Capital Adequacy and Risk Management

Transcription

1 Capital Adequacy and Risk Management Pillar 3 Disclosure Report As of 31 December 2014

2 Capital Adequacy and Risk Management Pillar 3 Disclosure Report DHB BANK 2014 Table of Contents I. BACKGROUND AND OVERVIEW... 2 II. RISK AND CAPITAL MANAGEMENT Regulatory development Risk Governance Risk Appetite Capital Management Framework III. CAPITAL BASE IV. PILLAR 1 RISKS AND CAPITAL REQUIREMENTS V. CREDIT RISK Overview of credit risk management Credit risk profile Counterparty risk and derivatives Credit risk mitigation Asset quality VI. MARKET RISK VII. OPERATIONAL RISK VIII. PILLAR 2 RISKS Interest rate risk in the banking book (IRRBB) Liquidity risk Concentration risk Other risks: Legal, compliance and reputation risk IX. CAPITAL ADEQUACY CONCLUSION

3 I. BACKGROUND AND OVERVIEW This document discloses DHB s risk profile, risk management practices and capital adequacy position to fulfill the Basel III disclosure requirements, as stipulated in the Capital Requirements Regulation and Directive IV (CRR/CRD IV). The CRD IV was enforced in the Dutch law as amendments to the Wet op het financieel toezicht and further accompanying regulations. Jointly, these regulations represent the new regulatory framework applicable in the Netherlands to, among other things, capital, leverage and liquidity as well as Pillar 3 disclosures. The Basel III framework holds three pillars. Each pillar concentrates on a different aspect of banking regulation: - Pillar 1 defines the way banking institutions calculate their regulatory capital requirements in order to cover credit risk, market risk and operational risk. - Pillar 2 addresses the banks risk management structure and processes for assessing overall capital adequacy in relation to risks, including other risks not identified in the first pillar such as concentration risk. Pillar 2 also introduces the Supervisory Review and Evaluation Process (SREP), the response of the Supervisor to the internal capital adequacy assessment process (ICAAP) conducted by banking institutions. - Pillar 3 complements the first two pillars of Basel III by requiring a range of disclosures on capital and risk assessment. Its aim is to encourage market discipline by enhancing transparency that will allow market participants to make a better assessment of the bank s capital, risk exposure, risk assessment processes, and hence the capital adequacy of the institution. The new regulatory framework became effective on January 1, 2014, subject to certain transitional rules. This report fulfills the disclosure required in the CRD IV regulation. The Pillar 3 report consists of both quantitative and qualitative information as at 31 December The quantitative exposures in this report are not directly comparable to the numbers in the 2014 Annual Report. The numbers in the Annual Report refer to book values and classifications in line with the International Financial Reporting Standards (IFRS). In this document, credit exposure is defined as the estimate of the amount lost in the event of default or through the decline in value of asset. This estimate takes into account contractual commitments to undrawn amounts. In contrast, an asset in the Bank s balance sheet, as published in the Annual Report, is reported as a 2

4 drawn balance only. This is one of the reasons why exposure values in the Pillar 3 report can differ from asset values as reported in the published accounts. Where this document discloses (credit) risk exposures or capital requirements, DHB has followed the scope and application of its Pillar 1 capital adequacy calculations. Where figures for impairment or losses are disclosed within this document, DHB has followed the IFRS definitions as used in DHB s Annual Report. Furthermore, the bank s Pillar 3 report supplements the qualitative information provided in the 2014 Annual Report on corporate governance, risk and capital management as well as the Notes to the financial statements. The information is not required to be and therefore has not been subject to external audit. However, it has been subject to internal review procedures broadly consistent with those undertaken for interim reports. DHB publishes Pillar 3 disclosures annually on its website: 3

5 II. RISK AND CAPITAL MANAGEMENT 1. Regulatory development New capital adequacy regulations were introduced in Regulation 575/2013 EU (CRR) came into force in the EU on 1 January 2014 and is directly applicable in the Netherlands. Directive 2013/36/EU (CRD IV) was also implemented in the Dutch law by the Wft. The directive specifically monitors the reinforcement of the capital and liquidity of banks and investment firms. The new requirements stipulate that the bank must have common equity tier 1 capital of at least 4.5 percent, tier 1 capital of at least 6 percent, and own funds that correspond to at least 8 percent of the total risk-weighted exposure amount for credit risks, market risks and operational risks. In addition to maintaining capital to meet the minimum capital requirement, the Bank must also maintain common equity tier 1 capital to comply with combined buffer requirements, which will be phased in over coming years, and requirements under Pillar 2 of the regulations. The requirements are decided by the supervisory authority after the Bank performs an ICAAP, in which all risks and capital requirements are assessed rigorously. In the forthcoming years, banks will be subjected not only to demanding capital and liquidity requirements but also to other closely related evolving regulations such as on how to proceed in case of financial distress (Recovery and Resolution Planning). On 15 April 2014, the European Parliament adopted the Bank Recovery and Resolution Directive (BRRD), which came into force on 1 January Its implementation in Dutch legislation has not been completed yet. The purpose of a Resolution Plan is to document how a bank can be resolved in case the recovery plan does not prevent the institution from reaching the point of non-viability. The recovery plan documents the ability of banks to recover from a situation where their business model is so challenged by the economic environment that it is necessary to revise its strategy in order to avoid reaching a point of non-viability. DHB delivered an update of its recovery plan to DNB in January The BRRD introduces a Minimum Requirement for own funds and Eligible Liabilities (MREL). The liability items qualifying for the bail-in buffer are referred to as Eligible Liabilities. These own funds and eligible liabilities form a buffer to absorb losses. In this connection, the aim of BRRD is to introduce a bail-in regime with effect from 1 January This means that, in the event of a bank failure, first the shareholders and lenders are charged for an amount of at least 8 percent of the balance sheet total or 20 percent of the risk-weighted assets. Only then can any 4

