AS LTB BANK ANNUAL REPORT FOR THE YEAR ENDED 31 DECEMBER 2010

Transcription

1 ANNUAL REPORT FOR THE YEAR ENDED 31 DECEMBER 2010

2 CONTENTS Page REPORT OF THE COUNCIL AND THE BOARD 3-5 MEMBERS OF THE COUNCIL AND THE BOARD 6 STATEMENT OF MANAGEMENT S RESPONSIBILITY 7 FINANCIAL STATEMENTS: STATEMENT OF COMPREHENSIVE INCOME 8 STATEMENT OF FINANCIAL POSITION 9 STATEMENT OF CASH FLOWS 10 STATEMENT OF CHANGES IN SHAREHOLDER S EQUITY AUDITORS REPORT 69 AS LTB Bank Address: Grēcinieku iela 22 Riga, LV Registration number:

3 REPORT OF THE COUNCIL AND THE BOARD Management of AS LTB Bank (hereinafter also the Bank) informs its shareholders, clients, cooperation partners and the public on the results of operations in Throughout the reporting period, the Bank continued to be affected by the global economic crisis manifested as shrinking volumes and the scope of clients commercial activities. Current developments permit, yet with certain prudence, to forecast that the slowdown phase in the global economy is over and the market henceforth will be relatively stable. The Bank has managed to retain its customer based and customer loyalty as it has always taken into account the specifics of the customers commercial activities in the area of investments and the related high fluctuations in the volume of customer deposits. The Bank continued operating in line with the strategy of OAO MDM Bank (MDM Bank) the parent bank, providing safe, fast and high-quality financial services to major groups of corporate customers, including business partners of the parent bank and other customers operating in the Russian Federation and international financial and consumer markets. The Bank holds a stable position in servicing corporate customers based on best practice standards and principles of corporate ethics. For 2010, the Bank prepared an operational scenario that was based on retaining the present business policy and continuing financial activities. The Bank s activities in 2010 were not significantly different from those in 2009, and the volume of business grew gradually. The primary focus of the Bank also this year was servicing of customer cash flows by providing services such as servicing of demand deposit accounts, cash transfers, documentary operations, currency translation, payment card servicing and trust management services. Based on the principle Follow Your Customer and in line with the Bank s business development strategy, in the autumn of 2010 the Bank opened a branch office in the Republic of Cyprus, an event preceded by extensive preparation work, including development of the normative basis for the branch operation and accounting, reporting and information systems, as well as furnishing the premises and other technological items. Average assets of the Bank in the reporting year amounted to LVL thousand, and at the end of the reporting year assets amounted to LVL thousand. The Bank places its assets only in highly liquid and low-risk assets. The fall of interest rates in the financial market down to the minimum level continued to impact the Bank s net interest income. However, commission income grew significantly compared to the respective period of Operations of the Bank during the last reporting period have generated profit of LVL 1,497 thousand after tax. Return on equity was 3.4% and return on assets was 0.6%. The operational efficiency has lessened on account of increased operational costs connected with opening and starting-up the Cyprus Branch and due to extremely low interest margins. 3

4 REPORT OF THE COUNCIL AND THE BOARD Key financial results and performance indicators in 2008, 2009 and 2010 (): Total assets 445, , ,286 Capital and reserves 44,398 42,899 40,812 Profit before tax 1,717 2,461 9,561 Net profit after tax 1,497 2,087 8,152 Operating income 3,891 4,245 11,417 Return on Equity (%) Return on Assets (%) Capital adequacy (normative, at reporting date, %) 39% 59% 48% The Bank continued improving its risk management system and paid significant attention to the implementation of the new requirements on liquidity risk management and compliance with limits on risk transactions. Capital is managed by the Bank by setting a target range of internal capital adequacy rates which is treated as the measure for achieving the Bank s strategic goals in capital management. Throughout 2010, the Bank maintained sufficient internal capital for covering the identified material risks and other inherent risks, and for establishing capital reserves. As usual, the Bank maintained high capitalization and liquidity levels. The average internal rate of capital adequacy was 42.7% and the liquidity ratio was above 100%. The Bank consolidates its branch in Cyprus. The Bank will continue all measures required to reduce the potential impact of inherent risks on the financial position and operations. A particular focus during the reporting period was risk management relating to information technologies. A number of actions were taken during the year to identify, measure and reduce this risk and to develop and improve information systems and increase overall safety. All such efforts will be continued in The Bank has maintained its reputation of being a stable and professional business partner. One of the largest banks in the world, Deutsche Bank, has expressed appreciation for the long term productive cooperation that it has had with AS LTB Bank. This is proof of the quality and efficiency of the Bank s internal payment system. It is the third year in succession that this correspondent bank has presented its award for high quality USD and EUR payments - Deutsche Bank s 2009 Straight Through Processing (STP) Excellence Award. The sole shareholder of AS LTB Bank is MDM Bank, one of the largest financial institutions in the Russian Federation. The sole shareholder of MDM Bank with significant investment in the capital is MDM Holding SE, a holding company, whose investment amounts to 73.6% (ordinary) and whose beneficial owners are Sergejs Popovs, Igors Kims and Martins Andersons. Other shareholders include significant international financial institutions such as the European Bank for Reconstruction and Development (5.2% investment) and International Finance Corporation, part of the World Bank Group, (3.6%), and other legal entities and private individuals. Three international rating agencies have granted the MDM Bank some of their highest credit ratings among private banks of the Russian Federation: Standard and Poor s (B+; stable), Fitch (BB, AArus, stable), and Moody s Investor Service (Ba2/ NP; stable). The Bank s strategic plan for years 2011 to 2014 that was approved in 2011, states that the Bank will focus on stable long-term operational planning, medium appetite for risk, avoidance of speculative transactions, maintaining and extending a diversified business model and an offer of lending services focussed on customers, and on improvement of the technological facilities of business. 4

5 REPORT OF THE COUNCIL AND THE BOARD The following two strategic objectives have been set: Increase of the Bank's operational efficiency by maintaining a conservative approach to accepting risks and ensuring stable long-term operations, high quality banking services to corporate customers, improving technological processes and information systems, as well as raising staff qualifications and satisfaction; diversification and balancing of the business aimed at raising the Bank's competitiveness by organizing and extending asset operations, including lending. The Bank's management would like to express their gratitude to all customers and partners for their understanding and cooperation in the past year and to all staff for their professional and high quality work. Chairman of the Council Nikita Ryauzov Chairman of the Board Armands Šteinbergs 21 February

6 MEMBERS OF THE COUNCIL AND THE BOARD As at 31 December 2010, the Members of the Council of the Bank were as follows: Date of Name Position appointment Nikita Ryauzov Chairman of the Council 08/10/2010 Anna Arkhangelskaya Deputy Chairman of the Council 11/05/2010 Nikolay Ustinov Member of the Council 11/05/2010 Anton Savushkin Member of the Council 11/05/2010 During 2010 the following Members of the Council resigned: Name Position Date of appointment Date of resignation Vadim Sorokin Chairman of the Council 16/12/ /05/2010 Tatiana Pupkova Deputy Chairman of the Council 16/12/ /05/2010 John Mc Naughton Chairman of the Council 01/06/ /10/2010 On May 11 th, 2010, the shareholders meeting appointed the new members of the Council: Anna Arkhangelskaya, Nikolay Ustinov, Anton Savushkin. On July 5 th, 2010 the changes in the Bank s Council were registered with the Register of Enterprises of the Republic of Latvia. On October 8 th, 2010, the shareholders meeting appointed Nikita Ryauzov as new member of the Council. On November 17 th, 2010 the changes in the Bank s Council were registered with the Register of Enterprises of the Republic of Latvia. On January 24 th, 2011, the shareholders meeting appointed the new member of the Council, where Nikolay Ustinov resigned and Artem Kirillov was appointed as member of the Council. As at the date of signing these financial statements, the Members of the Board of Directors of the Bank were as follows: Name Position Date of appointment Armands Šteinbergs Chairman of the Board 25/09/2000 Inna Harčenko Deputy Chairman of the Board 23/12/2005 Valda Knauere Member of the Board 06/11/2000 Rolands Pētersons Member of the Board 15/03/2010 On March 15 th 2010, the Council of the Bank appointed Rolands Petersons as Member of the Board of Directors. On April 1 st 2010, the changes in the Bank s Board were registered with the Register of Enterprises of the Republic of Latvia. 6

7 STATEMENT OF MANAGEMENT S RESPONSIBILITY Management of the AS LTB Bank is responsible for the preparation of the financial statements of the Bank. The financial statements have been prepared in accordance with International Financial Reporting Standards as adopted in the European Union and comply with legislative requirements of the Republic of Latvia. The financial statements on pages 8 to 68 are prepared based on source documents and present fairly the financial position of the Bank as at 31 December 2010 and the results of its operations, changes in shareholder s equity and cash flows for the year ended 31 December The aforementioned financial statements are prepared on a going concern basis, consistently applying accounting policies in conformity with International Financial Reporting Standards as adopted in the European Union. Prudent and reasonable judgments and estimates have been made by the management in the preparation of the financial statements. The management of the AS LTB Bank are responsible for the maintenance of a proper accounting system, safeguarding of the Bank s assets, and prevention and detection of fraud and other irregularities. They are also responsible for operating the Bank in compliance with the Law on Credit Institutions, regulations of the Financial and Capital Market Commission and the Bank of Latvia, and other laws of the Republic of Latvia applicable to credit institutions. For the Bank s management, Chairman of the Board Armands Šteinbergs Deputy Chairman of the Board Inna Harčenko 21 February

8 STATEMENT OF COMPREHENSIVE INCOME For the year ended 31 December 2010 Notes Interest income 5, ,184 Interest expense 6 (494) (494) Net interest income Fee and commission income 7, Fee and commission expense 8, 31 (75) (91) Net commission and fee income Net foreign exchange income 9 2,886 3,220 Other expenses (234) (200) Operating income 3,891 4,245 Impairment losses 11 (2) (5) General administrative expenses 10 (2,172) (1,779) Profit before income tax 1,717 2,461 Income tax expense 12 (220) (374) Profit for the year 1,497 2,087 Other comprehensive income Available-for-sale financial instruments revaluation 2 - Other comprehensive income for the year 2 - Total comprehensive income for the year 1,499 2,087 The accompanying notes on pages 12 to 68 form an integral part of these financial statements. Chairman of the Board Armands Šteinbergs Deputy Chairman of the Board Inna Harčenko 21 February

9 STATEMENT OF FINANCIAL POSITION As at 31 December 2010 Notes 31/12/ /12/2009 ASSETS Cash and demand deposits with the Bank of Latvia 13 7,551 10,383 Loans and advances due from financial institutions 14, , ,148 Loans and advances due from customers 16, Available-for-sale instruments Property and equipment Intangible assets Deferred tax asset 9 12 Income tax asset Other tax asset 44 - Other assets 20, Total assets 445, ,158 LIABILITIES AND SHAREHOLDER S EQUITY Deposits and balances due to financial institutions 21, Current accounts and deposits due to customers 22, , ,299 Provisions Tax payable 20 2 Other liabilities Total liabilities 400, ,259 Share capital 8,200 8,200 Share premium 4,470 4,470 Available-for-sale instruments revaluation reserve 3 1 Other reserves 1 1 Retained earnings 31,724 30,227 Total shareholder s equity 25 44,398 42,899 Total liabilities and shareholder s equity 445, ,158 Contingent liabilities and commitments 27, 31 Funds under trust management 30, 31 The accompanying notes on pages 12 to 68 form an integral part of these financial statements. Chairman of the Board Armands Šteinbergs Deputy Chairman of the Board Inna Harčenko 21 February

