I). Subordinated tranches will attract a higher charge that will result in them being moved out of the balance sheet. As such, capacity to distribute exposure in the lower part of the credit curve will become an essential instrument for achieving capital management goals.

As the implementation phase unfolds, changes in risk weightings for some products will also affect the types and structure of capital management tools required. For instance, residential mortgages will become more attractive for banks to fund on-balance sheet, as they will benefit from a lower risk charge, while leverage loans will head in the opposite direction as a result of the higher weightings.

In view of the above, capital optimisation opportunities can be expected to develop within the global financial industry as non-Basel II institutions (hedge funds, insurance companies and to some extent smaller banks reporting under ‘old’ Basel I/standardised approach) will be able to absorb the assets with the highest risk weighting.

The focus will again be on repositioning the distribution network to reach the above players, becoming a key investment for banks to ensure the successful execution of capital management decisions.

Alexandre Santos is global head of CMG portfolio strategy and execution, ABN AMRO.

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