6 public funds be used. The amount in retail deposits exceeding Euro 100 thousand will not fall under the 8% 'bail-in'. Another important development in 2014 was the the enactment of the Policy Rule on Maximizing the Deposits and Exposures Ratio under the Act on Financial Supervision (hereafter referred to as New Business Model Policy Rule) in February In nutshell, the New Policy Rule requires Dutch banks to comply with a certain ratio between the banks exposure outside the European Economic Area (EEA) and their deposits under the coverage of the Dutch deposit guarantee scheme, with the required ratio determined in relation to the respective banks balance sheet size. Accordingly, DHB will continue to shift its lending activities more towards the EEA, thus continuing in a direction that the bank had already started to pursue following the 2008 crisis in the context of its strategic alignment. This strategic path will further strengthen the bank s commercial standing by increasing the diversification in its assets. It is notable that country risk diversification would not only strengthen the Bank s risk posture but would also allow it to reduce Pillar 2 capital add-on requirements under the current capital regime. Overall, the banking sector continues to face a growing number of ever stricter international and regulatory requirements and a more severe monitoring of compliance by supervisors. Furthermore, data and reporting requirements are expected to increase substantially. DHB has assigned appropriate resources to the implementation of the regulations and is prepared to meet the consequences of the new regulatory requirements proactively. 2. Risk Governance Risk and capital management are key success factors for DHB s business and play a crucial role in enabling management to operate more effectively in a changing environment. The Bank assumes various risks, the most important being credit risk. Other relatively important risks are liquidity risk, interest rate risk and operational risk. DHB continually strives to further strengthen the bank-wide risk and capital management framework in terms of organizational structure, processes and responsibilities, as well as the methods for identification, measurement, monitoring and control of risks. Accordingly, the Bank ensures that all risk-related policies are fully communicated and adopted at all levels. 5

7 The Bank s risk governance framework is based on the risk strategy and the risk appetite, which is integrated within the risk organization, policies and methods. The framework aims to safeguard the Bank s risk profile and steer risk management processes in line with the risk appetite of the Bank. The Supervisory Board has the final authority to approve the risk strategy and the risk appetite statement proposed by the Managing Board, exercising its oversight of risk management principally through the Board s Risk & Audit Committee (RAC), supported by assessments and reports prepared by the Internal Audit Department (IAD), Risk Management Department (RMD) and Compliance & Legal Department (CL). RAC is responsible for the oversight of policies and processes by which risk assessment and management are carried out within the governance structure. RAC also reviews internal control and financial reporting systems that are relied upon to ensure integrated risk measurement and disclosure processes. The responsibility for risk management resides at all levels of the organization, from members of the board to individuals in the business units. The control environment in the Bank is based on the three lines of defense principles for segregation of duties. The structure starts with lines of business being responsible for managing risks in their operations within approved risk appetites. The three lines of defense structure provide clarity to every staff with regard to their role and the level of risk awareness that is expected at difference phases in the lifecycle of respective risks. With business units assuming the first line of defense function, RMD (Risk Management Department), Credit Analysis Department and Compliance & Internal Control department form the main second line of defense. They support the business units in their decision-making, but also have sufficient independence and countervailing power in managing risks. The Internal Audit Department as the third line of defense oversees and assesses the functioning and effectiveness of the first two lines. Formal risk governance processes are established in the Bank, whereby the management of risk is guided and monitored by a number of committees. Within the governance structure, DHB s Risk Management Committee (RMC), Credit Committee and Asset & Liability Management Committee (ALCO) oversee particular risks. RMC oversees the management and control of the Bank s risks on an aggregate level, in addition to the committees and specialized functions that focus on specific risk areas. RMC also discusses and ultimately endorses the methodology and outcomes of the ICAAP and the ILAAP by RMD. 6

