Risk and Capital Management information according to Pillar 3

Transcription

1 20 08 Risk and Capital Management information according to Pillar 3

2 Contents Page Introduction 2 Risk management 3 Risk organisation 4 Reporting and follow-up of risk and capital situation 4 Credit risk 5 Measurement of credit risks 5 Internal rating system 5 Exposure classes 6 Risk classification methods 6 Comparisons with external ratings 7 Quality assurance of the credit risk model 8 Collateral 9 Collateral which reduces the capital requirement 9 IRB-approved exposures 9 Exposures calculated according to the standardised approach 9 Credit risk concentrations 12 Securitisation 13 Credit portfolio 13 Impairments and past due loans 14 Capital requirement for credit risks 18 Counterparty risk 21 Payment risk 21 Market risk 22 Risk measurement 22 Risk at Handelsbanken Capital Markets measured as VaR 22 Interest rate risk 24 Equity price risk 25 Equity price risk in the trading book 25 Equity exposures in other operations 25 Exchange rate risk 25 Commodity price risk 25 Liquidity risk 26 Operational risk 29 Risks in the insurance operations 30 Capital base and capital requirement 31 Capital base 31 Capital requirement 31 Comprehensive risk management using the economic capital model 32 Svenska Handelsbanken AB (publ) Corporate identity number: Registered office: Stockholm This report is also available in Swedish. Capital planning 33 Short-term forecasting 33 Mid to long-term forecasting 33 handelsbanken risk and capital management 1

3 Introduction The purpose of the information in this document is to provide information about risks, risk management and capital adequacy as described in Pillar 3 of the new capital adequacy regulations (Basel II). The requirements are specified in the Swedish Financial Supervisory Authority s directives (FFFS 2007:5). Svenska Handelsbanken AB (publ) 1 is the parent company in the Handelsbanken Group. In the context of capital adequacy, it is the banking group that is affected by capital requirements and not the whole Group. Thus in this document, information is principally provided for the banking group. Handelsbanken is also covered by the rules applying to financial conglomerates. The conglomerate rules mean that the capital requirement for the banking group and the capital requirement for the insurance operations are combined. The conglomerate is not covered by the Pillar 3 rules. In the banking group, the Group s subsidiaries are fully consolidated, while the associated companies are either fully consolidated or consolidated in accordance with the equity method. The Group s annual report provides information about which subsidiaries exist. Companies that are not part of the banking group and thus not covered by the capital requirement according to the capital adequacy regulations are shown in the table. 1 Corporate identity no Companies not included in the banking group Corporate identity no. Domicile Handelsbanken Liv Försäkring AB (Group) Stockholm Handelsbanken Försäkring AB Stockholm Svenska Re S.A. RCS Lux B Luxembourg Handelsbanken Skadeförsäkrings AB Stockholm Handelsbanken Renting AB Stockholm handelsbanken risk and capital management 2

4 Risk management Handelsbanken s ability to manage risks and capital efficiently is crucial to the Bank s profitability. The Bank s traditionally low risk tolerance has proved over time even in a year such as this to bring low loan losses and stable earnings. Loan losses as a percentage of lending % Handelsbanken Other Nordic banks* *For the period up to 2000, only Swedish banks are included. Handelsbanken s strict approach to risk means that the Bank deliberately avoids high-risk transactions, even if the remuneration is high at that moment in time. The low risk tolerance is maintained through a strong risk culture that is sustained over time and applies to all areas of the Group. Lending has a strong local involvement, where the close customer relationship promotes low credit risks. Market risks in the banking operations are taken essentially as part of meeting customers investment and risk management needs. The Bank s liquidity situation is planned so that business operations are not restricted when the financial markets are disrupted. The strict approach to risk also enables the Bank to be a stable and long-term business partner for its customers. The fact that the Bank keeps credit risks on its own books instead of securitising them and selling them on, underlines the Bank s view of customer relationships. This contributes both to good risk management and sustaining a high service level even when operations are subject to strain. The same principles apply in all countries where the Bank operates and they are guiding principles in the Bank s ongoing international expansion. During the year several activities were undertaken to further reduce the risk level. The investment focus of the Bank s liquidity portfolio has been changed to mainly consist of government securities, covered bonds and bonds issued by banks with high creditworthiness (AA rating). The liquidity portfolio also contains holdings of structured credit products where the value is SEK 12.5bn (32.7). Otherwise, the Bank s exposure to structured credit products is very limited: the total exposure is less than SEK 1bn. Further, exposure to other banks whose credit rating has been questioned has actively been reduced during the year and interbank deals are generally secured to a much greater extent than previously. The year was characterised by the strained liquidity situation in financial markets, which has affected most banks. Handelsbanken has had good access to liquidity and has been a continual net lender in the Swedish overnight market. Funding, both short-term and long-term, has mainly functioned normally, and at prices that were lower than those of competitors. At the end of the year and in early 2009, the Bank also issued Tier 1 capital loans. Financial institutions weighed down by problems have successively reduced their lending during the year due to strains on capital and a lack of liquidity. This has led to increased focus on the capacity of the bank sector to meet companies demand for credits. In this respect too, the Bank s situation was satisfactory and lending to customers could be continued. The Tier 1 capital loans further strengthen the Bank s capacity to meet the heavy demand for credit. Handelsbanken is a universal bank, offering a complete range of different bank products. This entails a variety of risks that are systematically identified, measured and managed in all parts of the Group. Risks at Handelsbanken Credit risk Market risk Liquidity risk Operational risk Insurance risk Property risk Business risk Description Credit risk is the risk of the Bank facing economic loss because the Bank s counterparties cannot fulfil their contractual obligations. Market risks arise from price and volatility changes in the financial markets. Market risks are divided into interest rate risks, equity price risks, exchange rate risks and commodity price risks. Liquidity risk is the risk that the Bank will not be able to meet its payment obligations when they fall due without being affected by unacceptable costs or losses. Operational risk refers to the risk of loss due to inadequate or failed internal processes, human error, erroneous systems or external events. The definition includes legal risk. The risk in the outcome of an insurance that depends on the insured party s longevity or health. The risk of changes in prices of the Bank s property holdings. The risk of unexpected changes in earnings that are not attributable to the risk categories described above. handelsbanken risk and capital management 3