10 STATEMENT OF CASH FLOW For the year ended 31 December 2010 Notes CASH FLOW FROM OPERATING ACTIVITIES Profit before income tax 1,717 2,461 Depreciation and amortisation 18, Disposal of equipment 2 - Change in impairment allowances 11 (2) (5) Change in provisions (59) 39 Unrealised foreign exchange gain/(loss) 3 (233) Increase in cash and cash equivalents before changes in assets and liabilities, as a result of ordinary operations 1,742 2,332 (Increase)/decrease in loans and advances due from financial institutions 27,367 (27,860) (Increase)/decrease in loans and advances to customers (73) 70 Increase in prepaid expense and accrued income (16) - (Increase)/decrease in other assets 785 (77) Increase/(decrease) in current account and deposits due to customers ,013 (62,689) Increase/(decrease) in deferred income and accrued expense 17 (121) Increase/(decrease) in other liabilities 132 (40) Increase/(decrease) in cash and cash equivalents from operating activities before corporate income tax 206,967 (88,385) Corporate income tax paid (396) (991) Net cash and cash equivalents from/(used in) operating activities 206,571 (89,376) CASH FLOW FROM INVESTING ACTIVITIES Acquisition of property and equipment and intangible assets 18, 19 (363) (35) Increase in cash and cash equivalents from investing activities (363) (35) Net cash flow for the period 206,208 (89,411) Cash and cash equivalents at the beginning of the year 237, ,438 Cash and cash equivalents at the end of the year , ,027 OPERATIONAL CASH FLOWS FROM INTEREST Interest paid (521) (635) Interest received 899 1,204 There were no dividends paid or received during the years 2010 and The accompanying notes on pages 12 to 68 form an integral part of these financial statements. Chairman of the Board Armands Šteinbergs Deputy Chairman of the Board Inna Harčenko 21 February

11 STATEMENT OF CHANGES IN SHAREHOLDER S EQUITY For the year ended 31 December 2010 Share capital Share premium Other reserves Available for sale instruments revaluation reserve Retained earnings Total Balance as at 31 December ,200 4, ,140 40,812 Profit for the year ,087 2,087 Balance as at 31 December ,200 4, ,227 42,899 Other comprehensive income Profit for the year ,497 1,497 Balance as at 31 December ,200 4, ,724 44,398 The accompanying notes on pages 12 to 68 form an integral part of these financial statements. Chairman of the Board Armands Šteinbergs Deputy Chairman of the Board Inna Harčenko 21 February

12 1 GENERAL INFORMATION Information on the Bank AS LTB Bank (the Bank ) was established in the Republic of Latvia on 6 December 1991 as a closed joint stock company. The Bank operates under a banking license issued by the Financial and Capital Market Commission according to which the Bank is allowed to conduct financial services without any restrictions. The principal activities of the Bank involve local and international money transfers, trade financing, trust operations, granting loans to private individuals and corporate customers, foreign exchange transactions on behalf of customers and safeguarding services (individual depositories). At the end of 2009 the Bank completed the first stage for the plan to create a regional presence in the EU. Management made a decision on opening a branch office in the Republic of Cyprus, and received permission for it from supervisory authorities in Latvia and Cyprus. As a result, during 2010 all preparatory measures for commencing operations and servicing customers in the Republic of Cyprus were completed and activities of the Bank s branch were started at October 8, 2010: Information about the branch: AS LTB Bank Cyprus Branch, Address: 82, Nikou Pattichi, Maritania Court, P.C. 3070, Limassol, Cyprus Legislation regulating the Bank s operations The Bank s operations are governed by the Law of the Republic of Latvia on Credit Institutions, the Commercial Law, other laws of the Republic of Latvia, and regulations issued by the Financial and Capital Market Commission. The above regulations govern capital adequacy, minimum equity, liquidity, foreign exchange positions, exposure restrictions with respect to one counterparty, a group of related customers, and related parties of the Bank, as well as other applicable requirements. Authorisation of financial statements According to the requirements of the legislation of the Republic of Latvia, on 10 February 2011, the Board of the Bank examined the Bank s financial statements for the year ended 31 December 2010 and submitted them to the Council for reviewing and the auditor of the Bank for auditing. The Council reviews the financial statements submitted by the Board and prepares a written report hereon. The financial statements are confirmed by the shareholder s meeting convened by the Board after both the auditors and the Council s reports have been received. The financial statements were authorized for issue by the Board of Directors on 10 February The shareholders have the power to reject the financial statements prepared and presented by management and the right to request that new financial statements be prepared. 12

13 2 ACCOUNTING POLICIES (1) Statement of compliance The financial statements of the Bank have been prepared in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union (EU) and regulations of the Financial and Capital Market Commission s Regulations on the preparation of annual reports and annual consolidated accounts for banks, investment brokerage firms and investment management companies in force as at the reporting date. (2) Basis of preparation The accounting system of the Bank is organised in accordance with the legislation of the Republic of Latvia, including requirements applicable to credit institutions operating in Latvia. The financial year of the Bank coincides with the calendar year and includes financial information of the Bank and it s branch in Cyprus. The financial statements have been prepared on a historical cost basis for assets and liabilities except for derivatives carried at fair value, financial assets and liabilities designated at fair value through profit or loss, and available-for-sale assets whose fair value can be reliably estimated. The financial statements have been prepared using accounting principles consistent with those used in the prior year, except as disclosed in note 2 (16). The accompanying financial statements are reported in thousands of lats (), which is the functional and presentation currency of the Bank. Figures in brackets contained in the comments to the notes to the financial statements represent figures as at 31 December 2009, unless otherwise stated. (3) Use of significant accounting estimates and judgments The preparation of financial statements in conformity with IFRSs as adopted by the EU requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets and liabilities, income and expenses. The estimates and associated assumptions are based on historical experience and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis of making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates. The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognised in the period in which the estimate is revised if the revision affects only that period or in the period of the revision and future periods if the revision affects both current and future periods. Estimation and assumptions related to depreciation and amortisation rates of equipment and intangible assets, determining the allowance for credit losses and the fair value of financial assets and liabilities are not assumed as significant areas for financial year ended as at 31 December 2010 and 31 December (4) Foreign currency Foreign currency transactions Transactions denominated in foreign currencies are recorded in lats at the exchange rate set by the Bank of Latvia on the transaction date. Currency exchange differences arising from foreign currency transactions are charged to the statement of comprehensive income on the transaction date. 13

14 2 ACCOUNTING POLICIES (CONTINUED) All monetary assets and liabilities, including funds under trust management, contingent liabilities and commitments denominated in foreign currencies are translated into lats in accordance with the exchange rate set by the Bank of Latvia on the last date of the reporting period. Currency exchange differences arising due to changes in exchange rates are charged to the statement of comprehensive income as incurred, except for differences arising from revaluation of available-for-sale equity instruments which are recognised in other comprehensive income. Non-monetary assets and liabilities denominated in foreign currencies that are measured at fair value or cost are translated at the exchange rate at the date when the fair value or cost is determined. Foreign operations The assets and liabilities of foreign operations are translated into LVL at exchange rates set by Bank of Latvia at the reporting date. The income and expenses of foreign operations are translated into LVL at average exchange rates. Foreign exchange rates for the key currencies at the end of the reporting period were the following (LVL vs. one unit of foreign currency): Reporting date USD EUR RUB 31 December December Foreign exchange gains or losses arising from a monetary item receivable from or payable to a foreign operation, the settlement of which is neither planned nor likely in the foreseeable future and which in substance is considered to form part of the net investment in the foreign operation, are recognised directly in the foreign currency translation reserve. (5) Income and expense recognition All income and expense categories, including interest income and expense, are recognised on an accrual basis. Income is recognised only to the extent that an inflow of economic benefits to the Bank is possible and such income is reasonably estimable. Impairment loss is recognised if the receipt of income becomes doubtful. Interest income and expense are recognised in the income statement using the effective interest rate method. Payments made by the Bank to the deposit guarantee fund are disclosed under other interest expense. Loan origination fees and other fees that are considered to be integral to the overall profitability of a loan, together with the related direct costs, are deferred and amortised to interest income over the estimated life of the financial instrument using the effective interest rate method. Commission and fee income and expense on non-recurring services are recognised on the transaction date on an accrual basis. Commission and fee income and expense on services provided or received in a certain period of time are accrued and charged to the income statement over the period of the services received/rendered. Other fees, commissions and other income and expense items are recognised when the corresponding service has been provided. Dividend income is recognised in the statement of comprehensive income on the date that the dividend is declared. 14

15 2 ACCOUNTING POLICIES (CONTINUED) (6) Financial instruments Initial recognition Financial instruments are recognised when the Bank becomes a party to the contractual provisions of the instrument. All regular way purchases and sales of financial assets are recognised in the statement of financial position on the settlement date representing the date when the financial asset is delivered. In the period between the dates of transaction and settlement, the Bank accounts for the changes in the fair value of the received or transferred asset based on the same principles as used for any other acquired asset of the respective category. Derecognition Financial assets are derecognised when the rights to receive cash flows from the financial asset have expired or where the Bank has transferred substantially all the risks and rewards of ownership. Financial liabilities are derecognised when the obligation is discharged, or cancelled or expire. The Bank also derecognises certain assets when it writes off balances pertaining to the assets deemed to be uncollectible. Classification Upon initial recognition, all financial instruments are classified into one of the following categories: Financial assets and liabilities designated at fair value through profit or loss are: Held-for-trading financial instruments; and Financial assets and liabilities designated at fair value through profit or loss upon initial recognition. A financial instrument is classified as held for trading if it is acquired or incurred principally for the purposes of selling or repurchasing in the near term or it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking. Derivatives are also categorised as held for trading unless they are designated as hedging instruments for hedge accounting purposes. The financial instrument may be designated at fair value through profit or loss when: Doing so significantly reduces measurement inconsistencies; Certain assets are managed and evaluated on a fair value basis in accordance with a documented risk management or investment strategy and reported to key management personnel on that basis; Financial instruments containing one or more embedded derivatives that significantly modify the cash flow are designated at fair value through profit or loss. Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity with respect to which the Bank has the positive intention and ability to hold them to maturity. Held-to-maturity investments include certain debt securities. Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than: Those that the Bank intends to sell immediately or in the short-term; Those that the Bank upon initial recognition designates as at fair value through profit or loss or as available-for-sale; Those for which the holder may not recover substantially all of its initial investments, other than because of credit deterioration. 15