8 The RMC consists of Managing Board members, two Assistant General Managers responsible for credit analysis and for operational processes, respectively, the head of risk management department, the ORCA (Operational Risk and Control Assessment) project leader and the Compliance Officer. Chief Internal Auditor also participates in the meetings as an observer/adviser in order to provide the committee with insight from an audit perspective. IT related risk factors are controlled and monitored by different committees. The access control to the core banking application resides on SPD (System Analysis and Process Improvement Department) while technical control is exercised by the IT Department. Information security in the broadest sense (including access control, technical control and business continuity policies and activities) is ensured by the Information Security Manager (referred to as ISM ). SPD, ISM and IT units are assigned together in the IT & IS Steering Committee, a platform for communication and decision on IT-related procedures and measures. IT related risk factors are controlled and monitored through the IT & IS Steering Committee that is chaired by the responsible Managing Board member and the Assistant General Manager, responsible also for operational risk policies. To mitigate the IT related risk exposure further, an (Information) Security Assessment and Response Team (referred to as SART ) has been established, which reports to the IT & IS Steering Committee. SART, chaired by the ISM, consists of four IT specialists to bring in expertise to the committee in the fields of database & core banking applications, network, Internet and third-party interfaces. In the framework of compliance, the Security Officer, beside anti-money laundering measures, is responsible for the incident and the complaint management systems. In addition to the immediate benefits, the ultimate aim for maintaining these systems is gathering sufficient data needed to model operational risks in time. The overall control with respect to the non-financial risks is carried out by the Internal Control Unit (referred to as ICU ) and the internal and the external auditors. The ICU executes predefined operational controls daily, weekly or quarterly depending on the risks attributed to the concerned activities. The internal and external auditors also execute their inspections on the risk management systems, policies and practices. Finally the Compliance Officer, who reports directly to the Managing Board, is responsible for integrity and compliance in the broadest context. Both financial risks and non-financial risks are reported to the Risk Management Committee meeting at least four times a year with a special focus on regulatory risk, earnings risk, capital risk and strategy risk. The Managing Board is in turn responsible for reporting to the Risk & 7

9 Audit Committee and the Supervisory Board. With this structure, a consistent segregation of duties is achieved between risk generating, measuring, controlling and reporting units. The independent organizational structure of the Internal Audit Department and the Compliance Department, with a direct information line to the RAC, also ensures an effective control in the respective fields. The risk governance at DHB is depicted in the following figure: 3. Risk Appetite Risk appetite framework is central to an integrated approach to risk, capital and business management and supports the bank in achieving its strategic objectives as well as being a key element of meeting the bank s obligations under the supervisory review process. The Bank defines risk appetite after performing the assessment of key risk sources and perspectives of all key stakeholders (i.e. shareholders, regulators, external rating agencies, auditors and customers) in the context of the Bank s prevailing strategy. 8

10 A clear articulation of the overall risk appetite that reflects multiple risk perspectives, stakeholder expectations and business objectives not only help protect the Bank s performance and comply with regulations and safeguard reputation, but it also moves risk management well beyond risk mitigation toward optimization of risk and return characteristics across the business as well as toward the identification of unused risk capacity. Risk appetite is articulated by the Managing Board of DHB as part of the strategic planning process, assessed by the Risk & Audit Committee, and approved by the Supervisory Board prior to communicating the respective document to the wider organization involved with risk management and to the stakeholders via various disclosures. The articulation of risk appetite is also linked to the results of a comprehensive risk assessment, which is periodically performed during ICAAP and ILAAP. On an annual basis, the Risk Appetite Statement (RAS) is discussed and re-evaluated by the Supervisory Board s Risk & Audit Committee to enable the alignment of the Bank s future strategy with the chosen risk appetite, as and if circumstances and various stakeholders risk expectations change. RAS can also be revised during the year when there are material changes in the Bank s strategy or business environment. To facilitate monitoring, risk appetite is quantified (to the extent possible) and expressed through risk based performance targets and limits. In addition, the Bank also uses stress testing and scenario analysis to formulate risk appetite, especially in liquidity and capital adequacy management. Periodic risk assessment and reporting of inherent risks in the Bank s activities is part of the risk management framework to allow for an aggregated view of risks. If risk limits and targets are breached, or an activity or a product seems to be straying from the approved risk profile, decisions must be made timely and pro-actively. RAS is communicated to the head of departments and country managers and used as the main starting point for quarterly risk assessment reports for discussion in RMC and RAC. RAS, and also other policy documents, are accessible for all relevant staffs. By communicating within the organization and embedding it in the internal processes, the Bank encourages a more conscious risk taking behavior and reinforces risk culture within the organization. A strong and widespread risk culture is in its turn an essential catalyst that elevates a risk appetite statement from a set of words into a statement of action. 9

11 4. Capital Management Framework The bank s risk environment requires continual monitoring and assessment in order to identify and manage complex interactions. The risk governance and ownership, risk appetite as well as the scope and nature of monitoring and reporting processes that DHB has put in place are aimed at meeting these challenges. Furthermore, DHB ensures that it has adequate own resources to cover unexpected losses arising from discretionary risks such as credit risk and market risk, or non-discretionary risks, which are risks arising by virtue of its operations, such as operational risk and reputation risk. DHB essentially has two approaches for the calculation of its capital need: a regulatory and an internal approach. The regulatory approach is largely based on fixed, uniform rules for covering the bank s risks in accordance with the Basel II/III standards. The internal approach sets capital adequacy targets and uses the bank s risk appetite along with its risk profile and business plans as a basis. Other determining factors are expectations and/or requirements of the stakeholders as well as the position of the bank in the Dutch banking sector. As a consequence, the internal approach has to encompass the regulatory approach in order to be comprehensive, effective and consistent. The requirements/expectations of regulators concerning capital adequacy are not only driven by the Basel guidelines for Pillar 1 and Pillar 2 risks, but also by a new capital add-on requirement introduced in the Netherlands in July 2010 to achieve a certain prudential objective, namely to reduce banks credit risk concentration in emerging countries. The internal capital management approach is embedded in a formal ICAAP whose regulatory framework is rooted in the CRD IV. DHB defines the ICAAP by which the Managing Board examines the bank s risk profile from both regulatory and economic capital viewpoints and ensures that the level of available capital: i. Exceeds the bank s minimum regulatory capital requirements by an agreed margin, ii. iii. iv. Remains sufficient to support the bank s risk profile, Remains consistent with the bank s strategic goal, Is sufficient to absorb potential losses under severe stress scenarios. Although the regulatory approach and constraint have become more dominant as indicated above, 10

