Risk and capital management information according to Pillar 3

Transcription

1 2009 Risk and capital management information according to Pillar 3

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3 Contents Page Introduction 2 Risk management 3 Risk organisation 5 Reporting and follow-up of risk and capital situation 5 Credit risk 6 Measurement of credit risks 6 Collateral 13 Credit portfolio 15 Impairments and past due loans 20 Capital requirement for credit risks 24 Counterparty risk 30 Payment risk 31 Market risk 32 Risk measurement 32 Risk at Handelsbanken Capital Markets measured as VaR 33 Interest rate risk 34 Equity price risk 35 Exchange rate risk 35 Commodity price risk 35 Liquidity risk 36 Operational risk 38 Risks in the insurance operations 39 Capital base and capital requirement 40 Capital base 40 Capital requirement 40 Capital adequacy for the financial conglomerate 41 Model for economic capital 42 Capital planning 43 Svenska Handelsbanken AB (publ) Corporate identity number: Registered office: Stockholm This report is also available in Swedish. 1

4 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 capital adequacy regulations (Basel II). The disclosure requirements are specified in the Swedish Financial Supervisory Authority s directives (FFFS 2007:5). Complete information is published every year in the form of this document. For periodic information, see the relevant interim report. The disclosure requirements in Pillar 3 include a description of the Bank s capital requirement calculated according to the prescribed capital requirement for credit, market and operational risk (Pillar 1), as well as information on the Bank s internal processes which have been structured and documented in order to assess the Bank s total capital requirement (Pillar 2). The latter includes risk types in addition to those in Pillar 1. 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 subject to 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 below. In 2009, Handelsbanken continued to implement the method for internal risk ratings for more types of exposures in accordance with the plan approved by the Swedish Financial Supervisory Authority. At the end of 2009, the Bank calculated the capital requirement using the IRB approach for about 90 percent of total risk-weighted assets, calculated according to Basel II rules. Handelsbanken has also been working on an application to switch to the advanced approach for the Bank s IRB-approved exposures with the aim of implementing the advanced method in In 2009, Handelsbanken s goal was for the Tier 1 ratio according to Basel II in the long term to be in the 9 11 percent range and for available financial resources (AFR) to be at least 120 percent of economic capital (EC). Companies not included in the banking group Corporate identity no. Domicile Handelsbanken Liv Försäkrings AB (group) Stockholm Handelsbanken Försäkring AB Stockholm Svenska Re S.A. RCS Lux B Luxembourg Handelsbanken Skadeförsäkrings AB Stockholm Handelsbanken Renting AB Stockholm Flisekompaniet Holding AS Oslo Gryck Invest AB Gothenburg Festival AS Søgne Plastal Industri AB Gothenburg 1 Corporate identity no

5 Risk management There was a high degree of uncertainty concerning the economy during the year. Companies had to adapt to lower demand and unemployment rose. This is a trend that directly or indirectly affects the Bank s customers and consequently the Bank. On the other hand, the recession has not changed the Bank s way of doing business. All business decisions always take into account the risk of changed conditions externally. This has been manifested in the longer term through low loan losses and an even financial performance. Furthermore, Handelsbanken has not utilised government or central bank support. Loan losses as a percentage of lending ,2 1,0 0,8 0,6 0,4 0,2 0,0-0, Handelsbanken Other Nordic banks* * For the period until 2000 inclusive, 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 sustainable in the long term and applies to all areas of the Group. Lending has a strong local involvement, where the close customer relationship promotes low credit risks. In all essentials, market risks in the banking operations are only taken 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. This strict approach to risk also enables the Bank to be a stable and long-term business partner for its customers. Handelsbanken s view of customer relationships is also underlined by the fact that the Bank keeps credit risks on its own books rather than securitising them and selling them on. This contributes both to good risk management and sustaining a high service level even when operations and the markets on which the Bank operates are subject to strain. The same principles apply in all countries where the Bank operates and they are guiding principles in the Bank s future international expansion. Throughout the financial crisis, Handelsbanken has had good access to liquidity and the overall liquidity reserve was built up during the period. This is partly because the Bank has had access to the financial markets through its short-term and long-term funding programmes and partly due to its good access to liquidity from higher deposits from institutions and the public as a result of the strong confidence the Bank enjoys in the market. The Central Treasury department s liquidity portfolio, which is part of the Bank s liquidity reserve, has a very low risk profile and consists mainly of government bonds, covered bonds, and government-guaranteed bonds. The total liquidity reserve provides a high degree of resistance to possible disruptions in the financial markets. At the year-end, the Bank s liquidity reserve exceeded SEK 450 billion. This reserve covers the Bank s liquidity requirement for over two years without access to new market funding. The Bank s capital situation was strengthened during the year. The Bank s earnings have been stable. Coupled with low loan losses, this has contributed to the strong position given the prevalent external conditions. The low risk profile of the credit portfolio has resulted in a comparatively low capital requirement for credit risks. The Bank has also issued SEK 2.7 billion in hybrid loans. The strong capital situation provides good protection insurance in the case of deteriorating conditions externally. Handelsbanken is a universal bank, thus offering a wide range of various bank and insurance 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 changes in prices and volatilities 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. 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 in which 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 in the event of problems. Each branch 3