5 The Bank s overall view of its risk and capital management can be described in terms of four levels of risk control and risk management: 1. Business operations The Bank is characterised by a clear division of responsibility where each business unit bears full responsibility for its business and risk management. Those who know the customer and market conditions best are best equipped to assess the risk and can also act at an early stage if any problems arise. Each branch and each profit centre bears the responsibility for dealing with problems that arise. A consequence of this is that there are strong incentives for high risk awareness and for prudence in business operations. 2. Operations-related risk control The accountability of the person taking a business decision is supplemented by local risk management in the various business areas and in the regional banks. This ensures that excessive risk-taking is avoided in individual transactions or local operations. The operations-related risk control assesses risk, checks limits, etc, and verifies that individual business transactions are documented and conducted in a manner that does not involve unknown risks. 3. Central risk control The Central Credit Department prepares decisions made by the board or by the board s credit committee. The Central Credit Department also ensures that credit assessments are consistent and that loans are granted in accordance with the credit policy decided by the board. Further, the Central Credit Department is responsible for identifying risks in all major individual commitments and offers support and advice to other areas of the credit organisation. The task of the Central Risk Control function is to identify, measure, analyse and report on all the Group s material risks. Central Risk Control also monitors the risks and risk management activities to ensure that they comply with the Bank s low risk tolerance. It is also responsible for ensuring that there is an appropriate level of local risk control in the business areas and subsidiaries, that risks are measured effectively and consistently and that the Bank s senior management receives regular reports and analyses of the current risk situation. 4. Capital planning If despite the work at the three levels described above the Bank should suffer serious losses, it holds capital to ensure its survival even in the wake of extreme events. An assessment of the capital situation in terms of the legal capital requirement, a calculation of economic capital and stress tests form the basis of capital planning. Stress tests identify the measures that need to be prepared or implemented to ensure satisfactory capitalisation at any given time. Apart from the formal risk organisation, Central Treasury is responsible for ensuring that the Group at any given time has satisfactory liquidity and is prepared to be able to quickly strengthen liquidity as needed. A liquidity report is issued daily to the CFO and regularly to the Bank s CEO and board. In addition to this risk management, internal and external auditors assess the operations. Handelsbanken s risk management activities have stood the test of time and their effectiveness is illustrated by the fact that the Bank for a long time has had lower loan losses than its competitors. This can mainly be ascribed to the work on risk in the business operations and the operations-related risk control. The heightened risk sensitivity in calculation of the capital adequacy requirement which follows from the Basel II rules makes greater demands on the Group s risk management and capital planning. These functions have therefore had a more prominent role in the Group in recent years. The Bank has obtained approval for the foundation approach in the internal rating system for calculating capital adequacy for credit risk and is now preparing to be approved for the advanced approach. Four risk management levels Four risk management levels Business operations Operations-related risk control Central risk control Capital planning Internal/external audit handelsbanken risk and capital management 4