12 the ICAAP framework of DHB as an integral part of risk management retains its relevance since it ensures a coherent link between the bank s risk profile, its risk management, risk mitigation and capital. The bank s ICAAP framework also promotes a continuous monitoring of the risk environment and an integrated evaluation of risks and their interactions. It represents a bankwide approach to deal with all material risks and all business activities of DHB. The process itself starts with risk identification, assessment and measurement, which involves all relevant departments. DNB s Financial Institutions Risk Analysis Method (FIRM) has been chosen by DHB as an integral part of the ICAAP for its comprehensiveness in identifying and assessing risks and control qualities. Identified risk types are classified into low, medium and high risk levels based on the assessment of their relevance and potential impacts. The table below shows a summary of the risk assessment results and methodologies under the ICAAP framework for FYE 2014: 11

13 Risk area Risk type Risk assessment Desired direction of risk level Regulatory reference, benchmark and method for risk evaluation Capital requirement calculation approach Pillar 1 Pillar 2 Credit Risk (CR) Default and rating migration Underestimation of CR in the SA Concentration: Medium Low Standardized Approach (SA), periodical credit portfolio risk assessment, collective provisioning and stress testing Qualitative assessment and adjustment Country risk -Borrower Medium Adapted from Bank of Spain -Sector Medium Approach Medium to High Policy Rule on the treatment concentration risk in emerging countries (2010) Market Risk (MR) Trading risk Low Standardized Approach, Valueat-risk model (VaR) and Limits FX risk Low Standardized Approach, Valueat-risk model (VaR) and Limits Underestimation of MR in the SA Low No addon Interest Rate Risk in the Banking Book Low (Duration) Gap analysis, Earnings-at-Risk and Capital-at- Risk models Liquidity Risk Low Addressed in Internal Liquidity Adequacy Assessment Process (ILAAP) No addon IT related risks Low Operational Risk (OR) Other Risks Non-IT related risks Underestimation of OR under SA Low Low Legal Low Reputation Low Business (incl. strategy) Medium Pension Model Low Low Basic Indicator Approach Qualitative review No addon No addon 12

14 Stress tests are part of the bank s capital planning in the ICAAP and an important tool for analyzing the bank s risk profile. By incorporating appropriate stress testing and capital planning, the ICAAP result is expected to reflect internal measures to establish if the bank is adequately capitalized now and in the future. The bank has also developed its capital management framework by benchmarking its ICAAP and stress testing methodology against recommended good practices. As the regulation and supervision of financial institutions are currently undergoing a period of significant change in response to the global financial crisis, the bank has dedicated considerable time to monitor policy actions that may influence its capital position and capital management framework. Refinement of the internal methodology has been performed regularly since its first implementation in 2007/2008. DHB performs regular internal stress tests designed to replicate shocks that are particularly relevant for the bank s existing business mix and macro environment. The stress test reveals how the capital need varies during a stress scenario, and how the financial position, Pillar I capital requirement and target capital ratio are affected. Outcomes of the stress tests are also used as early warning indicators to evaluate the adequacy of the above mentioned recovery plan. 13

15 III. CAPITAL BASE Under CRD IV, DHB s capital structure consists entirely of common tier 1 capital - which includes paid-in capital, reserves and minority interests. The total capital base of DHB rose to Euro million at the end of 2014 from Euro million a year earlier. The components of the capital base are presented in the table below: Capitalization (1,000) 2014 (CRD IV) 2013 (CRD III) Total Equity - IFRS (EU) 230, ,611 Intangible assets - - Cash flow hedge reserve - Expected dividend pay-out (4,686) (9,053) Regulatory adjustments - Common equity tier 1 (CET 1) capital 225, ,559 Additional Tier 1 capital - - Tier 2 capital - - Total regulatory capital (net after deduction) 225, ,559 14