16 2 ACCOUNTING POLICIES (CONTINUED) Loans and receivables include term deposits due from credit institutions, loans and receivables due from customers, and other financial assets which meet these classification criteria. Available-for-sale financial assets are financial assets classified at inception as available-for-sale or assets other than classified as held-for-trading, held-to-maturity, or loans and receivables. Availablefor-sale assets include short-term investments and certain debt and equity securities. Generally, this category is assigned by the Bank to financial assets that are held for an indeterminate period of time and may be sold based on liquidity or interest rate needs, or as a result of changes in exchange rates and share prices. Financial liabilities carried at amortised cost represent financial liabilities of the Bank other than financial liabilities designated at fair value through profit or loss. This category includes term balances due to credit institutions, customer deposits, and other financial liabilities corresponding to such a classification. Measurement Financial instruments are measured initially at fair value and except for financial instruments at fair value through profit or loss include directly attributable transaction costs. Subsequent to initial recognition, all financial assets and liabilities designated at fair value through profit or loss and all available-for-sale financial assets are measured at fair value except those equity instruments for which no reliable fair value measurement is possible. In this case, such instruments are carried at cost less transaction expenses and impairment loss. All other financial assets are measured at amortised cost using the effective interest rate method. All financial liabilities other than financial liabilities designated at fair value through profit or loss are measured at amortised cost using the effective interest rate method. Profit or loss arising from changes to the fair value of financial assets and liabilities designated at fair value through profit or loss are recognised in the income statement. Differences arising from changes to the fair value of available-for-sale financial instruments are recognised in other comprehensive income. Fair value measurement principles Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction on the measurement date. When available, the Bank measures the fair value of an instrument using quoted prices in an active market for that instrument. A market is regarded as active if quoted prices are readily and regularly available and represent actual and regularly occurring market transactions on an arm s length basis. If a market for a financial instrument is not active, the Bank establishes fair value using a valuation technique. Valuation techniques include using recent arm s length transactions between knowledgeable, willing parties (if available), reference to the current fair value of other instruments that are substantially the same, discounted cash flow analyses and option pricing models. The chosen valuation technique makes maximum use of market inputs, relies as little as possible on estimates specific to the Bank, incorporates all factors that market participants would consider in setting a price, and is consistent with accepted economic methodologies for pricing financial instruments. Inputs to valuation techniques reasonably represent market expectations and measures of the risk-return factors inherent in the financial instrument. The Bank calibrates valuation techniques and tests them for 16

17 2 ACCOUNTING POLICIES (CONTINUED) validity using prices from observable current market transactions in the same instrument or based on other available observable market data. The best evidence of the fair value of a financial instrument at initial recognition is the transaction price, i.e., the fair value of the consideration given or received, unless the fair value of that instrument is evidenced by comparison with other observable current market transactions in the same instrument (i.e., without modification or repackaging) or based on a valuation technique whose variables include only data from observable markets. When transaction price provides the best evidence of fair value at initial recognition, the financial instrument is initially measured at the transaction price and any difference between this price and the value initially obtained from a valuation model is subsequently recognised in statement of comprehensive income depending on the individual facts and circumstances of the transaction but not later than when the valuation is supported wholly by observable market data or the transaction is closed out. Assets and long positions are measured at a bid price; liabilities and short positions are measured at an asking price. Where the Bank has positions with offsetting risks, mid-market prices are used to measure the offsetting risk positions and a bid or asking price adjustment is applied only to the net open position as appropriate. Fair values reflect the credit risk of the instrument and include adjustments to take account of the credit risk of the counterparty where appropriate. Fair value estimates obtained from models are adjusted for any other factors, such as liquidity risk or model uncertainties, to the extent that the Bank believes a third-party market participant would take them into account in pricing a transaction. Offsetting Financial assets and liabilities are offset and the net amount reported in the statement of financial position when there is a legally enforceable right to set off the recognised amounts and there is an intention to settle on a net basis, or realise the asset and settle the liability simultaneously. (7) Impairment losses Financial assets carried at amortised cost The Bank assesses at each reporting date whether there is any objective evidence that a financial asset or a group of financial assets is impaired. A financial asset or a group of financial assets is impaired and impairment losses are incurred if there is objective evidence of impairment as a result of one or more loss events that occurred after the initial recognition and that event has an impact on the estimated future cash flows that can be reliably estimated. The criteria that the Bank uses to determine that there is objective evidence of an impairment loss include: Delinquency in contractual payments of principal and/or interest; Cash flow difficulties experienced by the borrower; Breach of the loan covenant or conditions; Initiation of bankruptcy proceedings; Deterioration of the borrower s competitive position; Deterioration in the value of collateral; Downgrading below investment grade level. 17

18 2 ACCOUNTING POLICIES (CONTINUED) The Bank first assesses whether objective evidence of impairment exists individually for financial assets that are individually significant, and individually or collectively for those that are not individually significant. If no objective evidence of impairment is determined for individual assets, whether significant or not, the impairment is tested collectively for groups of assets with similar credit characteristics, excluding assets for which an impairment loss is or continues to be recognised on an individual basis. The amount of the loss is measured as a difference between the asset s carrying amount and its recoverable amount. The carrying amount of the asset is reduced through the use of the allowance account and the amount of the loss is recognised in the income statement. When an asset is uncollectible, it is written off against the related allowances. Recovered amounts are disclosed in the income statement as a reduction in the allowance for bad debts. Available-for-sale financial assets The Bank assesses at each reporting date whether there is any objective evidence that a financial asset or a group of financial assets is impaired. In the case of equity investments classified as available-forsale, objective evidence would include a significant or prolonged decline in the fair value of the investment below its cost. The Bank considers more than 20% decline below cost as significant and a decline for more than one yearly accounting period as prolonged. If any such evidence exists, the cumulative loss measured as the difference between the acquisition cost and the current fair value, less any impairment loss previously recognised in income statement is reclassified from equity and recognised in the income statement. Impairment losses recognised in the income statement on equity instruments are not reversed through the income statement. If, in a subsequent period, the fair value of a debt instrument increases and the increase can be objectively related to the event occurring after the impairment loss was recognised in income statement, the impairment loss is reversed through the income statement. Other assets The book value of other Bank s assets other than a deferred tax asset is reviewed for impairment on each reporting date. If impairment indications exist, the recoverable amount of the asset is calculated. An impairment loss is recognised whenever the carrying amount of an asset exceeds its recoverable amount. All impairment losses are recognised in the income statement. (8) Calculation of the recoverable amount The recoverable amount of financial assets carried at amortised cost and at cost is calculated as the present value of future cash flows including amounts that may be recovered from guarantees and loan securities, discounted at the original effective interest rate. The recoverable amount of financial assets and liabilities designated at fair value through profit or loss, and available-for-sale assets is their fair value. The recoverable amount of other assets is the larger of the fair value less cost to sell and the value in use. In assessing the value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. The recoverable amount is determined for an individual asset, unless the asset does not generate cash inflows that are largely independent of those from other assets or groups of assets. If this is the case, the recoverable amount is determined for the cash-generating unit to which the asset belongs. 18

19 2 ACCOUNTING POLICIES (CONTINUED) (9) Property and equipment Property and equipment are stated at acquisition cost including direct costs, net of accumulated depreciation and impairment losses, if any. Depreciation is calculated on a straight-line basis. Annual depreciation rates are determined based on the useful life of the respective category of property and equipment. The following depreciation rates are used: Furniture and equipment 10 50% Computers and equipment 25% Software inseparable from equipment (OEM software) 25% Leasehold improvements are capitalised and depreciated over the remaining lease period on a straightline basis. Leasehold improvements are not depreciated as long as the respective assets are not completed. An item of property and equipment is derecognised upon disposal or when the asset is no longer in use and no future economic benefits are expected to arise from the continued use of the asset. Any gain or loss arising on derecognition of the asset calculated as the difference between the net disposal proceeds and the carrying amount of the item upon disposal is included in the income statement. Depreciation methods, useful lives, and residual values are reviewed annually. (10) Intangible assets Intangible assets are identifiable non-monetary assets without physical substance (licences and software that are separately identifiable from electronic devices, etc.) held for rendering of services or other purposes if it is expected that an economic benefit attributable to these assets will flow to the Bank. Intangible assets are stated at cost less accumulated amortisation and are amortised by equal charges to the income statement over the useful life of the asset. The useful life of each intangible asset is estimated on an individual basis, considering the contractual conditions, and/or based on the estimated period over which the asset is expected to generate economic benefits. The amortisation rates as per class of intangible assets are as follows: Software other than OEM 20% Mastercard licence 10% Other licences 20% Licences acquired by the Bank for a period up to one year are expensed as acquired. Amortisation methods and useful lives are reviewed annually. (11) Leased assets and lease payments Leases where the Bank assumes substantially all the risks and rewards of ownership are classified as finance leases. Upon initial recognition, the leased asset is measured at the lower of fair value and the present value of the minimum lease payments. Subsequent to initial recognition, the asset is accounted for in accordance with the accounting policy applicable to that asset. Other leases are operating leases and leased assets are not recognised on the Bank s statement of financial position. 19

20 2 ACCOUNTING POLICIES (CONTINUED) Minimum lease payments under finance leases are apportioned between the finance charges and the reduction of the outstanding liability. Finance charges are allocated to each period during the lease period so as to produce a constant periodic rate of interest on the remaining balance of the liability. Payments under operating leases are recognised in income statement on a straight-line basis over the term of the lease. Lease incentives received are recognised as an integral part of the total lease expense, over the term of the lease. (12) Trust operations The trust operations policy of the Bank sets forth the general guidelines on organisation and execution of trust operations, their control and monitoring. The Bank s policy for trust operations is reviewed annually. The Bank provides trust services only to customers of the Bank. Trust operations are accounted for separately from the Bank s own operations thus ensuring separate accounting in a separate trust sheet for assets of each customer, by customer and by type of assets under management. The Bank accepts no risk for its trust operations; all risk is retained by its customers. The Bank earns fee income for administration of trust operations. (13) Taxation Corporate income tax comprises current and deferred tax. In accordance with Latvian tax regulations, corporate income tax is applied at the rate of 15% on taxable income generated by the Bank during the taxation period (2009: 15%). In accordance with Cyprus tax regulations, corporate income tax is applied at the rate of 10% on taxable income generated by the Bank during the taxation period. Deferred tax is provided for temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Deferred tax is not recognised for the following temporary differences: the initial recognition of goodwill, the initial recognition of assets or liabilities in a transaction that is not a business combination and that affects neither accounting nor taxable profit or loss, and differences relating to investments in subsidiaries to the extent that they probably will not reverse in the foreseeable future. Deferred tax is measured at the tax rates that are expected to be applied to the temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the reporting date. A deferred tax asset is recognised only to the extent that it is probable that future taxable profits will be available against which the asset can be utilised. Deferred tax assets are reviewed at each reporting date and are reduced to the extent that it is no longer probable that the related tax benefit will be realised. (14) Provisions Provisions are recognised when the Bank has a present obligation (legal or constructive) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and a reliable estimate can be made of the amount of the obligation. If the effect is material, provisions are determined by discounting the expected future cash flows at pre-tax rate that reflects current market assessments of the time value of money and, where appropriate, the risks specific to the liability. The provision for employee holiday pay is calculated for each Bank employee based on the total number of vacation days earned but not taken, multiplied by the average daily remuneration expense for the preceding six months, to which bonuses and the relevant social security expense are added. 20