6 Risk organisation Handelsbanken s board is responsible for assessing and monitoring the risks arising in the Group s operations. The board ratifies policy documents and instructions describing how various risks should be managed and reported. The board also ratifies the decision structure for credit limits. At Handelsbanken, the credit process is based on a conviction that a decentralised organisation with local presence ensures high quality in credit decisions. Customer and credit responsibility lies with the branch manager or the employee delegated by the manager at the local branch. Most staff at branches have personal decision limits for credits or credit limits for the customers for whom they have credit responsibility. If there is a need for larger credits, there are regional and central decision levels. The largest credit limits are set by the board s credit committee. However, no credit application may be processed in the Bank without the recommendation of the branch responsible for the customer. Decentralisation also means that the documentation that forms the basis for credit decisions is always prepared by the branch responsible for the credit, regardless of whether the decision is to be made at the branch, or at regional or central level. Credit decision documentation includes general and financial information regarding the borrower, and an assessment of the repayment capacity, valuation of collateral, loans and credit terms. For borrowers whose total loans exceed SEK 1m (or SEK 6m for mortgage loans), the credit decision is made in the form of a credit limit. Granted credit limits are valid for a maximum of one year. They are extended after the branch has prepared decision documentation in the same way as for a new loan, and the decision-making process is also the same. Central Risk Control which reports to the CFO has the day-to-day responsibility for overall risk assessment. This responsibility entails ensuring that decision documentation regarding risk measurements and limits is prepared, and that there are appropriate information and report systems for this. Central Risk Control is also responsible for identifying and controlling the Group s risks and for the models used to measure these risks, and also for proposing risk reduction measures. The board determines the overall market risk and liquidity risk limits for the entire Group within each type of risk. The limits are then allocated to the various business areas by the group chief executive. In each business area which has been allocated a limit, a local risk control unit reports the risk exposure to Central Risk Control and to the business area. The group chief executive is responsible for the Bank pursuing capital planning to ensure that the Group s supply of capital is secure. The head of the Capital Management department is responsible for measuring available capital and for applying the Group s capital planning policy. This includes responsibility for maintaining the correct level of available capital and the correct composition of Tier 1 and Tier 2 capital in the capital base. Central Treasury has responsibility for group liquidity and funding, and for carrying out such risk management measures as are decided upon by the CFO. Central Risk Control, Capital Management and Central Treasury are all departments within the Central Control and Accounting department, the head of which is the CFO. Reporting and follow-up of risk and THE capital situation The credit risk situation is reported quarterly to the board in terms of volume growth, non-performing loans, information from the Bank s credit risk models, etc. In addition to the reporting of loans with provision requirements, which is carried out within the framework of external accounting, defaulting credits are reported regularly, to satisfy the requirements of the internal credit risk model and the calculation of the capital requirement. Each branch also compiles a quarterly risk report, where it reviews its credit commitments to identify and report credit granted, where the borrower s repayment capacity is impaired and the Bank s collateral is insufficient, or there is a risk that it will be insufficient. The risk is classified as a low or high potential risk or as a probable or actual loss. Normally problems are identified at an early stage and risk-limiting measures are taken before a commitment becomes non-performing. The risk reports are presented quarterly to the boards of the regional banks and subsidiaries and to the board. The financial risks and limit utilisation for the trading operation, the internal bank, the mortgage business and other operations which carry less market risk, are checked on a daily basis and summarised when necessary at least weekly. Every month, there is a more detailed follow-up of the market risk and liquidity risk situation presented to the Bank s risk committee chaired by the Bank s CFO. Any overdrawn limits are reported to this committee, as well as the current risk situation in the various risk categories and for the Group as a whole. The risk committee s analyses and observations are regularly reported to the group chief executive and the board of the Bank. The capital situation is reported weekly to the CFO and head of Capital Management, based on a short-term capital forecast. In cases where certain thresholds are exceeded, or where, for any other reason, the head of Capital Management deems it appropriate, the matter is reported on to the group chief executive. A summary of the capital situation for the medium and long term is compiled quarterly by the Capital committee. The forecast is fully updated quarterly, and when there are significant changes in market conditions. The liquidity risk is reported daily to the management of the Bank. Every month, before each meeting of the board and whenever otherwise necessary, there is a meeting of the Liquidity committee which acts as an advisory unit to the head of Central Treasury. At this committee meeting, reports are presented on the current liquidity situation, on results of stress tests and a scenario analysis and other information which is relevant for the assessment of the Group s liquidity situation. handelsbanken risk and capital management 5