6 and each profit centre bears the responsibility for dealing with any 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 risktaking 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 are conducted in a manner that does not involve unknown risks. The operations-related risk control reports to Central Risk Control. 3. Central risk control As business decisions become more decentralised, the need for central monitoring of the risk and capital situation increases. Thus, the central credit and risk functions are a natural component of the Bank s business model. 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. The Central Credit Department is also responsible for identifying risks in all major individual commitments and offers support and advice to other areas of the credit organisation. The Central Risk Control function has the task of identifying, measuring, analysing and reporting on all the Group s material risks. The Central Risk Control function 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 continually receives reports and analyses of the current risk situation. 4. Capital planning If despite the work at the three levels described above Handelsbanken were to suffer serious losses, it holds capital to ensure its survival even in the wake of extreme events. Capital planning is based on an assessment of the capital situation in terms of the legal capital adequacy requirement, combined with calculation of economic capital and stress tests. 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 well prepared to quickly strengthen liquidity as needed. A liquidity report is issued daily to the CFO and regularly to the Bank s group chief executive and board. In addition to these four levels of 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 for a long time the Bank 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 the capital requirement for credit risk. In 2009, it applied to the Swedish Financial Supervisory Authority for approval of the advanced approach for calculating the capital requirement, with the aim of implementation during Four risk management levels Four risk management levels Business operations Operations-related risk control Central risk control Capital planning Internal/external audit 4

7 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. Central Risk Control which reports to the CFO has the day-to-day responsibility for overall risk assessment. Reports are also made to the Bank s group chief executive and the board. 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, for the models used to measure these risks, and also for proposing risk reduction measures. The board determines the overall market 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 which ensures 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 proportions of Tier 1 and Tier 2 capital in the capital base. Central Treasury has responsibility for group liquidity and funding, and for carrying out the risk management measures that are decided upon by the CFO. Central Risk Control, the Capital Management department and Central Treasury are all departments within the Group Finance department, the head of which is the CFO. REPORTING AND FOLLOW-UP OF RISK AND 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 information requirement 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 impaired, or there is a risk that it will be impaired. 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 risklimiting measures are taken before a commitment becomes nonperforming. The risk reports are presented each quarter to the boards of the regional banks and subsidiaries and to the board of the Bank. 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. The liquidity risks are reported daily to the management of the Bank. 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 summarised quarterly by the Capital committee. The forecast is fully updated quarterly, and when there are significant changes in market conditions. A report is made quarterly to the board of the Bank and otherwise when necessary. 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 the 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. 5