21 2 ACCOUNTING POLICIES (CONTINUED) (15) Cash and cash equivalents Cash and cash equivalents include notes and coins on hand, unrestricted balances held with central banks and highly liquid financial assets with original maturities of less than three months, which are subject to insignificant risk of changes in their fair value, and are used by the Bank in the management of its short-term commitments. (16) Adoption of new and/or changed IFRSs and IFRIC interpretations New Standards and Interpretations New and amended standards, and interpretations mandatory for the first time for the financial year beginning 1 January 2010 but not currently relevant to the Bank: IFRS 3 (revised), Business combinations, and consequential amendments to IAS 27, Consolidated and separate financial statements, IAS 28, Investments in associates, and IAS 31, Interests in joint ventures, are effective prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after 1 July The revised standard continues to apply the acquisition method to business combinations but with some significant changes compared with IFRS 3. For example, all payments to purchase a business are recorded at fair value at the acquisition date, with contingent payments classified as debt subsequently remeasured through the statement of comprehensive income. There is a choice on an acquisition-by-acquisition basis to measure the noncontrolling interest in the acquiree either at fair value or at the non-controlling interest s proportionate share of the acquiree s net assets. All acquisition-related costs are expensed. IAS 27 (revised) requires the effects of all transactions with noncontrolling interests to be recorded in equity if there is no change in control and these transactions will no longer result in goodwill or gains and losses. The standard also specifies the accounting when control is lost. Any remaining interest in the entity is remeasured to fair value, and a gain or loss is recognised in profit or loss. IFRIC 17, Distribution of non-cash assets to owners (effective on or after 1 July 2009). The interpretation was published in November This interpretation provides guidance on accounting for arrangements whereby an entity distributes noncash assets to shareholders either as a distribution of reserves or as dividends. IFRS 5 has also been amended to require that assets are classified as held for distribution only when they are available for distribution in their present condition and the distribution is highly probable. IFRIC 18, Transfers of assets from customers, effective for transfer of assets received on or after 1 July This interpretation clarifies the requirements of IFRSs for agreements in which an entity receives from a customer an item of property, plant and equipment that the entity must then use either to connect the customer to a network or to provide the customer with ongoing access to a supply of goods or services (such as a supply of electricity, gas or water). In some cases, the entity receives cash from a customer that must be used only to acquire or construct the item of property, plant, and equipment in order to connect the customer to a network or provide the customer with ongoing access to a supply of goods or services (or to do both). 21

22 2 ACCOUNTING POLICIES (CONTINUED) IFRIC 9, Reassessment of embedded derivatives and IAS 39, Financial instruments: Recognition and measurement, effective 1 July This amendment to IFRIC 9 requires an entity to assess whether an embedded derivative should be separated from a host contract when the entity reclassifies a hybrid financial asset out of the fair value through profit or loss category. This assessment is to be made based on circumstances that existed on the later of the date the entity first became a party to the contract and the date of any contract amendments that significantly change the cash flows of the contract. If the entity is unable to make this assessment, the hybrid instrument must remains classified as at fair value through profit or loss in its entirety. IFRIC 16, Hedges of a net investment in a foreign operation effective 1 July This amendment states that, in a hedge of a net investment in a foreign operation, qualifying hedging instruments may be held by any entity or entities within the Bank, including the foreign operation itself, as long as the designation, documentation and effectiveness requirements of IAS 39 that relate to a net investment hedge are satisfied. In particular, the Bank should clearly document its hedging strategy because of the possibility of different designations at different levels of the Bank. IAS 38 (amendment), Intangible assets, effective 1 January The amendment clarifies guidance in measuring the fair value of an intangible asset acquired in a business combination and permits the grouping of intangible assets as a single asset if each asset has similar useful economic lives. IAS 1 (amendment), Presentation of financial statements. The amendment clarifies that the potential settlement of a liability by the issue of equity is not relevant to its classification as current or non current. By amending the definition of current liability, the amendment permits a liability to be classified as non-current (provided that the entity has an unconditional right to defer settlement by transfer of cash or other assets for at least 12 months after the accounting period) notwithstanding the fact that the entity could be required by the counterparty to settle in shares at any time. IAS 36 (amendment), Impairment of assets, effective 1 January The amendment clarifies that the largest cash-generating unit (or group of units) to which goodwill should be allocated for the purposes of impairment testing is an operating segment, as defined by paragraph 5 of IFRS 8, Operating segments (that is, before the aggregation of segments with similar economic characteristics). IFRS 2 (amendments), Group cash-settled share-based payment transactions, effective form 1 January In addition to incorporating IFRIC 8, Scope of IFRS 2, and IFRIC 11, IFRS 2 Group and treasury share transactions, the amendments expand on the guidance in IFRIC 11 to address the classification of group arrangements that were not covered by that interpretation. IFRS 5 (amendment), Non-current assets held for sale and discontinued operations. The amendment clarifies that IFRS 5 specifies the disclosures required in respect of non-current assets (or disposal groups) classified as held for sale or discontinued operations. It also clarifies that the general requirement of IAS 1 still apply, in particular paragraph 15 (to achieve a fair presentation) and paragraph 125 (sources of estimation uncertainty) of IAS 1. 22

23 2 ACCOUNTING POLICIES (CONTINUED) A number of new standards, amendments to standards and interpretations are not yet effective for the year ended 31 December 2010, and have not been applied in preparing these financial statements: Revised IAS 24 Related Party Disclosure (effective for annual periods beginning on or after 1 January 2011). The amendment exempts government-related entities from the disclosure requirements in relation to related party transactions and outstanding balances, including commitments, with (a) a government that has control, joint control or significant influence over the reporting entity; and (b) another entity that is a related party because the same government has control, joint control or significant influence over both the reporting entity and the other entity. The revised Standard requires specific disclosures to be provided if a reporting entity takes advantage of this exemption. The revised Standard also amends the definition of a related party which resulted in new relations being included in the definition, such as, associates of the controlling shareholder and entities controlled, or jointly controlled, by key management personnel. Revised IAS 24 is not expected to result in new relations requiring disclosure in the financial statements. Amendment to IFRIC 14 IAS 19 The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction (effective for annual periods beginning on or after 1 January 2011). The amendment of IFRIC 14 addresses the accounting treatment for prepayments made when there is also a minimum funding requirements (MFR). Under the amendments, an entity is required to recognize certain prepayments as an asset on the basis that the entity has a future economic benefit from the prepayment in the form of reduced cash outflows in future years in which MFR payments would otherwise be required. The amendments to IFRIC 14 is not relevant to the Bank s financial statements as the Bank does not have any defined benefit plans with minimum funding requirements. IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments (effective for annual periods beginning on or after 1 July 2010). The Interpretation clarifies that equity instruments issued to a creditor to extinguish all or part of a financial liability in a debt for equity swap are consideration paid in accordance with IAS The initial measurement of equity instruments issued to extinguish a financial liability is at the fair value of those equity instruments, unless that fair value cannot be reliably measured, in which case the equity instrument should be measured to reflect the fair value of the financial liability extinguished. The difference between the carrying amount of the financial liability (or part of the financial liability) extinguished and the initial measurement amount of equity instruments issued should be recognized in profit or loss. The Group did not issue equity to extinguish any financial liability during the current period. Therefore, the Interpretation will have no impact on the comparative amounts in the Bank s financial statements for the year ending 31 December Further, since the Interpretation can relate only to transactions that will occur in the future, it is not possible to determine in advance the effects the application of the Interpretation will have. Amendment to IAS 32 Financial Instruments: Presentation Classification of Rights Issues (effective for annual periods beginning on or after 1 February 2010). The amendment requires that rights, options or warrants to acquire a fixed number of the entity s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. The amendments to IAS 32 are not relevant to the Bank s financial statements as the Bank has not issued such instruments at any time in the past. 23

24 2 ACCOUNTING POLICIES (CONTINUED) (17) Comparative information Certain balances for 2009 have been reclassified differently from the prior year, due to management judgment. There is no impact on the financial result from this change in reclassification. Prior year balances have been reclassified, where appropriate, to conform to current year presentation, for details refer to following notes: - Note 6 Interest expense ; - Note 24 Other liabilities tax payable disclosed separately from other liabilities. 24

25 3 FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES A number of the Bank s accounting policies and disclosures require the determination of fair value of financial assets and liabilities. The methods described below have been used for the determination of fair values. When applicable, further information about the assumptions made in determining fair values is disclosed in the respective notes. (1) Deposits with other credit institutions The fair value of demand deposits, overnight deposits and floating rate deposits is their carrying amount. The estimated fair value of fixed interest bearing deposits is based on discounted cash flows using prevailing money-market interest rates for debts with a similar credit risk and remaining maturity. (2) Loans due from customers The estimated fair value of loans represents the expected discounted amount of estimated future cash flows. The interest rates used to discount estimated cash flows are based on the prevailing moneymarket interest rates curve plus an adequate credit spread. (3) Shares and other non-fixed income securities The fair value of shares (S.W.I.F.T) and other non-fixed income securities is determined by reference to their quoted bid price at the reporting date, if available. For a non-material amount of non-listed shares, where disposal opportunities are limited, the assumption has been made that the reliable estimate of fair value is not possible. The fair value of S.W.I.F.T shares was determined based on the transfer amount approved for the respective year by the shareholder s meeting, that represents the price for new share allocation and participants quit price. (4) Derivative financial instruments The fair value of currency swaps is estimated by discounting the contractual cash flows to be received and to be paid in appropriate foreign currencies for the remaining maturity, and translating the difference of the discounted cash flows into lats, applying exchange rate set by Bank of Latvia. EURIBOR or LIBOR interest rates are used as the benchmark for risk-free interest rate for discounting purposes. (5) Balances due to other credit institutions and customers The estimated fair value of deposits with no stated maturities, which include also non-interest-bearing deposits, is the amount repayable on demand. The estimated fair value of overnight deposits is their carrying amount. The estimated fair value of fixed interest-bearing deposits not quoted in the active market is based on discounted cash flows using interest rates for new debts with a similar remaining maturity. 25

