Enterprise Risk Management at ABN AMRO

Market Risk contd...

Interest Rate Risk

Group ALCO set limits to ensure that the potential adverse impact on trading and non-trading earnings, due to market movements, was well controlled. Group ALCO monitored the activities of ALCOs in the US, the Netherlands and Brazil. Some other countries had ALCOs with centrally approved limits.

In smaller countries, all interest rate risks (trading and non-trading) were managed within the market risk framework. Several methods 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 EUR and USD in Europe and the US.

Interest rate risk positions in other currencies and other countries were managed by gap analysis and/or market value limits, as these positions were typically less complex. Simulation models and estimation techniques were used to assess the sensitivity to movements in the shape and level of the yield curve.

Assumptions about client behavior played an important role in these calculations. 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. On the liability side, the re-pricing characteristics of savings and deposits were based on estimates since the rates were not coupled to a specified market rate. A statistical approach was used for forecasting and sensitivity analyses because it best suited these products. Although comparable with macro-economic forecasts in many ways, this approach was based on information in individual client contracts.

The sensitivity of net interest revenue to interest rate conditions was estimated, assuming an immediate and lasting shift of 100 bps in the term structure of interest rates. ABN Amro's sensitivity analysis indicated that such an upward movement would lower net interest revenue by 3.8% in the first year after the rate jump. A downward shift would raise net interest revenue by only 1.1%, (based on the bank's positions as of 31 December 2002). This asymmetric outcome was largely due to the historically low levels of interest rates in the US and Europe in recent times, leading to unprecedented pre-payment behavior in the US and leaving limited scope to adjust rates on the liability side in the US and Europe.

Currency Risk

Currency risk was the result of investments in the bank's overseas operations and through trading activities. In trading portfolios, exposures to exchange rate movements were managed through market risk limits based on VAR. Short and long positions were monitored to ensure compliance with the GRC's limits. Gains or losses in the trading book were reported in the P&L. ABN Amro pursued various hedge strategies with respect to investments in overseas operations to protect itself against the adverse effects of translating foreign currency into euro, the reporting currency:

� Ratio hedge
The Bank's BIS-ratios (tier-1 and tier-total capital as a percentage of RWA) were protected against fluctuations in the EUR / USD rate. As capital and RWA were subject to foreign currency translation, this was done by maintaining the BIS-ratios for USD elements close to the overall BIS-ratios.

� Capital hedge
Investments in overseas operations denominated in currencies other than USD were hedged selectively. Hedging was considered when the expected currency loss was larger than the interest rate differential between the two currencies (the interest rate differential represented the cost of the hedge). Gains and losses on these capital exposures were taken through equity, as were the costs of hedging.

As of 31 December 2002, an increase of 10% in the value of the euro against all other currencies would have led to a EUR 437 million reduction in reserves, and vice versa. On this basis, there would have been no material impact on the Bank's BIS ratios because the ratios were hedged against changes in the EUR / USD exchange rate.

� Profit hedge
Profits were hedged selectively to dampen the impact of currency movements on the P&L. The decision criteria for profit hedging were similar to capital hedging. As of 31 December 2002, all budgeted net USD profits for the years 2003 and 2004 were sold forward at a rate of USD 0.8994 per EUR and USD 0.9563 per EUR respectively.

Liquidity Risk

Liquidity risk was an integral part of ABN Amro's business. Liquidity risk would arise if, for example, the bank was unable to fund its portfolio of assets at appropriate maturities and rates or was unable to liquidate a position in a timely manner at a reasonable price.

ABN Amro managed liquidity on a daily basis throughout the 66 countries and territories in which it operated. Each national market was unique in the scope and depth of its financial markets, competitive environment, products and the characteristics of its customer profile. Local line management was therefore responsible for managing local liquidity requirements under the supervision of Group ALCO. Each location needed to comply with local liquidity regulations.

On a day-to-day basis, ABN Amro's liquidity management depended on the proper functioning of local and international financial markets. The bank had established group-wide contingency funding plans that anticipated changes in the bank's structural liquidity under different scenarios and set out damage-limitation procedures in case of crises. These plans could be activated in the event of a dramatic change in the normal business activities or in the stability of the local or international financial markets.

As part of its liquidity management contingency planning process, ABN Amro regularly assessed potential trends, demands, and commitments, events and uncertainties, which might have an impact on structural liquidity. More specifically, ABN Amro considered the impact of these potential changes on the bank's sources of short-term funding and its long-term liquidity planning horizons.

At a group level, stress testing of liquidity was conducted several times a year and the outcomes were reported to Group ALCO. To mitigate the liquidity risk, the bank had a liquidity buffer consisting of unencumbered liquid assets, such as marketable securities and other short-term investments. These included Dutch government bonds, US Treasury and US government agency paper and other OECD government paper, which could be readily converted into cash. The size of the liquidity buffer was linked to the outcomes of these stress tests.

At all times, on a group-wide basis, the bank maintained what it believed were adequate levels of liquidity to meet deposit withdrawals, to repay borrowings and to fund new loans, even under stress conditions.

The ability to sell assets (apart from marketable securities) quickly was an additional source of liquidity for the bank. The bank's loan syndication and securitization programmes were part of liquidity management activities. ABN Amro believed the diversity of the banks funding sources and funding providers increased funding flexibility and limited dependence on any source of funds. The bank was an active participant in the capital markets, issuing commercial paper and medium-term notes, as well as debentures, subordinated debt and preferred stock. Diversity of funding products, market and maturity played an important role in funding decisions.

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