8 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. At Handelsbanken, the credit process is based on a conviction that a decentralised organisation with local presence ensures high quality in credit decisions. The Bank aims to be a relationship bank and the branches are in continual contact with their customers, thus giving them an in-depth understanding of each individual customer and a continually updated picture of the individual, company or institution. In the Bank s decentralised organisation, the branch responsible for the customer has total credit responsibility. Customer and credit responsibility lies with the branch manager or the employee at the local branch delegated by the manager. 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 decided by the board s credit committee, where cases are prepared by the Central Credit Department. 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 final 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 1 million (or SEK 6 million 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. 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 95 percent (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 local branch s close contact with its customers 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 has full financial responsibility for granting credits and therefore addresses the problems that arise when a customer has repayment difficulties and also 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. Permission was granted in The permission applied to the financial company group led by Svenska Handelsbanken AB (publ) and the two companies Svenska 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. Certain exposures in the subsidiaries Handelsbanken S.A in Luxembourg and ZAO Svenska Handelsbanken in Russia were reported according to the IRB approach. The Swedish 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 as defined in the Financial Supervisory Authority s regulations as well as the equity exposures held by the Bank at the turn of the year 2007/2008. The portfolios in Lokalbanken i Nordsjælland a/s 4, which is now part of Regional Bank Denmark, and the portfolio in Handelsbanken Fonder AB 5, are portfolios of insignificant size. At the end of 2009, the Bank calculated the capital requirement using the IRB approach for about 90 percent of total risk-weighted assets, calculated according to Basel II rules. The portfolios included are mainly the Swedish regional banks, Regional Bank Norway, Regional Bank Finland, Regional Bank Denmark, Handelsbanken Finans in Sweden and Finland, most of the regional banks in Great Britain, the Bank s exposures to other banks (institutional exposures) and large parts of the Handelsbanken International and Handelsbanken Capital Markets business areas. 2 Corporate identity no Corporate identity no CVR no Corporate identity no

9 Decision levels for credits Proportion of number of limits Board Board s credit committee Proportion of limit amount 7% 73% Proportion of number Proportion of limit amount Central Credit Department * 2% Board Board Board 4% 34% Credit committee Credit committee Credit committee Credit sub-committee 18% 57% Branches Credit committee foreign branches 5% Regional banks Handelsbanken International Handelsbanken Finans Stadshypotek * Most of the credits provided by Stadshypotek are granted at branch level in the regional banking operations. Internal rating system Handelsbanken s risk rating system comprises a number of different systems, methods, processes, procedures and mechanisms to support Handelsbanken s classification and quantification of credit risk. 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, which is based on 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 also reviewed periodically as stipulated in the regulations. The rating is primarily assigned by the person responsible for granting the credit. Exposure classes One of the basic premises of the capital adequacy regulations is that the institution s exposures are categorised into the exposure classes stipulated by the regulations. The number of exposure classes depends on the method used to calculate the credit risk. Exposures to be calculated according to the standardised approach can be allocated to fifteen different exposure classes while in the IRB model there are seven exposure classes. The Bank uses different models for calculating credit risk depending on the type of exposure. The overall division into exposure classes in the IRB model comprises sovereign, institutional, corporate, retail and equity exposures as well as positions in securitisations. In addition there are also exposures without counterparties assets where no performance is required from a counterparty. Some 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 5 million. Also included are companies that are legal entities with a maximum turnover of SEK 50 million, where the total exposure within the Group does not exceed SEK 5 million (excluding mortgage loans). Retail exposures are subdivided into two groups: property credit and other retail exposures. Corporate exposures refer to exposures to non-financial companies, consisting of legal entities with a total exposure within the Group in excess of SEK 5 million or where the company s turnover is more than SEK 50 million, and sole traders with a total exposure for the Group in excess of SEK 5 million. Apart 7