26 4 RISK AND CAPITAL MANAGEMENT The Bank s activities expose it to a variety of financial and non-financial risks. The Bank s strategic aim is to achieve an appropriate balance between risks assumed by the Bank and returns and minimize the potential adverse effect on the Bank s financial performance and operations. The risk management system is integrated in the framework of the Bank s internal control based on the effective bank supervision requirements laid down by the Financial and Capital Market Commission and the Basel Committee on Banking Supervision to provide for a risk control function and operational compliance control function independent from business units. Risk measurement, assessment and control functions are separated from the business unit (risk acceptance) functions. The Bank identifies all inherent significant risks and develops documents and implements appropriate policies for risk management, including measurement, assessment, control, mitigation, and risk reporting and disclosures. Policies are reviewed at least on an annual basis in line with changes in the Bank s operations and external factors impacting the Bank s activities. With respect to new products and services, the Bank assesses the potential inherent risks and approves risk management procedures prior to marketing these new products or services in order to timely and adequately identify risks and determine the permissible exposure limits. The most important types of risk are credit risk, including counterparty risk for credit institutions, concentration risk, liquidity risk, interest rate risk, foreign exchange risk, and operational risk. Market risks other that foreign exchange risks and interest rate risk, i.e. equity price risks are not significantfor the Bank. The independent risk control process does not include business risks such as changes in the environment, technology and industry. The impact of these risks has been taken into account during strategic planning. (1) Credit risk Credit risk represents the Bank s exposure to potential loss in case a borrower (debtor) or a business partner fails or refuses to fulfil his contractual liabilities towards the Bank. The Bank is exposed to credit risk which is a significant inherent risk for the Bank. Therefore, credit risk management is performed with particular care. The Bank is mainly exposed to two types of credit risks: counterparty risk when a business partner credit institution - fails or refuses to settle its contractual liabilities towards the Bank, and credit risk arising from the borrower s (debtor s) failure to meet his contractual liabilities towards the Bank. Sources of credit risk The key source for credit risk of the Bank is amounts due from credit institutions, which represent both a material asset and a significant line of business for the Bank. Credit risk exists also in connection with letters of credit, warranties/guarantees and credit limits on payments cards. For the Bank mostly as a payment bank, exposure to credit risk may interfere with liquidity management activities as the Bank should maintain sufficient funds on accounts with several principal correspondents to provide necessary customers payments in relevant currencies, which sometimes causes also significant concentrations with particular counterparties. Management and control of credit exposures The Bank ensures ongoing monitoring of concentrations of credit risk whenever they are identified, in particular, to individual counterparties or groups of counterparties, and to industries and countries. 26

27 4 RISK AND CAPITAL MANAGEMENT (CONTINUED) The Bank structures the levels of credit risk it undertakes by placing limits on the amount of risk accepted in relation to one counterparty, or a group of counterparties, and to geographical and industry segments, and for a specific type of transaction. Such limits are monitored on a revolving basis and subject to an annual or more frequent review, taking into account changes in the Bank s operations or external circumstances that can affect the Bank s operations. The credit risk monitoring system applied by the Bank comprises of regular review of the borrower s/ counterparty s credit standing as well as monitoring of the credit ratings granted by the international credit rating agencies, compliance with the contractual terms and conditions, fulfillment of the obligations, collateral control, as well as ongoing limit control. The Bank uses different credit risk management techniques for credit institutions and non-banks, but such techniques are applied consistently to all financial instruments used for items of financial position, contingent liabilities and commitments, associated with a particular counterparty or a group of related counterparties, as well as delivery risk in relation to foreign exchange transactions. Limits on exposures to operations with credit institutions and products are considered by the Assets and Liabilities Management Committee and approved by the Management Board. Limits on exposures to non-banks are considered by the Credit Committee and approved by the Management Board or the Supervisory Council depending on the authorisation scope. The Bank performs regular monitoring of the counterparty credit risk and in case a transaction is to be made with a member of a group of counterparties, the Bank would also assess the overall credit risk exposure of the group. The Bank ensures regular monitoring of the quality of receivables from counterparties/borrowers and the assessment of credit risk is performed by reference to expected loss and the amount of capital required for addressing credit risk. Exposures to related groups of counterparties and counterparties related to the Bank are also subject to regulatory requirements. According to the regulator s requirements, the amount of risk transactions with a non-bank client or a group of related non-bank clients must not exceed 25% of the Bank s equity. In case the client is a credit institution or an investment broker subject to capital adequacy requirements specified in the normative acts regulating the market of financial instruments, or a group of related clients includes one or several credit institutions or investment brokers referred to above, the amount of risk transactions with such clients or groups of related clients must not exceed the Bank's equity. At the same time, the Bank ensures that the amount of risk transactions with all other clients in the above group of related clients other than credit institutions or investment brokers does not exceed 25% of the Bank s equity. Regulations stipulate that the total risk transactions with parties related to the Bank must not exceed 15% of the Bank s equity. This restriction does not apply to the Bank's investment in subsidiaries and entities where the Bank holds stakes. Credit risk mitigation policies The Bank employs a range of credit risk mitigation methods. The most traditional method is taking security for funds disbursements, which is the common practice. Credit risk arising from issued warranties/guarantees and credit limits attached to payment cards is primarily covered by term deposits. The Bank has implemented guidelines with respect to various types of collateral. 27

28 4 RISK AND CAPITAL MANAGEMENT (CONTINUED) The required amount of collateral may differ depending on the level of credit risk but it is usually set to cover at least the outstanding principal. The Bank grants credit limits on payment cards that in general are not higher than 75% of the security deposit. The Bank s exposures to credit institutions are usually unsecured. Quantitative disclosures Further quantitative disclosures in respect of credit risk are presented in Note 33. (2) Foreign exchange risk Foreign exchange risk represents potential loss from revaluation of items of financial position and contingent liabilities and commitments denominated in foreign currencies due to movements in foreign exchange rates. Foreign exchange risk management process The foreign exchange risk management policy determines and regulates the tasks to be performed by the Bank s management and structural units and their responsibilities in managing foreign exchange risk, and foreign exchange risk control regulations and mitigation measures relevant for the Bank s transactions in foreign currencies, as well as measurement, reporting and disclosure procedures. Limits on the foreign exchange open position in a single currency and the total open position in foreign currencies are set both on open currency positions to be maintained during the business day and open positions at the end of the day which are monitored and controlled. Quantitative disclosures Further quantitative disclosures in respect of foreign exchange risk are presented in Note 34. (3) Liquidity risk Liquidity risk represents the Bank s exposure to significant loss in the event that the Bank does not have a sufficient amount of liquid assets to meet legally substantiated claims or overcome unplanned changes in the Bank s assets and/or market conditions on a timely basis. Liquidity risk management process The Bank s liquidity risk management policy sets the key principles and processes of liquidity risk management, tasks of management and structural units and their responsibilities in liquidity management and maintenance, methods and conditions, asset and liability management procedure, measures for preventing and managing liquidity crisis, and reporting and disclosure procedure. Liquidity risk management is performed by the Bank on the basis of the asset and liability management method ensuring a balanced asset and liability term structure. The Bank manages liquidity risk as an aggregate of market liquidity risk and financing liquidity risk. If necessary, current liquidity may be managed using other methods such as attracting interbank resources, entering into REPO transactions and FX SWAPs. 28

29 4 RISK AND CAPITAL MANAGEMENT (CONTINUED) The following techniques are used to manage liquidity: Assessment and regular analysis of early warning indicators that help identify adverse trends that may impact the Bank s liquidity; Cash flow planning and daily monitoring of the ageing structure of receivables and the Bank s liabilities in key currencies; Maintaining sufficient liquid funds such as balances on correspondent accounts and short-term inter-bank deposits to ensure that financial liabilities can be met; Monitoring of liquidity risk limits and restrictions and liquidity indicators by reference to the Bank's internal and regulating requirements. To cover liabilities the Bank maintains liquid assets in the amount of at least 70% of current liabilities of the Bank; Monitoring the term structure of assets and liabilities, which includes the impact of guarantees and unused loan commitments. The Bank does not calculate capital requirements for liquidity risk as it uses the above described risk management and hedging methods. Quantitative disclosures Further quantitative disclosures in respect of liquidity risk are presented in Note 35. (4) Interest rate risk Interest rate risk represents the Bank s exposure in the event that changes in interest rates have an adverse impact on the Bank s income and expenses and result in a decrease of the Bank s equity. Interest rate risk represents the risk that there may be changes in future cash flows connected with financial instruments (cash flow interest rate risk) or fair value of financial instruments (fair value interest rate risk) resulting from changes in interest rates on the market. The period when the interest rate of a financial instrument is constant determines how it is exposed to interest rate risk. Sources of interest rate risk The Bank mainly is exposed to cash flow interest rate risk which represents the effect of changes in interest rates on the Bank s net interest margin and the amount of net interest income due to the inadequate term structure of interest rate sensitive assets and liabilities. Interest rate risk management process The interest rate risk management policy states risk management principles, tasks and responsibilities of the Bank s management and structural units in interest rate risk management, interest rate risk measurement, setting of limits, and control processes, stress testing, as well as reporting and disclosure procedures. The Bank assesses the impact produced by changes in interest rates on the entire Bank s business, as well as transactions belonging to the Bank s trading and non-trading portfolios, and interest rate risk in each currency for which assets or liabilities exceed 5% of the total balance, and all currencies in total. Interest rate risk control and mitigation are performed through: Ensuring interest rate sensitive assets and liabilities are maintained up to an interest rate risk level acceptable to the Bank; Constant monitoring of changes in interest rates on the financial instrument and money markets; 29

30 4 RISK AND CAPITAL MANAGEMENT (CONTINUED) interest rate hedges, if necessary, as well as restricting option contracts for Bank s products related to interest rates; controlling customer contracts involving interest rate risk (such as option contracts). Quantitative disclosures Further quantitative disclosures in respect of interest rate risk are presented in Note 36. (5) Operational risk Operational risk is the risk that the Bank may suffer loss as a result of noncompliant, unsuccessful or incomplete internal processes or due to staff activities and system operations, or due to external impacts, including risks connected with information technologies and legal risks but excluding reputational risk and strategy and business risk. In order to identify operational risk events promptly and to take appropriate and timely measures to minimize operational risk the Bank has developed and implemented a statistical data base for registering operational risk events on a regular basis. The Bank has implemented a procedure that all employees regardless of their position immediately make entries of operational risk events in the Event Database upon identifying any circumstances that have caused or may cause losses (irrespective of the type) to the Bank or may inflict damage to the Bank s reputation. If required, all operational risk events entered in the Event Database are checked according to the procedures specified in internal documents, and risk mitigation measures are developed and assigned to improve the internal controls. Operational risk management process The Operational Risk Management Policy details the tasks to be performed by the Bank s management and structural units and their responsibilities in the operational risk management, the basic principles of the operational risk management system and operational risk management processes, reporting and disclosures. Besides the above policy, operational risk management connected with the Bank's information systems is regulated by Information System Management Policy and Information System Security Management Policy and internal documents that govern the application thereof. Operational risk management is performed in the Bank as a complex of systemic measures and it includes: identification and assessment of operational risks, control of operational risks, measures to mitigate operational risks, set duties, authorities and responsibilities, procedure for reporting and disclosures. The operational risk management system is integrated in the Bank s internal control system and is aimed at effective management of operational risk. The Bank reviews and improves the operational risk management system on a regular basis to reflect changes in the Bank s operations and external circumstances that impact operations. The control over operational risks in the Bank is performed using the following control procedures: Systematic assessment of the operational risk management system, including efficiency assessment; Compliance reviews against normative documents regulating operational risk management; 30