16 IV. PILLAR 1 RISKS AND CAPITAL REQUIREMENTS This section describes DHB s regulatory capital requirements that arise from Pillar 1 risks in the CRD, namely credit, market and operational risks as of 31 December The regulatory minimum capital requirement is expressed as eight percent of risk weighted assets (RWA). To calculate RWA according to the Basel II/III framework, DHB adopted the Standardized Approach (SA) for credit and market risk, and the Basic Indicator Approach for operational risk. The adopted approach is consistent with the size, complexity and nature of its activities in In order to calculate the regulatory capital requirements under the SA, the bank uses eligible external ratings from Standard & Poor s, Moody s and Fitch Ratings. These are applied to all relevant exposure classes in the SA. If more than one rating is available for a specific borrower, the selection criteria as set out in the CRR are applied in order to determine the relevant risk weight for the capital calculation. The following standardized exposure classes apply to DHB: Sovereigns Exposures to governments consist of sovereign governments, central monetary institutions and agencies guaranteed by a sovereign government. Sovereign exposures are risk weighted based on their credit ratings. Exposures to central governments within the European Union are assigned a risk weight of 0%, where such claims are denominated and funded in the relevant domestic currency of that sovereign. Banks Exposures to banks relate to all claims on financial institutions authorized and supervised by the competent authorities and subject to prudential requirements comparable to those in the European Union. Exposures to a bank are risk weighted based on the ratings assigned to them by eligible rating agencies. Exposures to a bank of up to three months residual maturity for which a credit assessment by eligible rating agencies is available are assigned risk weights that are generally one category more favorable than the standard risk weights applied to banks exposures (see CRR Article 120). 15

17 Corporates Exposures to corporates include exposures to large non-bank corporations as well as to small and medium-sized companies, which do not meet the conditions of retail exposure. Exposures to corporates with external credit ratings by eligible rating agencies are assigned a risk weight from 20% to 150%. Exposures without external rating are assigned a risk weight of 100%. Retail Exposures are classified as retail exposures upon meeting the conditions stipulated in the Dutch Regulation on Solvency Requirements for Credit Risk. Retail exposures are assigned a risk weight of 75%. Exposure secured on real estate property This exposure class refers to the exposures or any part of an exposure secured by mortgages on residential property. Exposures in this class are assigned a risk weight of 35%. Past due items In line with the requirements of the Dutch Central Bank, this exposure class only includes claims which are past due more than 90 days. Shorter past due items are included in the corresponding exposure classes mentioned above. The unsecured part of any past due item is assigned a risk weight of 150% if value adjustment allowances are less than 20% and 100% if value adjustments allowances are no less than 20% of the unsecured part. Others Other items consist of fixed assets, prepayments and other assets for which no counterparty can be determined. Other items are assigned a risk weight of 100%. 16

18 An overview of the capital requirements and the RWA at the year-ends of 2014 and 2013 divided into the different risk types is presented in the table below Pillar 1 Risks and Capital Requirement, Euro (1,000) Capital Capital RWA RWA Requirement Requirement (Basel III) (Basel II) 8% 8% Credit risk 1,263, ,070 1,211,354 96,908 of which: Sovereign Banks 337,237 26, ,899 28,712 Corporates 897,923 71, ,700 64,856 Retail 2, ,581 1,887 Exposure secured on real estate property 3, , Past due items 8, , Others 13,751 1,100 13,517 1,081 Market risk 6, , Operational risk 70,343 5,627 70,713 5,657 Credit valuation adjustment (CVA) 4 - TOTAL 1,340, ,245 1,284, ,793 17

19 V. CREDIT RISK Credit risk is the largest risk making up 94.2% of the total RWA at 31 December The information in this section is analyzed in several dimensions to give an in-depth view of the distribution of the credit portfolio in different exposure classes, risk weights, geography, and industry. 1. Overview of credit risk management DHB manages credit risk in a coordinated manner at all relevant levels within the organization. A primary element of the credit approval process is a thorough risk assessment of the credit exposure associated with each borrower and obligor. An obligor is defined as a group of individual borrowers that are linked to one another by various numbers of criteria, including capital ownership, demonstrable control over business or other indication of group affiliation. The Bank measures and consolidates all claims on the same obligor ( one obligor principle ), requiring the aggregation of all facilities (direct or contingent) to the borrower itself, its subsidiaries, parent and related affiliates. The creditworthiness of a borrower or an obligor is represented by internal rating. While DHB uses the standardized approach for credit risk, internal rating system has been further refined in order to strengthen the Bank s credit risk management system. In addition to the internal rating on obligor, the Bank s risk assessment procedures also take into consideration the risks specific to the type of credit facility or exposure. DHB dedicates considerable resources to controlling credit risk effectively. Credit monitoring is carried out through credit reviews on obligor level by the Credit Risk Management that reports to the Credit Committee on a regular basis. An independent credit portfolio risk assessment is conducted monthly by the Risk Management Department, which reports directly to the Managing Board. 2. Credit risk profile This section presents an overview of DHB s credit risks in terms of key credit risk dimensions. All exposures in this document refer to on-and off balance sheet items after specific provisions and the application of credit conversion factors. In the following table, the credit exposures are broken down into risk weights at the end of 2014 and