10 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 refer to the Bank s holdings of shares that are not in the trading book. For equity exposures held by the Bank at the year-end 2007/2008, the capital requirement was calculated according to the standardised approach during New equity exposures after this date have been calculated according to the IRB model. For division into exposure classes according to the standardised method, the Bank s volumes are put into the following exposure classes: sovereign and central banks, municipalities, institutions, retail, exposures with collateral in property, nonperforming items and other items. Non-performing items are exposures where overdue interest or principal amounts have remained unpaid for more than 90 days, calculated from the original contracted payment date. Other items includes prepaid costs, holdings in equities, cash in hand and unminted gold. 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 PD value of 0.5 percent 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 set by the credit organisation for each counterparty is directly converted 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 determined by the collateral provided for a certain exposure. For retail exposures, the risk grade is also based on the internal rating assigned to all credit customers. The rating is not directly converted 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 the 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. For retail exposures, the loss given default (LGD) is determined by the Bank s own loss history and not by the regulatory code. Different values are used for the two sub-divisions of retail exposures: property exposures and other exposures. Different values are applied to property 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 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 Handelsbanken s method for business cycle adjustment is intended to even out business cycle fluctuations in probability of default (PD) per risk class. In 2009, the business cycle adjustment led to the Bank adjusting upwards the PD values where the measurements were based on internal history, in spite of the fact that the economy was in recession and counterparties could have been expected to have migrated poorer risk classes. 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 that part of the credit which is unutilised by the customer. 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. 8

11 PD range and proportion of exposure per exposure type, corporate, excluding credits in default PD range and proportion of exposure per exposure type, retail, excluding credits in default Proportion of exposure, % Proportion of exposure, % < >1.00 PD, % 0 < >1.00 PD, % Loans Interest-bearing securities Other products Loans Other products PD range and proportion of exposure per exposure type, institutions, excluding credits in default Proportion of exposure, % < >1.00 PD, % Loans Interest-bearing securities Other products In addition to the capital adequacy calculation, the risk measurements (PD, EAD, LGD) are used to price risk in each individual transaction and to calculate economic capital (EC). 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 losses have a direct impact on risk calculations and capital requirements, which contributes to the positive outcome for the Bank of the new capital adequacy regulations. For corporate, institutional and retail exposures, the figures show how the exposure is distributed between bonds and other fixed-income securities, and loans and other products respectively. The diagrams show how the exposures, excluding credits in default, are distributed between different PD ranges in each counterparty category. Exposures within a certain range are shown in terms of the distribution between loans, fixed-income securities and other types of product. Other products 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 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 for reasons of caution. 9

12 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 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 the Bank 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. 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 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 a comparison of the rating of counterparties with a credit rating from both Moody s and Handelsbanken. The same information is provided for institutions. Handelsbanken s risk classification of companies compared to Moody s rating for companies Aaa-A Baa Ba B Caa-C F Handelsbanken s risk classification of institutions compared to Moody s rating for institutions Aaa-A Baa Ba B Caa-C F 10

13 Quality assurance of the credit risk model The Bank carries out a detailed annual review of its internal rating model. The review checks that the internal ratings on which the Bank s risk classification is based are applied in a consistent, correct and fit-for-purpose manner (evaluation) and also that the statistical models used measure risk satisfactorily (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 Swedish Financial Supervisory Authority. The table below shows the values applied for 2009 (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 in The LGD outcome for 2009 refers to the average (exposure-weighted) realised loss shares for counterparties defaulting in 2007 with a 24-month recovery period. For expected loss shares (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 percent. 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 of EL and LGD is weighted according to the exposure volume. PD is number-weighted. The PD values shown here are those applied in the capital adequacy report, thus both security margins and the business cycle adjustment factor affect the PD values. The expected loss share presented here does not in fact represent the most likely loss level for the Bank. This is partly because the PD values used should correspond to a long-term average. The conditions in 2009 suggest that losses might be expected to exceed the long-term average. It is also partly because a number Predictions and outcome for risk parameters in the IRB model % Excluding defaults EL PD LGD Including defaults Loan losses provisions Prediction for 2009 Outcome (2009) Prediction for 2009 Outcome (2009) Exposure class Corporate Retail, property Retail, other Institutions Total, all