31 4 RISK AND CAPITAL MANAGEMENT (CONTINUED) Assessment of the results of operational risk assessment and stress testing and, if applicable, implementation of corrective measures in the risk management system; Consistent control over restrictions and limits imposed by internal documents regulating the respective area; Regular testing of business continuity plans; Assessment of changes in the Bank s operations and external environment in order to determine the potential impact on the Bank and its business processes; Providing the Bank s management with reports of various detail and information on operational risk management and non-compliance with procedures, restrictions and limits. Control over the development of new banking products or services and related internal documents in order to identify operational risks on a timely and complete basis, assess the acceptable level of operational risk and make a decision on risk management. Control over compliance with the Bank s procedures during implementation of new products and services. (6) Capital management The strategic objective of the Bank s capital management is to maintain the adequate capital base that would promote attaining the strategic business goals set by the Bank, that is: Comply with the regulatory requirements; Be sufficient and optimal to support and further development of the Bank s business in terms of both volume and structure; Ensure that the Bank s capital, which, based on the internal calculations, is required to cover risks and to establish the capital reserve, both existing and potential, inherent in the current and future business of the Bank, is sufficient to cover significant inherent risks and establish the capital reserve in terms of amount, components and proportion. The Law on Credit Institutions and the regulations developed by the Financial and Capital Market Commission to apply the provisions of this Law require that the Bank maintains equity that at all times is equal to or exceeds the minimum regulatory capital requirement. In 2010, the Bank calculated the statutory capital and capital requirements according to the Regulations of the Financial and Capital Market Commission on the Calculation of Minimum Capital Requirements and the Regulations on the establishment of the process of capital adequacy assessment that are based on the provisions of Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) and Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast). The minimum capital requirement for credit risk is calculated according to the standardised approach. Operational risk employs the basic indicator approach to calculate the capital requirement. 31

32 4 RISK AND CAPITAL MANAGEMENT (CONTINUED) The table below summarises the regulatory capital, capital requirements, and capital adequacy ratios of the Bank as at 31 December /12/2010 Tier 1 capital Paid-in share capital 8,200 Share premium 4,470 Reserve capital 1 Retained earnings 30,227 Profit for the reporting year 1,497 Less: intangible assets (275) Total Tier 1 capital 44,120 Equity used for capital adequacy calculation 44,120 Summary of calculations Capital requirement for credit risk in the banking book: (7,536) Due from central governments and central banks (275) Due from regional governments (1) Due from and contingent liabilities to credit institutions (7,089) Due from and contingent liabilities to companies (99) Other items of financial position and contingent liabilities (72) Total capital requirements for market risks, including: (131) Capital requirement for currency risk (131) Capital requirement for operational risk (1,351) Total capital requirement (9,018) Surplus of available equity over capital requirement 35,102 Capital adequacy ratio 39.14% A detailed capital adequacy calculation is provided in Note 37. The capital management policy of the Bank lays down the key principles of capital management, components and definition of the capital, tasks of the Bank s management and structural units and their responsibilities, capital calculation, capital management process and control, reporting and disclosure procedures, as well as emergency actions. According to the policy, the Bank s capital should be always larger and the methods employed for capital assessment should be more prudent than it is prescribed by laws. The Bank manages its capital by setting the target range for the capital adequacy ratio, which is treated as a measure of whether the strategic objectives set in capital management have been attained. The goal of capital management control is to maintain the adequate capital to cover significant risks and keep the reserve on an ongoing basis as well as to comply with the capital adequacy targets set by the Bank. The Bank performs control of the capital management process as a set of systematic measures, defining the relevant control procedures. A detailed internal capital adequacy calculation is provided in Note

33 5 INTEREST INCOME Loans and advances due from financial institutions 895 1,171 Loans and advances due from customers ,184 6 INTEREST EXPENSE Current accounts and deposits due to customers Other interest expense * The Bank has reclassified LVL 36 thousand from other interest expense to Other expenses in year 2009 disclosure. 7 FEE AND COMMISSION INCOME Money transfers Trust account servicing Current account servicing Payment cards Documentary operations - 5 Other FEE AND COMMISSION EXPENSE Money transfers Payment cards Other commission and fee expense NET FOREIGN EXCHANGE INCOME Gain on currency exchange transactions 2,788 2,804 Gain on translation of balances denominated in foreign currencies Unrealized gain on currency exchange transactions ,886 3,220 33

34 10 GENERAL ADMINISTRATIVE EXPENSE Remuneration to the Board and Council members Remuneration to staff Statutory social insurance contributions Depreciation and amortisation Rent expenses Security Professional services Telecommunications Taxes 3 1 Transportation Repairs and maintenance of premises Business trips Advertising and marketing 4 - Representation expense 13 1 Charity and sponsorship 2 2 Other expense ,172 1,779 The average number of the Bank s employees in 2010 was 64 ( ). 11 IMPAIRMENT LOSSES Loans and advances due from customers Other assets Total As at 31 December Allowance for impairment Write-off of the allowance for impairment - (2) (2) As at 31 December Allowance for impairment Write-off of the allowance for impairment - (2) (2) As at 31 December INCOME TAX EXPENSE The components of income tax expense for the years ended 31 December 2010 were as follows: Current income tax Deferred tax 3 (3) Total income tax expense

35 12 INCOME TAX EXPENSE (CONTINUED) The table below discloses the difference between the actual and theoretical income taxes using the base rate of 15% (2009: 15%): Income before tax 1,717 2,461 Income tax at the statutory rate of 15% Tax effects of expenses not deductible in determining taxable profit (38) 7 Tax effects of tax rebates - (2) Total tax expense for the year The following table presents deferred tax included in the statement of financial position and changes recorded in the income statement for the years ended 31 December 2010 and 2009: 31/12/ /12/2009 Deferred tax asset at the beginning of the year (12) (9) (Increase)/ decrease of deferred tax assets during the year 3 (3) Deferred tax asset at the end of the year (9) (12) The temporary differences that (increase)/ decrease the deferred tax asset as at 31 December 2010 and 2009 are presented in the following statement of financial position captions: 31/12/ /12/2009 Accelerated depreciation of property and equipment Provisions (18) (27) Tax losses carried forward (branch) (20) - Deferred tax asset at the end of the year (9) (12) The Bank s management believes that there is reasonable certainty that future taxable profit will be sufficient to fully recover the recognised deferred tax asset in the taxation period following the reporting year. 13 CASH AND DEMAND DEPOSITS WITH CENTRAL BANKS 31/12/ /12/2009 Cash Demand deposits with the Bank of Latvia 7,274 10,032 Total cash and demand deposits with central banks 7,551 10,383 Demand deposits with the Bank of Latvia represent cash on the correspondent account used for clearing purposes and to comply with the obligatory reserve requirement. The Bank receives interest income on these balances within the limits set in the obligatory reserve requirement. In accordance with the Bank of Latvia regulations, the Bank has to comply with the obligatory reserve requirement ranging from 0% to 5%, depending on the Bank s total attracted resources subject to the reserve requirement at the end of each month. The compulsory reserve is compared to the Bank s average monthly correspondent account balance in LVL. The Bank s average correspondent balance should exceed the compulsory reserve requirement. The Bank was in compliance with the aforementioned compulsory reserve requirement at the end of the reporting year. 35

36 14 LOANS AND ADVANCES DUE FROM FINANCIAL INSTITUTIONS 31/12/ /12/2009 Nostro accounts Latvian commercial banks OECD banks 380, ,606 Non-OECD banks 14,365 35,168 Total nostro accounts 395, ,816 Loans and deposits Latvian commercial banks 7,504 12,730 OECD banks 33,729 34,602 Total loans and deposits 41,233 47,332 Total loans and advances due from financial institutions 436, ,148 For concentration risk please see Note FINANCIAL INSTRUMENTS AT FAIR VALUE THROUGH PROFIT OR LOSS The Bank uses derivatives for generating risk-free trading profits and hedging currency risk. Transactions with derivatives are performed in accordance with the derivative usage strategy. The strategy for using derivatives is reviewed by the Asset and Liability Management Committee and approved by the Board. Hedge effectiveness is assessed for the derivatives used for hedging purposes. The Bank s transactions with derivatives are not exposed to position risk related to the underlying asset. The Bank s credit risk represents the potential cost to replace the swap contracts if the counterparties default on their obligations. To control the level of credit risk taken, the Bank assesses counterparty credit risk. Unfinished currency exchange deals (like SPOT and TOM) are not considered to be derivative financial instruments. As at 31 December 2010 the Bank had no derivative assets or liabilities. 36

37 16 LOANS AND ADVANCES DUE FROM CUSTOMERS The breakdown of loans is as follows: (a) by borrower 31/12/ /12/2009 Commercial loans Loans to small and medium size companies 2 3 Total commercial loans 2 3 Loans to individuals Consumer loans Credit cards Total loans to individuals Gross loans and advances due from customers Impairment allowance (2) (2) Net loans and advances due from customers Credit quality of commercial loan portfolio The following table provides information on the credit quality of the commercial loan portfolio as at 31 December 2010: Gross loans Impairment Net loans Impairment to gross loans % Loans for which no impairment has been identified: - Standard loans Total loans for which no impairment has been identified: Impaired loans: - overdue more than 1 year 2 (2) Total impaired loans 2 (2) Total commercial loans 2 (2)

38 16 LOANS AND ADVANCES DUE FROM CUSTOMERS (CONTINUED) The following table provides information on the credit quality of the commercial loan portfolio as at 31 December 2009: Loans for which no impairment has been identified: Impairment Gross loans Impairment Net loans to gross loans % - Standard loans Total loans for which no impairment has been identified: Impaired loans: - overdue more than 90 days and less than 1 year 2 (2) Total impaired loans 2 (2) Total commercial loans 3 (2) 1 67 Credit quality of loans to individuals The following table provides information on the credit quality of loans to individuals portfolios as at 31 December 2010: Gross loans Impairment Net loans Impairment to gross loans % Consumer loans - Not past due Total consumer loans Credit cards - Not past due Total credit cards Total loans to individuals The following table provides information on the credit quality of loans to individuals portfolios as at 31 December 2009: Gross loans Impairment Net loans Impairment to gross loans % Consumer loans - Not past due Total consumer loans Credit cards - Not past due Total credit cards Total loans to individuals

39 16 LOANS AND ADVANCES DUE FROM CUSTOMERS (CONTINUED) (b) by the term of agreement 31/12/ /12/2009 Up to one year More than one year Gross loans and advances due from customers Impairment allowance (2) (2) Net loans and advances due from customers (c) by industry 31/12/ /12/2009 Loans to small and medium size companies 2 3 Loans to individuals Gross loans and advances due from customers Impairment allowance (2) (2) Net loans and advances due from customers (d) by geographical region 31/12/ /12/2009 Latvia Non-OECD 4 8 Gross loans and advances due from customers Impairment allowance (2) (2) Net loans and advances due from customers AVAILABLE-FOR-SALE ASSETS 31/12/ /12/2009 Shares and other non-fixed income securities 11 9 Total available-for-sale financial assets 11 9 Shares and other non-fixed income securities represent an immaterial amount of un-listed and nonliquid shares of a Latvian private company, as well as S.W.I.F.T shares. S.W.I.F.T membership is required for ensuring payment services of the Bank. 39