7 Credit risk Credit risk is defined as the risk of the Bank facing economic loss as the result of the Bank s counterparties not being able to fulfil their contractual obligations. In the Bank s decentralised organisation, the branch responsible for the customer has total credit responsibility. The branches are responsible for credit decisions, but credit limits are decided at different levels depending on the credit amount. Rather than being a mass market bank, Handelsbanken is selective in its choice of customers and borrowers must be of high quality. The quality requirement is never neglected in favour of higher loan volumes or to achieve higher returns. Some 97% of the overall limit volume for credit exposures was to customers with a repayment capacity assessed as normal or better than normal, i.e. with a rating grade between one and five on the Bank s ten-point rating scale. The Bank aims to be a relationship bank and the branches maintain ongoing contact with the customer, which gives them an in-depth understanding of each individual customer and a continually updated picture of the private customer or company. This contact also enables the branch to quickly identify any problems and take action. In many cases, this means that the Bank can take action more rapidly before problems have escalated than would have been possible with a more centralised management of problem loans. The branch also bears full economic responsibility for granting the credit. The branch therefore addresses the problems that arise when a customer has repayment difficulties and it bears any loan losses. If necessary, the branch obtains support from the regional head office and central departments. The Bank s method of work means that all employees whose work involves transactions linked to credit risk acquire a solid and well-founded approach to such risks. This approach forms an important part of the Bank s culture. Measurement of credit risks In 2005, the Bank applied to the Swedish Financial Supervisory Authority for permission to use an internal ratings-based (IRB) approach to credit risk to calculate the capital adequacy requirement and permission was granted in The permit applied to the financial company group led by Handelsbanken AB (publ) and the two companies Handelsbanken AB (publ) and Stadshypotek AB (publ). The Bank has subsequently applied for and received the equivalent permission for Handelsbanken Finans AB 2 and Handelsbanken Rahoitus Oy 3. The Financial Supervisory Authority has also approved the Bank s gradual implementation of the approach according to a fixed plan. This means that in 2008, the Bank s subsidiaries Handelsbanken S.A in Luxembourg and ZAO Sv. Handelsbanken in Russia were included in calculations according to the IRB approach. The Financial Supervisory Authority has also granted time-limited and permanent exceptions from the IRB approach for certain exposures, for which the standardised approach will be used instead. The allowed permanent exception refers to exposures to sovereign exposures, Sveriges Riksbank (Swedish central bank) and Swedish municipalities. Time-limited exceptions comprise portfolios of insignificant size defined according to the regulations of the Swedish Financial Supervisory Authority as well as the equity exposures that the Bank held at the turn of The portfolios in Lokalbanken i Nordsjælland a/s 4 and in Handelsbanken Fonder AB 5 are also portfolios of insignificant size. At the end of 2008 the Bank calculated the capital requirement using the IRB approach for about 91% of total risk-weighted assets, calculated according to Basel I rules. The portfolios included are mainly Swedish regional banks, Regional Bank Norway, Regional Bank Finland, Handelsbanken Finans in Sweden and Finland, most of Regional Bank Denmark, the regional banks in Great Britain, the Bank s exposures to other banks (institutional exposures) and parts of the Handelsbanken International and Handelsbanken Capital Markets business areas. Internal rating system Handelsbanken s internal rating system is used to measure the credit risk in all operations reliably and consistently. The credit risk rating builds on the Bank s internal rating system, based on 2 Corporate identity no Corporate identity no CVR no Corporate identity no Decision levels for granting credits Proportion of number of limits Board Board's credit committee Proportion of limit amount 8% 77% Proportion of number Proportion of limit amount Central Credit Department * 35% Regional banks Credit committee Credit committee Credit subcommittee 19% 57% Branches Credit committee international branches Regional banks Handelsbanken International Handelsbanken Finans Stadshypotek 4% * Most of the credits provided by Stadshypotek are granted at branch level in the regional banking operations. handelsbanken risk and capital management 6