14 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 adjoining diagram shows how these adjustments affect the calculated value for expected losses. Apart from these adjustments, the risk is further 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 to the right shows EL for all IRB-approved exposures, excluding defaulted exposures. The first column shows the observed EL value, that is EL based on the outright estimate of PD and LGD, which is 0.11 percent. The next columns show 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. For 2009, the business cycle adjustment resulted in the PD values being adjusted upwards in relation to the measured PD values on which the model is based. The final column shows EL calculated using the approved IRB approach. It is approximately 0.18 percent of the exposure. The 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. This level is also considerably closer to the Bank s net loan loss ratio for 2009, namely 0.21 percent. Breakdown of EL for all IRB-approved exposures, excluding defaulted exposures % Estimate +LGD sec, marg. +LGD downturn adj. +PD sec. marg. +PD bus. cycle adj. =Applied In addition to evaluations and validations, the internal auditing department also carries out an important part of the quality control. It examines the risk rating system, its components 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. The Swedish Financial Supervisory Authority s supervision of the Bank includes regular monitoring of how the Bank s application of the IRB approach is progressing. There were no observations during the year as part of this supervision which required the Bank to take action. Within the framework of its overall capital assessment, the Swedish Financial Supervisory Authority confirmed the application of the IRB approach as the starting point for assessing the Bank s capitalisation. 12

15 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 good collateral being offered. 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. For the latter category, special loan covenants are in many cases 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 breached. 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 loans to credit institutions consists of reverse repos. A reverse repo is a repurchase transaction in which the Bank buys fixed-income 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. Loans to the public, collateral Collateral which reduces the capital requirement The information in the following section describes capital requirement-reducing collateral for exposures that are IRBapproved and the same for the exposures that are subject to the standardised approach. The Bank accepts 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. Handelsbanken has also entered into a large number of netting agreement with, for example, institutional counterparties, thus reducing the exposures. Information concerning the netting effect on derivative contracts is presented in the section on counterparty risk. Handelsbanken has set up procedures for fulfilling the processing requirements for eligible collateral. This includes the 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. IRB-approved exposures In 2009, the Bank established the conditions for increased use of capital requirement-reducing collateral. This includes new technical solutions. For capital requirement calculation of corporate exposures, property mortgages correspond to approximately 29 percent (23) of the reported exposure amount. The equivalent figure for financial collateral mainly in the form of repos is about 3 percent (2) and for guarantees and other collateral it is about 8 percent (7) for each category. The remaining exposure amount is included in the capital adequacy calculation as unprotected exposure. For retail exposures, mortgages on property mainly residential correspond to around 83 percent (83) of the reported exposure amount. Of the remaining exposure amount, roughly Residential property Other property Sovereigns, municipalities and county councils Guarantees Unsecured Other collateral Loans to the public Including ownership housing co-operatives. 13

16 2 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 the type of borrower, type of credit or number of borrowers. For institutional exposures, financial collateral in the form of repos accounts for some 60 percent (41) of the reported exposure amount. The corresponding figure for guarantees is some 2 percent (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. The same 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 the type of credit, number of borrowers and type of collateral. Collateral is divided up into residential property, other collateral and unprotected exposures. Of the collateral for loans to the public (1,477,183), some 72 percent is collateral that reduces the capital requirement. Exposures calculated according to the standardised approach For institutional, corporate and retail exposures calculated using the standardised approach, collateral totals about 15 percent (7) of the reported exposure amount, of which approximately 3 percent (1.5) refers to guarantees. The equivalent figure for the class of exposures with collateral in property is 100 percent. For all exposures calculated using the standardised approach, the regulations state a risk weight based on the exposure class of the counterparty. The risk weight multiplied by the 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. Collateral which reduces the capital requirement, exposures calculated according to the standardised approach Type of collateral Exposure amount covered by collateral Proportion of total exposure, % Sovereign & central banks - Financial collateral Institutions - Financial collateral 35 1 Corporate - Guarantees Financial collateral Retail - Guarantees Financial collateral Collateral in property - Property Total Collateral which reduces the capital requirement, IRB-approved exposures Type of collateral Exposure amount covered by collateral Proportion of total exposure, % Corporate exposures - Guarantees Receivables Financial collateral Property Retail exposures - Guarantees Residential property Institutional exposures - Guarantees Financial collateral Total IRB