40 18 PROPERTY AND EQUIPMENT Leasehold Other assets Total improvements Historical cost As at 31 December Additions Disposals - (36) (36) As at 31 December Accumulated depreciation As at 31 December Depreciation charge Disposals - (34) (34) As at 31 December Net carrying amount As at 31 December As at 31 December Leasehold improvements Other assets Total Historical cost As at 31 December Additions Disposals - (27) (27) As at 31 December Accumulated depreciation As at 31 December Depreciation charge Disposals - (27) (27) As at 31 December Net carrying amount As at 31 December As at 31 December All items of property and equipment are used in the operating activities of the Bank. 40

41 19 INTANGIBLE ASSETS Software and licences Historical cost As at 31 December Additions 238 As at 31 December Accumulated amortisation As at 31 December Amortisation charge 14 As at 31 December Net carrying amount As at 31 December As at 31 December Software and licences Historical cost As at 31 December Additions 15 As at 31 December Accumulated amortisation As at 31 December Amortisation charge 14 As at 31 December Net carrying amount As at 31 December As at 31 December All intangible assets including software are used in the operating activities of the Bank. 41

42 20 OTHER ASSETS 31/12/ /12/2009 Prepaid expense Accrued income Currency transactions in progress Other Less: allowance for impairment (3) (3) DEPOSITS AND BALANCES DUE TO FINANCIAL INSTITUTIONS 31/12/ /12/2009 Vostro accounts As at 31 December 2010 and 2009, the largest amounts due on demand were to AB Bankas Snoras (Lithuania). 22 CURRENT ACCOUNTS AND DEPOSITS DUE TO CUSTOMERS As at 31 December 2010, the largest deposit from one non related customer (registration country Virgin Islands) with the Bank amounted to LVL 234,910 thousand, or 59% of the total deposits (2009: LVL 56,546 thousand, or 25%), while the deposit from one group of related customers amounted to LVL 292,123 thousand, or 73% of the total deposits (2009: LVL 81,771 thousand, or 37%). As at 31 December 2010, a customer deposit on demand collateralizes loans and advances to financial institutions in amount of LVL 0 thousand (2009: LVL 24,450 thousand). The breakdown of current accounts and deposits due to customers is as follows: (a) by the term of the agreement 31/12/ /12/2009 Current accounts, including accrued interest 392, ,731 Deposits: up to six months 4,288 9,486 from six months to one year 2, more than one year 351 1,920 Accrued interest Total current accounts and deposits due to customers 400, ,299 42

43 22 CURRENT ACCOUNTS AND DEPOSITS DUE TO CUSTOMERS (CONTINUED) (b) by depositor 31/12/ /12/2009 Current accounts Residents: Private enterprises Private individuals Public organisations 1 3 Bank employees Non-residents: Financial institutions 6,184 2,376 Private enterprises 384, ,359 Private individuals 657 1, , ,930 Total demand deposits 392, ,731 Deposits Residents: Private enterprises Private individuals Public organisations - - Bank employees Non-residents: Private enterprises 6,649 11,060 Private individuals ,886 11,126 Total deposits 7,666 11,568 Total current accounts and deposits due to customers 400, ,299 Interest rates applied to deposits of the Bank s employees do not differ from interest rates on deposits from other customers. (c) by geographical region 31/12/ /12/2009 Residents of Latvia 1,709 1,243 Non-residents: Residents of OECD countries 28,225 39,910 Residents of other countries 370, ,146 Total current accounts and deposits due to customers 400, ,299 43

44 23 PROVISIONS Employee unused Bonuses Total holiday pay As at 31 December Increase in provisions Amounts charged against provisions (130) (125) (255) As at 31 December OTHER LIABILITIES 31/12/ /12/2009 Accrued expense Cash in transit 19 4 Payment card liabilities 1 5 Creditors Other SHAREHOLDER S EQUITY Share capital As at 31 December 2010 and 2009, the paid-in share capital of the Bank was LVL 8,200 thousand and consisted of 820,000 voting ordinary registered shares with the nominal value of LVL 10 each. The share capital is fully paid in. All the shares rank equally with regard to the Bank s residual assets, to the right to dividends and to vote at meetings of the Bank.The shareholders as at 31 December 2010 and 2009 are as follows: Shareholder Country 31/12/2010 % of the paid-in share capital 31/12/2009 % of the paid-in share capital MDM Bank Russian Federation The sole shareholder of MDM Bank with significant investment in the capital is MDM Holding SE, a holding company, whose investment amounts to 73.6% (ordinary) and whose beneficial owners are Sergejs Popovs, Igors Kims and Martins Andersons. Other shareholders include significant international financial institutions such as the European Bank for Reconstruction and Development (5.2% investment) and International Finance Corporation, part of the World Bank Group, (3.6%), and other legal entities and private individuals. Share premium In summer 2004, the Bank attracted an additional capital of LVL 2,980 thousand with share premium of LVL 4,470 thousand. Other reserves Other reserves comprise the remaining portion of the statutory reserves made in the previous years from the year end profit. As at 31 December 2010 and 2009 there was no legislative requirement for creation such a reserve. 44

45 26 CASH AND CASH EQUIVALENTS 31/12/ /12/2009 Cash and demand deposits with the Bank of Latvia 7,551 10,383 Loans and advances due from financial institutions 435, , , , CONTINGENT LIABILITIES AND COMMITMENTS 31/12/ /12/2009 Contingent liabilities Guarantees Commitments Credit cards commitments Unutilised credit lines and overdraft facilities 30,075-30, To meet the financial needs of customers, the Bank enters into various contingent liabilities and commitments. Even though these financial liabilities are not recognised in the statement of financial position, they do contain credit risk and are therefore part of the overall risk of the Bank. However, the potential credit loss is less than the total unused part of the liability since these are contingent upon customers maintaining specific standards. Issued guarantees commit the Bank to make payments on behalf of the customers in the event of a specific act. Other commitments represent contractual obligations on payment cards overdraft facilities. Since contingent liabilities and commitments may expire without being drawn on, the total contract amount do not necessarily represents future cash requirements. 28 OPERATING LEASES Leases as lessee For the Bank as a lessee, the breakdown of the future minimum lease payments by periods until the maturity of operating leases effective as at 31 December 2010 was as follows: Less than one year Between one and five years Total Rent of premises Rent of transport vehicles The leases typically run for an initial period of three to five years, with an option to renew the lease after that date. Lease payments are fixed for the whole lease period. None of the leases includes contingent rentals. During the current year LVL 139 thousand was recognised as an expense in the income statement in respect of operating leases (2009: LVL 101 thousand). 45

46 29 LITIGATION In the ordinary course of business, the Bank is subject to legal actions and complaints. Management believes that the ultimate liability, if any, arising from such actions or complaints, will not have a material adverse effect on the financial conditions of the results of future operations of the Bank. As the result no provision recognized as at 31 December FUNDS UNDER TRUST MANAGEMENT 31/12/ /12/2009 Assets under management Non-residents: Loans 6,777 23,912 Placement of resources 267 2,473 7,044 26,385 Liabilities under management Non-residents: Financial institutions - 9,780 Private enterprises 7,044 16,605 7,044 26, RELATED PARTY TRANSACTIONS Related parties are shareholders and actual owners with significant shareholdings in the Bank, members of the Council and the Board, head and staff of internal audit, their close relatives, and companies in which they hold significant investments. The Law on Credit Institutions defines significant investment as a shareholding of 10 or more per cent of the company s capital or voting shares, obtained directly or indirectly, or providing an opportunity to exercise significant influence over the company s activities. The definition of related parties of the Law on Credit Institutions generally complies with the requirements of IAS 24 which also specifies the requirements for disclosure of related party transactions in the financial statements. The Bank enters into transactions with related parties in the ordinary course of business. All the loans, advances and financing activities to related parties are given at market rates. For the year ended 31 December 2010, these are performing and free of any allowances for possible credit losses (2009: nil). 46

47 31 RELATED PARTY TRANSACTIONS (CONTINUED) The Bank s financial statements comprise the following outstanding balances, contingent liabilities and commitments, and statement of comprehensive income items of related parties: Statement of financial position 31/12/2010 Parent Bank 31/12/2009 Key management personnel 31/12/ /12/2009 Other related parties 31/12/ /12/2009 Assets Loans and advances due from financial institutions 14,344 35, Loans and advances due from customers Other assets ,345 35, Liabilities Deposits and balances due to financial institutions Current accounts and deposits due to customers ,230 51, ,230 51,226 Contingent liabilities and commitments Parent Bank Key management personnel Other related parties 31/12/ /12/ /12/ /12/ /12/ /12/2009 Assets under management ,229 Liabilities under management ,132 Other commitments ,003 - Statement of comprehensive income Parent Bank Key management personnel Other related parties Interest income Fee and commission income Fee and commission expense (2) (1) Detailed information about remuneration to the Board and Council members disclosed in note

48 32 FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES Set out below is the comparison of the carrying amounts and fair values of the Bank s financial instruments that are recognised in the financial statements. 31/12/ /12/2009 Carrying amount Fair value Carrying amount Fair value Cash and demand deposits with central banks 7,551 7,551 10,383 10,383 Loans and advances due from financial institutions 436, , , ,549 Loans and advances due from customers Available-for-sale assets Other financial assets Total financial assets 444, , , ,553 Deposits and balances due to financial institutions Current accounts and deposits due to customers 400, , , ,322 Other financial liabilities Total financial liabilities 400, , , ,974 The methodology for determining the fair value is disclosed in Note 3. The following table presents interest rates used to discount estimated cash flows, where applicable, by the classes of financial assets and financial liabilities. 31/12/ /12/2009 Loans and advances due from financial institutions % % Loans and advances due from customers % % Current accounts and deposits due to customers % % The following table shows an analysis of financial instruments recorded at fair value as at 31 December 2010, depending on the input data used for fair value determination purposes. Valuation techniques non-market observable inputs Shares and other non-fixed income securities 11 Total financial assets 11 The following table shows an analysis of financial instruments recorded at fair value as at 31 December 2009, depending on the input data used for fair value determination purposes. Valuation techniques non-market observable inputs Shares and other non-fixed income securities 9 Total financial assets 9 48

49 32 FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES (CONTINUED) As discussed in Note 3, the fair value of currency swaps is estimated by a valuation technique, which utilises the exchange rates of foreign currencies set by the Bank of Latvia as partly market observable input and EURIBOR or LIBOR interest rates as market observable input data. For financial instruments whose fair value is estimated using valuation techniques with non-market observable inputs, net unrealised amount due to changes in the inputs was zero during the year 2010 (2009: Nil). 33 CREDIT RISK Maximum credit risk exposure The table below shows the maximum exposure to credit risk for the components of the statement of financial position. Exposures are based on net carrying amounts as reported in the statement of financial position, less impairment allowances. The maximum credit exposures are shown both gross, i.e. without taking into account any collateral and other credit enhancements, and net, i.e. after taking into account any collateral and other credit enhancements. Notes Gross maximum credit exposure Net maximum credit exposure 31/12/ /12/ /12/ /12/2009 Demand deposits with the Bank of Latvia 13 7,274 10,032 7,274 10,032 Loans and advances due from financial institutions , , , ,698 Loans and advances due from customers Available-for-sale assets Other financial assets Total financial assets 444, , , ,351 Guarantees Credit cards commitments Unutilised credit lines and overdraft facilities 27 30,075-30,075 - Total contingent liabilities and commitments 30, , Total maximum credit risk exposure 474, , , ,437 As it is shown above, 92% of the total gross maximum credit exposure is derived from balances due from credit institutions (2009: 96%). 49