8 the branch s assessment of each counterparty s repayment capacity. The rating is determined by the risk of financial strain and resistance to such strain. The methods and classification are based on the rating model that the Bank has applied for many years. The internal rating is the most important component of the Bank s model for calculating capital adequacy under the Basel II rules (IRB approach). The rating is dynamic; it is reassessed if there are signs that the counterparty s repayment capacity has changed. The rating is primarily assigned by the person responsible for granting credit. Exposure classes The Bank uses different models for calculating credit risk depending on the type of exposure. The overall division into exposure classes, which is mainly steered by the capital adequacy regulations, comprises sovereign, institutional, corporate, retail and equity exposures as well as positions in securitisations. Some of these exposure classes contain sub-groups in which special models are applied. In practice the division into exposure classes and sub-groups is made when the employee at a branch or unit responsible for the customer decides which credit rating template is to be used when assigning the counterparty a rating. Sovereign exposures refer to exposures to governments, central banks and government agencies. Exposures to institutions refer to exposures to counterparties defined as banks and other credit institutions and certain securities companies. Retail exposures include both exposures to private individuals and to sole traders, where the total exposure within the Group does not exceed SEK 5m. Also included are companies that are legal entities with a maximum turnover of SEK 50m, where the total exposure within the Group does not exceed SEK 5m (excluding mortgage loans). Retail exposures are subdivided into two groups; real estate credit and other retail exposures. Corporate exposures refer to exposures to non-financial companies, consisting of legal persons with a total exposure within the Group in excess of SEK 5m or where the company s turnover is more than SEK 50m, and sole traders with a total exposure for the Group in excess of SEK 5m. Apart from ordinary non-financial companies, the exposure class includes insurance companies, co-operative apartment associations and exposure in the form of specialised lending. Equity exposures are the Bank s holdings of shares that are not in the trading book. The capital required for equity exposures in 2008 was calculated using the standardised approach. Risk classification methods To quantify its credit risks, the Bank calculates the probability of default (PD), the Bank s exposure at default (EAD), and the proportion of the loan that the Bank would lose in the case of default (loss given default LGD). Default is defined as a counterparty being more than 90 days late with a payment, or an assessment having been made prior to this that the counterparty will be unable to pay according to the contract. The PD value is expressed as a percentage where a value of 0.5% statistically means that one borrower of 200 is expected to default within one year. A credit in default does not necessarily mean that the Bank will incur a loss since in most cases there is collateral for the exposure. Nor does a default mean that it is out of the question that the counterparty will pay at some time in the future. For corporate and institutional exposures, the internal rating assigned by the credit organisation for each counterparty is translated directly into a risk grade on a scale between one and ten. A certain average probability of default (PD) is calculated for each risk grade. Standardised values prescribed by the regulatory code are applied to loss given default (LGD) for corporate exposures. The standardised value that may be used is regulated by the collateral provided for a certain exposure. For retail exposures, the risk classification is also based on the internal rating assigned to all credit customers. The rating is not directly translated into a risk grade as it is for corporate exposures; instead the various exposures are sorted into a number of smaller groups, depending on certain factors such as type of credit, non-payment records, number of borrowers etc. An average probability of default has been calculated for each of the smaller groups, which are then assigned to one of the ten risk grades according to the result of that calculation. Different models are used for exposures to private individuals and small businesses, but the principle is the same. Loss given default (LGD) for retail exposures is not prescribed by the regulatory code; the Bank uses its own calculations based on its loss history. Different values are used for the two subdivisions of retail exposures; real estate exposures and other exposures. Different values are applied to real estate exposures in Sweden depending on the loan-to-value ratio of the exposure. For other exposures, the LGD value is determined by factors that may depend on the collateral, the product, etc. For all exposure classes a certain average probability of default (PD) has been calculated for each of the risk grades. Probability of default is based on calculations of the historical percentage of default for different types of exposure. The average probability of default is then adjusted by a safety margin and a business cycle adjustment factor. The safety margin is intended to ensure that the probability of default is not underestimated. The business cycle adjustment factor takes into account the fact that the estimated probability of default per rating class can be expected to vary due to the business cycle. The probability of default used for risk weighting therefore needs to be adjusted in relation to where in the business cycle the Bank s borrowers were in the period on which the calculations are based. The business cycle adjustments are based on the Bank s internal history from 1985 to When the exposure at default (EAD) is to be calculated, certain adjustments are made to the carried exposure. This applies predominantly to various types of commitments where exposure may increase without any active decision on the part of the Bank. Examples of this are credit commitments or revolving credit, where the Bank agrees with the customer that the customer may borrow up to a certain amount in the future. This type of commitment constitutes a credit risk that must also be covered by adequate capital. Normally this means that instead of the actual exposure, the credit granted is used, adjusted using a conversion factor (CF). For corporate exposures the conversion factors are determined by the regulatory code, while for retail exposures the Bank uses its own calculated conversion factors. Here it is the product referred to that mainly governs the conversion factor, but other factors may also be of relevance. In addition to the capital adeqacy calculation, the risk measurements are used to price risk in each individual transaction and to calculate economic capital (EC) and capital requirements. New credits that are judged to involve higher than normal risk are refused, irrespective of the collateral available. The method used means that the Bank s historical and low losses have a direct impact on risk calculations and capital adequacy requirements, which contributes to the positive outcome for the Bank of the new capital adequacy regulations. handelsbanken risk and capital management 7

9 For corporate and institutional exposures, the below diagram shows how the exposure is distributed between bonds and other interest-bearing securities, and loans and other exposures respectively. The diagrams show how the exposures, excluding credits in default, are distributed between different PD intervals in each counterparty category. Exposures within a certain interval are shown in terms of the distribution between loans, interestbearing securities and other types of exposure. Other exposures are for example derivatives, guarantees and credit commitments. The PD values used are those applied for the statutory capital adequacy calculation. This means that there are significant margins in the form of business cycle and safety adjustments in the PD values. The loss levels implied by the PD values are thus overestimated. Proportion of exposure by category, corporate, excl. default credits Proportion of exposure by category, institutions, excl. default credits Proportion of exposure, % 25 Proportion of exposure, % < >1.00 PD 0 < >1.00 PD Loans Interest-bearing securities Other products Loans Interest-bearing securities Other products Comparisons with external ratings The Bank s risk categories are not directly comparable with the ratings applied by external credit rating agencies. The agencies ratings do not correspond to a direct classification of the probability of the counterparty defaulting, as the Bank s internal rating model does. In addition, the rating agencies vary in the extent to which they factor in the seriousness of the losses that default can lead to. Nor is the time horizon within which creditworthiness is assessed always the same for banks as it is for the rating agencies. Nor do the Bank s risk categories reflect a uniform scale, whereby a certain risk category always corresponds to a certain probability of default (PD). This is because different PD scales are applied to different parts of the credit portfolio, and also the PD values change over time, depending on business cycle adjustment factors and developments in the model. With some allowance for the above-mentioned differences, the Bank s risk classification can still be compared diagrammatically with the ratings that the agencies use. The figure below is an assessment of how the Bank s risk classification of companies relates to Moody s rating of companies. The assessment is based on the actual default frequency for Handelsbanken s and Moody s customers, and also on a comparison of the rating of counterparties with a credit rating from both Moody s and Handelsbanken. Handelsbanken s risk classification of companies in relation to the rating for companies from Moody s Aaa-A Baa Ba B Caa-C F Handelsbanken's risk classes handelsbanken risk and capital management 8