20 Credit exposures by risk weights, Euro (1,000) Exposures RWA Exposures (Basel III) RWA (Basel III) 0% 202, , % 163,434 32,687 96,139 19,228 35% 9,356 3,274 10,014 3,505 50% 550, , , ,902 75% 3,930 2,948 5,011 3, % 949, , , , % 2 3 5,706 8,558 Other risk weights TOTAL 1,879,008 1,263,373 1,742,545 1,211,354 The next tables provide the distribution of DHB s total exposure by remaining maturity at the end of 2014 and 2013 respectively. Credit Exposures by maturity at 31 December 2013, Euro (1,000) < 3 months 3 < 6 months 6 < 12 months 1-3 years > 3 years TOTAL Sovereign 102, , ,315 Banks 117, , , ,268 33, ,474 Corporates 283, ,751 82, , , ,902 Retail 5, ,597-3,884 4,118 Exposure secured on real estate property ,214 9,356 Past due items 3, ,670 1,311 8,239 Other items , ,605 Total Credit Exposures 511, , , , ,132 1,879,009 Credit Exposures by maturity at 31 December 2013, Euro (1,000) < 3 months 3 < 6 months 6 < 12 months 1-3 years > 3 years TOTAL Sovereign 120, , ,106 Banks 130, ,310 97, ,652 66, ,968 Corporates 393,839 66,008 38, , , ,418 Retail 7, ,376 13,783 33,633 Exposure secured on real estate property ,847 10,014 Past due items Other items , ,637 Total Credit Exposures 652, , , , ,249 1,742,545 19

21 The following table breaks down the main exposure categories according to the sectors of DHB s counterparties at the year-ends of 2014 and Credit Exposures by exposure class and industry, Euro (1,000) Sovereign 108, ,106 Banks 769, ,968 Corporates 964, ,418 of which: Non bank Financial institutions 257, ,451 Construction and infrastructure 133,504 98,068 Tranportation 57,992 39,287 Metals 75,162 47,090 Energy 48,833 46,748 Communications and post 16,836 32,766 Textile 33,481 Food beverages 25,594 9,299 Media advertising 40,128 Petroleum refining & related industries 2,271 2,665 Domestic & International trade 45,142 27,248 Chemicals 30,584 21,123 Mining and quarrying Tourism 23,838 21,370 Automative 43,486 22,607 Oil & gas 19,689 23,324 Plastics 6,464 Real estate 40,840 5,106 Agricultural products 10,144 6,786 Electrical equipment 840 Paper 3,674 4,350 Corporate individuals 22,123 6 Retail individuals 30,808 Other 36,635 12,339 Retail 4,117 26,717 Exposure secured on real estate property 9,356 7,431 Past due items 8, Other items 14,605 24,536 Total Credit Exposures 1,879,008 1,742,745 The tables below show the credit exposures divided into main geographical areas according to the location of the ultimate shareholder at the end of 2014 and 2013 respectively. Credit exposures by exposure class and geography at 31 December 2014, Euro (1,000) Netherlands Other Europe Turkey CIS Others TOTAL Sovereign 102,469 5, ,315 Banks 148, , ,183 20, , ,473 Corporates 25, , ,500 71, , ,902 Retail 3, ,117 Exposure secured on real estate property 1,940 7, ,355 Past due items 22 5,132 3,086-8,240 Other items 5,720 8, ,605 Total Credit Exposures 287, , ,562 91, ,338 1,879,007 20

22 Credit exposures by exposure class and geography at 31 December 2013, Euro (1,000) Netherlands Other Europe Turkey CIS Others TOTAL Sovereign 120,007 2, ,106 Banks 64, , , , , ,968 Corporates 15, , ,781 74,069 60, ,418 Retail 4,612 18,173 10, ,633 Exposure secured on real estate property 2,754 6, ,014 Past due items Other items 6,485 8, ,637 Total Credit Exposures 214, , , , ,098 1,742, Counterparty risk and derivatives Derivatives not only affect the market risk but also counterparty risk measured within the calculation of RWA related to the credit risk. DHB uses derivatives to manage interest rate and currency risks on an ongoing basis. Counterparty risk is the risk that DHB s counterparts in a derivative contract defaults prior to maturity of the contract and that DHB at that time has a claim on the counterpart. As per year-ends of 2014 and 2013, the main sources of counterparty risk were currency swap and interest rate swap. Derivative Contracts Euro (1,000) Exposures* RWA (Basel III) Capital requirement Exposures* RWA (Basel II) Capital requirement Interest rate contracts 3,082 1, ,764 2, Foreign exchange contracts 2, ,408 2, Other contract TOTAL 5,898 2, ,172 4, *The exposures represent the credit exposure to derivative transaction after taking account of legally enforceable netting agreements and collateral arrangements DHB uses the mark-to-market method to calculate the exposure value according to the credit risk framework in CRR. Counterparty credit exposure comprises the sum of current exposure (replacement cost) and potential future exposure. The potential future exposure is an estimate that reflects possible changes in the market value of the individual contract during the remaining life of the contract, and is measured as the notional principal amount multiplied by a risk weight. The size of the risk weight depends on the contract s remaining lifetime and the underlying asset. The Bank applies limits to mitigate counterparty risk similar to any other credit risk. In addition, the Bank enters into collateral agreements with all major counterparties. 21