10 Predictions and outcome for PD and LGD risk parameters Excl. defaults Incl. defaults EL PD LGD Loan loss provisions* Prediction för 2008 Outcome (2007) Prediction för 2008 Outcome (2007) Exposure class Corporate 0.22% 0.39% 0.09% 0.94% 0.68% Retail, real estate 0.04% 0.08% 0.00% 0.51% 0.47% 13.37% 0.90% Retail, other 0.46% 0.94% 0.25% 2.85% 2.39% 30.67% 11.11% Institutions 0.03% 0.03% 0.00% 0.08% 0.00% Total all 0.17% 0.31% 0.07% 0.88% 0.69% 30.94% 3.03% * refers to the year's provisions for probable losses excluding writebacks Quality assurance of the credit risk model The Bank carries out a detailed annual review of its internal rating model. The review checks firstly that the internal ratings on which the Bank s risk classification is based are applied in a consistent, high-quality, appropriate manner (evaluation) and secondly that the statistical models used measure risk satis factorily (validation). The purpose of evaluating internal ratings is to ensure that they function well as the central factor in the risk classification of the Bank s counterparties. For example, this includes evaluating whether the ratings reflect the risk in the counterparty, that customers are assessed equally, regardless of where in the bank the rating takes place, that the rules for rating are followed, that ratings are updated, etc. The evaluation may highlight ratings in certain parts of the Bank or for certain types of counterparty, with measures being taken to remedy any deficiencies. Such measures may include more frequent, specifically targeted follow-up action, changes to rating instructions or adaptations to models. The statistical models and risk measurements on which these are based are validated at least annually. The aim of this validation is to check that the risk classification system has successfully measured the risk in the PD, LGD and the conversion factor (CF) risk dimensions. Above all, the validation aims to evaluate whether the outcomes observed over the preceding year confirm that the models applied by the Bank are working as intended. To achieve this, a number of statistical tests are used which have pre-defined threshold values, so that if there are deficiencies in the models, clear signals are given. The validation may necessitate changes to models, correction of risk measurements or revision of instructions. The results of the evaluations and validations are reported to the Bank s board and are examined by the Financial Supervisory Authority. The table above shows the values applied for 2008 (predictions) for the various dimensions of risk. The year s provisions for probable loan losses are also shown so that a comparison can be made between the losses the model implies and the actual losses the Bank has had for these exposures during For expected losses (EL), the total EL is shown for the exposures in approved IRB models, as at 31 December 2008, broken down by exposure class. EL for defaulted exposures is proportionally very high since their PD is 100%. The table shows EL both including and excluding defaulted exposures. For PD and LGD, the average PD and LGD values for the approved exposures are shown firstly the average value used and secondly the outcomes for the respective parameters in The average figures are weighted in terms of volumes of exposure. The PD values shown here are those applied in the capital adequacy report, that is both security margins and the business cycle adjustment factor affect the PD values. The expected loss amount presented here does not in fact represent the most likely loss level for the Bank. This is because a number of adjustments are made to the value calculated using the Bank s IRB model. The main aim of these adjustments is to ensure that the Bank s internal model does not underestimate the actual risk. The diagram below shows how these adjustments affect the calculated value for expected losses. Furthermore, the risk is overestimated since the LGD and CF for corporate exposures is determined by the regulations in the basic approach and these are considerably more conservative than the expected value. The diagram on the next page shows EL for all IRBapproved exposures, excluding defaulted exposures. handelsbanken risk and capital management 9