23 4. Credit risk mitigation DHB uses a variety of instruments to mitigate and reduce credit risk on its lending. The most essential of these is to assess, at the outset, the ability of an obligor to service the proposed level of borrowing without distress. As a result, depending on the customer s standing and the type of product, credit facilities may be granted on an unsecured basis. However, DHB usually obtains collaterals for the loans granted. Collateral as a credit risk mitigant is considered even if it does not affect the regulatory capital adequacy calculations for the exposure on hand. The internal rating assignment process also includes the assessment and valuation of collaterals among other factors. Besides cash collaterals to a small extent, the Bank also accepts unfunded credit protection mainly in the form of mortgages, third party (customer) cheques, promissory notes, assignment of receivables or guarantees. For the cases of insurance and guarantee, risk mitigation is effected in the form of substituting the risk of the counterparty by the risk of the provider of credit protection. However, this shift only takes place when the risk weighting of the guarantor is better than that of the obligor and other prudential conditions are met. The following table gives information on the credit risk mitigation for regulatory capital calculation purposes as per yearend of 2014 and Credit exposures and credit risk mitigation, Euro (1,000) Credit Credit Collateralised Guaranteed Exposures Exposures Collateralised Guaranteed Sovereign 108, , Banks 769,473 45,000 21, ,968 35,061 2,000 Corporates 964,903 44, ,418 27,279 - Retail 4, ,808 33, Exposure secured on real estate property 9, , Past due items 8, Other items 14, , TOTAL 1,879,009 89,776 52,480 1,742,545 62,382 2, Asset quality The information presented in this section uses financial statement values and is largely sourced from the 2014 Annual Report of DHB. 1 The valuation of credit risk mitigation (e.g. collateral, guarantee) that is in place to meet internal risk management objectives is much greater than the amounts reported for regulatory capital calculation purposes (see Annual Report 2014). 22

24 An assessment is made at each balance sheet date to test whether there is objective evidence that a specific financial asset or group of financial assets may be impaired ( loss event ). Developments that lead to loss events may include: - A breach of contract, such as default in the payment of interest or principal; - Significant financial difficulty of the issuer or obligor; - Restructuring of the loan where a concession is granted due to the borrower s financial difficulty. If such evidence exists, an impairment loss is recognized in the statement of income. An indication of the overall credit quality of DHB s financial assets can be derived from the table below as per year-ends of 2014 and Asset Quality Euro (1,000) Neither past due nor impaired 1,869,689 1,730,036 Past due and/or impaired 27,025 23,757 of which impaired 26,029 23,137 Provisions (17,706) (11,248) Total 1,879,008 1,742,544 The creditworthiness of the customers that are not rated by external rating agencies is assessed with reference to the Bank s internal credit rating system. The internal rating is based on many factors derived from both financial and non-financial assessments of the borrower. The internal rating system is an essential tool for managing and monitoring the credit risk for the Bank. The assessment and administration of past due and impaired loans, write-offs and provisions fall under the responsibilities of the credit risk management units and the Credit Committee. Provisions are set aside for estimated losses in outstanding loans for which there is doubt about the borrower s capacity to repay the principal and/or interest. Provision amounts are determined through a combination of specific reviews, historical data and estimates. Provisions for loan losses are determined separately for each exposure for wholesale loans, and according to a predefined model for retail loans. Provisions against a particular impaired loan may be released when there is improvement in the quality of the loan. The Bank s write-off policies are determined on a case-to-case basis. For 23

25 restructured loans, the policy enables reclassification of a restructured loan into a performing loan when a certain number of repayments are executed. The following table details the change of provisions balance at the end of 2014 and 2013 respectively. Change of total credit risk provisions Opening balance, 1 January 11,248 8,232 Addition 7,925 5,180 Release (1,723) (1,285) Write-off (411) (467) Exchange rate movement Closing balance, 31 December 667 (412) 17,706 11,248 Though provisions for loan losses are considered adequate, the use of different methods and assumptions could produce different provisions for loan losses, and amendments may be required in the future, as a consequence of changes in the expected loss, the value of collateral and other economic events. Furthermore, the Bank also sets aside provisions to cover potential losses in relation to loans for which a triggering event has occurred, while the related individual loan is not yet identified as such at the balance sheet date. This process to determine incurred but not reported losses includes an estimate, based on a model, by management to reflect current market conditions. 24

26 VI. MARKET RISK DHB uses the Standardized Approach to capture the market risk capital requirement. As of 31 December 2014, the capital requirement for market risk is solely due to foreign currency positions. Foreign currency risk is hedged generally by using derivatives to reduce currency exposures to acceptable levels. After taking into account foreign currency derivatives, the Bank has no material net exposure to foreign exchange rate fluctuations. The Bank uses a combination of value-at-risk (VaR) model and stress tests to monitor the risk arising from open foreign currency positions representing the net value of assets, liabilities, and derivatives in foreign currency. The internal VaR model and risk limits are used only for risk management purposes and not regulatory capital measurement purposes. The following table shows the breakdown of capital requirement for market risk at the end of 2014 and 2013 respectively. Market Risk and Capital Requirement, Euro (1,000) Market risk of which: RWA (Basel III) Capital Requirement 8% RWA (Basel II) Capital Requirement 8% 6, , Foreign Exchange 6, , Trading Book