11 The first column shows the observed EL value, that is EL based on the outright estimate of PD and LGD, which is 0.10%. The next columns shows how EL is affected when the security margins, business cycle adjustments and regulatory floor levels are introduced. The purpose of the safety margin is to ensure that the value applied does not underestimate the true risk because the statistical data on which the models are based is not sufficiently comprehensive. The business cycle adjustment takes into account the fact that the estimated probability of default and the loss can be expected to vary due to the business cycle. The probability of default used for risk weighting therefore needs to be adjusted in relation to where in the business cycle the Bank s borrowers were in the period on which the calculations are based. LGD applied refers to decimal rounding-off and adjustments for any floor regulations. The final column shows EL calculated using the approved IRB approach. It amounts to 0.17% of the exposure. % Estimate +LGD sec. marg. +LGD bus. cycle adj. +LGD applied +PD sec. marg. +PD bus. cycle adj. = Applied The above diagram excludes the capital requirement for defaulted credits. EL excluding defaulted exposures shows a more likely level for the Bank s losses than EL including defaulted exposures. In addition, this figure is considerably closer to the Bank s net loan loss level for 2008, namely 0.11%. In addition to assessments and validation, the internal auditing department also carries out an important part of the quality control. It examines the risk rating system and its application on a regular basis. The way the Bank calculates, rates and quantifies risks, and validates methods was also an important part of the Swedish Financial Supervisory Authority s review in conjunction with approval of the Bank s application of the IRB approach. Collateral When Handelsbanken assesses the credit risk of a specific customer, the assessment must start with the borrower s repayment capacity. According to the Bank s credit policy, weak repayment capacity can never be compensated for by offering the Bank good collateral. Collateral may, however, substantially reduce the Bank s loss if the borrower cannot fulfil his obligations to the Bank. Credits must therefore normally be adequately secured. This applies, for example, to mortgage loans to private individuals and loans to property companies. It also applies to securities lending, factoring, leases and many other types of financing. Credit without collateral is mainly granted in the case of small loans to private individuals and loans to large companies with very sound repayment capacity. In the latter case, special loan conditions are drawn up that entitle the Bank to renegotiate or terminate the agreement if the borrower s repayment capacity deteriorates or if the conditions are otherwise violated. Since collateral is not generally utilised until a borrower faces serious repayment difficulties, the valuation of collateral focuses on its expected value in the case of insolvency. The value of certain assets may change considerably in an insolvency situation and in the event of a forced sale. A large part of lending to credit institutions consists of reverse repos. A reverse repo is a repurchase transaction in which the Bank buys interest-bearing securities or equities under the agreement that the security will be resold to the seller at a specific price on a specific date. Handelsbanken regards reverse repos as secured lending. In special circumstances the Bank may buy credit derivatives or financial guarantees to hedge the credit risk in loan receivables, but this is not part of the Bank s normal lending operations. Collateral which reduces the capital requirement The information in the following section concerns capital requirement-reducing collateral for exposures that are IRB-approved. It is followed by descriptions of the equivalents for the exposures handled using the standardised approach. Handelsbanken has established procedures to fulfil the requirements contained in the regulations in terms of valuation of eligible collateral. These specify who/which body may update the valuation, how this is to be carried out, and the fact that it must be up-to-date. The Bank may receive other types of collateral than those considered eligible under the capital adequacy regulations. Floating charges on assets (corporate mortgages) are an example of such collateral. In some cases collateral in the form of mortgage deeds for a property is supplemented by a contract guarantee. Only one of these is used in calculation of capital required. Loans to the public, collateral Residential property Agricultural property Other property Sovereigns, municipalities and county councils Floating charges on assets Guarantees Unsecured Other collateral Loans to the public Including ownership housing co-operatives. handelsbanken risk and capital management 10

12 IRB-approved exposures For capital requirement calculation of corporate exposures, property mortgages correspond to approximately 23% of the reported exposure amount. The equivalent figure for financial collateral mainly in the form of repos is about 2% and for guarantees and other collateral it is about 7% each. The remaining exposure amount is included in the capital adequacy calculation as unprotected exposure. For retail exposures, mortgages on the property mainly residential correspond to around 83% of the reported exposure amount. Of the remaining exposure amount, roughly two percentage points are categorised as having some form of collateral, while the remaining 15 percentage points are set an LGD value due to other terms. These terms are chiefly determined by factors such as type of borrower, type of credit or number of borrowers. For institutional exposures, financial collateral in the form of repos accounts for some 41% of the reported exposure amount. The corresponding figure for guarantees is 1%. The remaining exposure amount is included in the capital adequacy calculation as unprotected exposure. For corporate exposures and institutional exposures where there is eligible collateral, the capital requirement is reduced through an adjustment of either the PD or the LGD. The PD is adjusted in cases where there are approved protection providers, for example the issuer of a guarantee, with a lower PD value than the borrower. For most other types of collateral, the LGD is adjusted to the values specified by the regulations for each type. In cases where an approved collateral value for the capital adequacy calculation does not cover the total exposure, a unique capital requirement is calculated for each collateral. A corresponding calculation is also carried out for the unprotected part of the exposure. For retail exposures, risk reduction takes place by the exposures being categorised into various groups, depending on the collateral which covers them. For private individuals in Sweden with collateral in the form of a house or second home, the LGD per exposure is calculated using a model based on the loan-tovalue ratio. To establish the LGD for other retail exposures, private individuals and small businesses, categorisation is performed that is based on factors such as type of credit, number of borrowers and type of collateral. Collateral is divided up into real estate, other collateral and unprotected exposures. Exposures calculated according to the standardised approach For institutional, corporate and retail exposures calculated using the standardised approach, collateral totals about 7% of the reported exposure amount, of which some 1.5 percentage points refers to guarantees. The equivalent figure for the class of exposures with property mortgages is approximately 35%. For all exposures calculated using the standardised approach, the regulations state a risk class based on the exposure class of the counterparty. Risk weight multiplied by exposure amount gives the risk-weighted exposure amount. Sovereign and municipal exposures include counterparties that, as per IRB regulations, are approved protection providers in the form of guarantors. Of the total reported exposure amount for sovereign and municipal exposures about SEK 61bn comprises protection providers. handelsbanken risk and capital management 11

13 Credit risk concentrations Handelsbanken s branches focus strongly on establishing longterm relationships with good customers of sound creditworthiness. If a branch identifies a good customer, it should be able to do business with this customer, irrespective of whether the Bank as a whole has major exposure to the business sector that the customer represents. In granting credit the Bank thereby has no built-in restrictions to having relatively extensive exposures in individual sectors. The Bank monitors and calculates concentration risks continually for various business sectors, geographic areas and individual major exposures. Concentration risks are detected in the Bank s calculation of economic capital for credit risks and in the stress tests conducted in the overall capital assessment. This ensures that Handelsbanken has sufficient capital, taking into account concentration risks. If the concentration risks are judged to be excessive, the Bank has the opportunity and capacity to mitigate them using various risk reduction measures. Handelsbanken has considerable lending operations, besides mortgage loans, to the property sector (SEK 343bn). The property sector refers here to all companies assessed for credit purposes as property companies. It is common for groups of companies operating in other industries to have subsidiaries managing the properties in which the group conducts its business, and such property companies are also considered here to belong to the property sector. Consequently, the underlying credit risk in such cases is not only property-related. The predominant proportion of this lending is to governmentowned property companies, municipal housing companies, housing co-operatives and other housing-related operations where the borrowers have a consistently very high creditworthiness. Within the category of non-residential property operations, customers have sound net operating income and a robust cash flow. Thus a large part of lending to the property sector is to companies with a very low probability of default. The Bank s exposure to the property sector is specified in the tables above. Lending to the property sector is well-diversified both in Sweden and abroad. For example, there is one counterparty with an exposure of more than SEK 1bn in Great Britain and two in Norway. The credit quality for the property lending is also good. The proportion of exposures with a lower rating than the Bank s normal risk in risk grade 5 is very low. For example, in the British operations, this proportion is less than 2%. Specification of Loans to the public Property management Loans before deduction of provisions Provisions for probable loan lossses Loans after deduction of provisions Loans after deduction of provisions Loans in Sweden State-owned property companies Municipal-owned property companies Residential property companies Other property management Total loans in Sweden Loans outside Sweden Denmark Finland Norway Great Britain Other countries Total loans outside Sweden Total loans Property management handelsbanken risk and capital management 12

14 Securitisation To a limited extent, Handelsbanken has exposures that can be regarded as securitisations in the capital adequacy regulations. These are holdings in bonds and other debt instruments issued by special purpose vehicles within the framework of securitisations. These exposures are almost exclusively in the Bank s liquidity portfolio. The purpose of the holdings is to utilise them as collateral with various central banks so as to create liquidity facilities. The Bank has not, however, securitised its own loans, except for a synthetic securitisation comprising a Basel II guarantee. This securitisation is a form of credit guarantee aiming to accelerate transition to Basel II. The guarantee entails a reduction in the risk-weighted assets as per Basel I but not according to Basel II. Standard & Poor s was the credit rating company used for this securitisation. The premium for the guarantee is recognised as reduced interest income in net interest income. Handelsbanken has applied the IRB approach to securitisations since the fourth quarter of All securitised exposures were acquired prior to However, some holdings in the trading book have been reclassified as other operations during the year. This means that the capital requirement is calculated according to the capital adequacy rules for credit risk instead of market risk. In the first quarter of 2008, Handelsbanken carried out a major sale of securitised credit card receivables valued at SEK 11bn. The realised loss on this sale was SEK 767m. Apart from this sale, no positions in the trading book have been sold to any material extent. Handelsbanken s total exposure in securitisation positions after credit risk protection, amounts to SEK 9,697m. Of this sum, SEK 279m was deducted from the capital base. All positions are in the role of investor. The risk weight for positions in securitisations is determined on the basis of external credit rating using the external rating approach. Securitisation positions after credit risk protection by risk weighting 6-10% 12-18% 20-35% 50-75% All exposures Credit portfolio Credit risk exposure Loans to the public of which reverse repos Loans to credit institutions of which reverse repos Unutilised part of granted overdraft facilities Credit commitments Certificate programmes Other commitments Guarantees, loans Guarantees, other Letters of credit Derivatives Treasury bills and other eligible bills Bonds and other interest-bearing securities Total SEK 6,688m (4,210) of this amount is lending which upon initial recognition was classified at fair value through profit or loss. 2 Refers to the total of positive market values. Including legally viable netting agreements, the exposure is SEK 56,122m (17,339). handelsbanken risk and capital management 13