27 VII. OPERATIONAL RISK The Bank defines operational risk as the potential for incurring losses in relation to employees, technology, system failure (including non-availability) and frauds. It excludes legal, compliance, business and reputation risk. The capital requirement for operational risk is calculated at DHB according to the Basic Indicator Approach. Under this approach, the capital requirement for operational risk is equal to 15% of the three- year average gross income, which results in a capital requirement for operational risk of Euro 5.7 million at 31 December Operational risk is inherent in all business activities and can never be eliminated entirely. However, shareholder value can be preserved and enhanced by managing, mitigating and, in some cases, insuring against operational risk. For the purpose of mitigating operational risk, since 2007 DHB has implemented a risk selfassessment program called ORCA, which stands for Operational Risk and Control Assessment. The main aim of this project is to enhance the risk awareness of every staff member in the Bank and minimize operational risk at every stage of the daily activities. The ORCA program covers all units of the Bank and involves all staff in developing a strong control environment. This program focuses on different areas of operational risks (IT related risks, process related risk, staff related risks and external risks) according to the specific business activities, business lines, departments and countries. With the guidance of Risk Management Department, all the units proceed through a predefined route to identify risks by using tools such as questionnaires, interviews and workshops; estimate their potential impact, and devise an action plan suitable to the size and nature of those risks. As a permanent self-improvement initiative, the project cycle foresees continuous monitoring and periodical independent review of the involved risks and respective measures in response to changing activities and operating environments. 26

28 VIII. PILLAR 2 RISKS 1. Interest rate risk in the banking book (IRRBB) Interest rate risk inherent in the banking book consists of exposures deriving from the balance sheet and is measured in several ways in accordance with the financial supervisory authority s guidelines. The IRRBB is monitored and controlled both from a value perspective (such as using the duration of equity and PV01 measure) and from an income perspective (sensitivity in net interest income, NII) 2. Through its management of interest rate risk, DHB aims to hedge the effect of prospective interest rate movements that could reduce its future net interest income, while balancing the cost of such hedging activities on the current net revenue stream. Regarding the income perspective, NII is exposed to external factors such as yield curve movements and competitive pressure. The NII risk depends on the overall business profile, especially mismatches between interest-bearing assets and liabilities in terms of volumes and repricing periods. The IRRBB is minimized as the Bank s rate sensitive assets and liabilities are mostly floating rate, where duration is lower. In general, DHB aims to use matched currency funding and usually converts fixed rate instruments to floating rate to better manage the duration in the asset book. The following tables indicate the Bank s interest rate sensitivities in the banking book from the income perspective at the end of 2014 and 2013 respectively. It is notable that the interest sensitivity results are based on the regulatory assumption that the level of interest rates after downward rate shocks do not fall below zero percent. NII sensitivities by major currencies at 31 Dec 2014, Euro (000) Interest rate shock of +/ 200 bp 200 bp decrease 200 bp increase EURO 436 1,012 US Dollar Other TOTAL 242 1,304 2 Non-maturity interest rate sensitive assets and liabilities are bucketed in the short term. The bank s equity is considered a non-interest sensitive component and is excluded from the interest rate risk computations. 27

29 NII sensitivities by major currencies Interest rate shock of +/ 200 bp at 31 Dec 2013, Euro (000) 200 bp decrease 200 bp increase EURO 4,609 2,951 US Dollar 759 1,100 Other TOTAL 5,380 1,764 In addition to the regular monitoring of the interest rate risk using the above mentioned metrics, on a monthly basis DHB performs stress testing to calculate the immediate net effect on the fair value (FV) of a range of parallel shocks in rates, by currency. Furthermore, the Bank reports PV01 to measure changes in economic value resulting from a one basis point (0.01%) parallel rise in interest rates. The PV01 measure incorporates the entire rate sensitive segment of the balance sheet for the Bank and is classified into appropriate buckets. As per the regulatory requirements, interest rate risk reporting also include the measurement of the outlier criterion, which refers to the maximum loss of market value expressed as a percentage of capital base in the event of a parallel rate hike or drop of 200 basis points. The outlier criterion is subject to a limit of 20%. The following tables show a range of severe interest rate shocks with positions at the end of 2014 and 2013 respectively. At 31 December 2014, the standard instantaneous parallel shock (decline) of 200 bps leads to a potential decrease of Euro 5.7 million, or 2.6% of the capital base. In term of the outlier criterion, the Bank s interest rate risk position increased somewhat in 2014 to a risk level that is generally considered low in view of the abovementioned 20% threshold. Fair value sensitivity to interest rate shocks at 31 Dec 2014, Euro (000) PV01 Euro 8,265 5,504 2,749 2,743 5,480 8, USD Other TOTAL 8,874 5,884 2,925 2,892 5,752 8, Capital base 225,743 Standard 200 bps shock as % of capital 2.55% Fair value sensitivity to interest rate shocks at 31 Dec 2013, Euro (000) PV01 Euro USD 3,297 2, ,643 2,299 8 Other TOTAL 3,340 2,182 1,069 1,024 2,004 2, Capital base 223,559 Standard 200 bps shock as % of capital 0.90% 28