50 33 CREDIT RISK (CONTINUED) Concentrations of the maximum credit risk exposure The following table breaks down the gross exposure related to balances due from credit institutions by geographical regions and major counterparties or groups of related counterparties. 31/12/ /12/2009 Latvia AS Swedbanka 3, AS UniCredit Bank 3,500 12,226 AS SEB bank Total Latvia 7,548 12,772 OECD countries Deutsche Bank group USA, Germany, UK 218,366 18,424 UBS AG Switzerland 41,705 70,618 HSBC BANK group USA, UK 40, Raiffeisen Zentralbank International AG Austria 40, ,008 BNP PARIBAS France 40,125 2 VTB BANK (AUSTRIA) AG Austria 33,729 - STANDARD BANK LONDON UK - 12,696 NATIXIS France - 2,427 Other credit institutions 4 1 Total OECD countries 414, ,208 Other countries OAO MDM Bank Russian Federation 14,344 35,156 Other credit institutions Total other countries 14,365 35,168 Total balances due from credit institutions 436, ,148 The gross maximum credit risk exposure to a single counterparty or a group of related counterparties and to a single country as at 31 December 2010 comprised 50% of the total gross credit exposure attributable to balances due from credit institutions (2009: 40%). The Deutsche Bank group includes the following credit institutions: Deutsche Bank Trust Company Americas (USA), Deutsche Bank (Germany), and Deutsche Bank London Branch (UK). As at 31 December 2010, the largest credit risk exposure in this group was in relation to the Bank s receivables from Deutsche Bank Trust Company Americas (USA) (2009: Deutsche Bank (Germany)). 50

51 33 CREDIT RISK (CONTINUED) Credit quality per class of financial assets Credit quality of financial assets is managed by the Bank by employing debtors (borrowers ) financial analysis techniques, analysis of the counterparty s reputation and historical cooperation with the counterparty, as well as using credit ratings granted by international rating agencies. The transactions subject to credit risk are divided into four credit quality groups depending on the credit ratings published by international rating agencies. There are the following credit quality groups: Group 1: AAA, AA (Standard& Poor's, Fitch) / Aaa, Aa (Moody's) This group includes first class transaction partners who are considered to be low-risk investments. The largest exposure included in this group relates to receivables from Deutsche Bank group banks, HSBC Bank USA and BNP Paribas. (2009: Deutsche Bank group banks and HSBC Bank London branch). Group 2: A, BBB (Standard& Poor's, Fitch) / A, Baa (Moody's) This group includes transaction partners with a market position ranging from medium to good. The largest exposure included in this group relates to receivables from UBS AG, Raiffeisen Zentralbank International AG, VTB Bank (Austria) AG (2009: UBS AG and Raiffeisen Zentralbank Oesterreich AG). Group 3: BB, B, CCC, CC, (Standard& Poor's, Fitch) / Ba, B, C (Moody's) The largest credit risk exposure in this group relates to receivables from transaction partners below medium rating BB (Standard& Poor's, Fitch) / Ba (Moody's). Out of the above group, the most significant receivables are from MDM Bank (2009: MDM Bank). No rating Transaction partners who have not been assigned an international credit rating are primarily Latvian private credit institutions. In this group, the largest receivables are from AS Swedbank and AS UniCredit Bank (2009: AS UniCredit Bank ). The table below shows the credit quality by class of financial assets as at 31 December 2010 based on international ratings. Neither past due nor impaired Past due, but not Impaired Total Group 1 Group 2 Group 3 No rating impaired Demand deposits with the Bank of Latvia - - 7, ,274 Loans and advances due from financial institutions 298, ,567 14,355 7, ,243 Loans and advances due from customers Available-for-sale assets Other financial assets Total financial assets, gross 298, ,567 21,629 8, ,110 Less: impairment allowance (5) (5) Total financial assets, net 298, ,567 21,629 8, ,105 51

52 33 CREDIT RISK (CONTINUED) The credit quality by class of financial assets as at 31 December 2009 based on international ratings was as follows: Neither past due nor impaired Past due but not Impaired Total Group 1 Group 2 Group 3 No rating impaired Demand deposits with the Bank of Latvia - 10, ,032 Loans and advances due from financial institutions 18, ,750 35,168 12, ,148 Loans and advances due from customers Available-for-sale assets Other financial assets Total financial assets, gross 18, ,782 35,168 13, ,806 Less: impairment allowance (5) (5) Total financial assets, net 18, ,782 35,168 13, ,801 52

53 34 CURRENCY RISK Currency risk exposure The currency analysis of assets and liabilities by currency profile as at 31 December 2010 was as follows: LVL USD EUR RUB Other currencies Total Assets Cash and demand deposits with the Bank of Latvia 7, ,551 Loans and advances due from financial institutions 7, ,865 31, ,243 Loans and advances due from customers Available-for-sale assets Intangible assets, property and equipment Deferred tax asset Income tax receivable Other tax receivable Other assets Total assets 15, ,117 31, ,185 Liabilities and shareholder s equity Deposits and balances due to financial institutions Current accounts and deposits due to customers ,971 12,118 16, ,312 Provisions Other liabilities Shareholder s equity 44,583 - (185) ,398 Total liabilities and shareholder s equity 45, ,012 12,094 16, ,185 Net on and off statement of financial position (30,119) 27,105 19,315 (16,321) 20 Spot transaction receivables 28, ,089-46,637 Spot transaction liabilities - (27,802) (17,817) (651) - (46,270) Net open position (1,219) (49) 1,

54 34 CURRENCY RISK (CONTINUED) The currency analysis of assets and liabilities by currency profile as at 31 December 2009 was as follows: LVL USD EUR RUB Other currencies Total Assets Cash and demand deposits with the Bank of Latvia 10, ,383 Loans and advances due from financial institutions - 141, , ,148 Loans and advances due from customers Available-for-sale assets Intangible assets, property and equipment Deferred tax asset Income tax receivable Other tax receivable Other assets Total assets 11, , , ,158 Liabilities and shareholder s equity Deposits and balances due to financial institutions Current accounts and deposits due to customers ,614 94,199 6, ,299 Provisions Other liabilities Shareholder s equity 42, ,899 Total liabilities and shareholder s equity 43, ,023 94,439 6, ,158 Net on and off statement of financial position (31,920) 19,500 18,870 (6,350) (100) Spot transaction receivables 31, , ,438 Spot transaction liabilities - (19,256) (17,814) - - (37,070) Net open position (920) 244 1,056 (20) 8 54

55 34 CURRENCY RISK (CONTINUED) The open foreign currency position as at 31 December 2010 was as follows: Assets, including spot receivables Liabilities, including spot liabilities Open position % of equity USD 398, ,814 (49) (0.11%) EUR 31,409 29,911 1, % RUB 17,129 17, % Other % Total long position 1,635 Total short position (49) Total open position 1, % Capital requirement for currency risk 131 The total net foreign currency position is the higher absolute value of net long positions or net short positions of certain foreign currencies. The capital requirement for currency risk is calculated as 8% of the total net currency position. The open foreign currency position as at 31 December 2009 was as follows: Assets, including spot receivables Liabilities, including spot liabilities Open position % of equity USD 141, , % EUR 113, ,253 1, % RUB 6,510 6,530 (20) (0.05%) Other % Total long position 1,308 Total short position (20) Total open position 1, % Capital requirement for currency risk 105 As at 31 December 2010 and 2009, the Bank was in compliance with the restrictions as to open currency positions set by the Law on Credit Institutions. 55

56 34 CURRENCY RISK (CONTINUED) Sensitivity analysis The scenario used for the analysis is based on reasonable volatility of exchange rates equal for all exposures of the Bank in foreign currencies assuming that all other variables, in particular interest rates, remain constant. The analysis is performed on the same basis for both years. A five percent strengthening of the following foreign currencies against the lat as at 31 December 2010 and 31 December 2009 respectively would have increased profit by the amounts shown below: EUR RUB 6 (1) USD (1) 7 Total A five percent weakening of the above foreign currencies against the lat as at 31 December 2010 and 31 December 2009 respectively would have had equal absolute value but opposite effect on the above currencies, i.e. decreased profit by the amounts shown above. As the sensitivity analysis shows, as at 31 December 2010 and 2009 there was no direct effect on the shareholder s equity from exposures in the financial instruments whose changes in fair value related to movements of the currency rates. 56

57 35 LIQUIDITY RISK Maturity analysis The table below reflects the maturity analysis of assets and liabilities based on the term from the reporting date until the maturity dates of the respective assets and liabilities. The maturity analysis of items of financial position and contingent liabilities and commitments as at 31 December 2010 was as follows: On Up to 1 No Total demand month maturity From 1 to 3 months From 3 to 6 months From 6 to 12 months From 1 to 5 years Assets Cash and demand deposits with the Bank of Latvia 7, ,551 Loans and advances due from financial institutions 395,010 23,114 17, ,243 Loans and advances due from customers Available-for-sale assets Intangible assets, property and equipment Deferred tax asset Income tax receivable Other tax receivable Other assets Total assets 402,973 23,365 17, ,185 Liabilities and shareholder s equity Deposits and balances due to financial institutions Current accounts and deposits due to customers 392,646 4, , ,312 Provisions Other liabilities Shareholder s equity ,398 44,398 Total liabilities and shareholder s equity 392,739 4, , , ,185 Contingent liabilities and commitments (30,202) (30,202) Net liquidity position (19,968) 19,139 17,405 (165) (2,482) (227) (43,904) Amounts due from credit institutions repayable, according to contracts, by prior notice of withdrawal are included in the category On demand. Other assets and liabilities are disclosed in accordance with their remaining contractual maturities. 57

58 35 LIQUIDITY RISK (CONTINUED) The maturity analysis of items of financial position and contingent liabilities and commitments as at 31 December 2009 was as follows: On demand Up to 1 month From 1 to 3 months From 3 to 6 months From 6 to 12 months From 1 to 5 years No maturity Total Assets Cash and demand deposits with the Bank of Latvia 10, ,383 Loans and advances due from financial institutions 207,816 19, , ,148 Loans and advances due from customers Available-for-sale assets Intangible assets, property and equipment Deferred tax asset Income tax receivable Other assets Total assets 218,684 20, , ,158 Liabilities and shareholder s equity Deposits and balances due to financial institutions Current accounts and deposits due to customers 187,281 9, ,657 1, ,299 Provisions Other liabilities Shareholder s equity ,899 42,899 Total liabilities and shareholder s equity 187,924 9, ,840 1, , ,158 Contingent liabilities and commitments (113) (113) Net liquidity position 30,647 10,933 (308) 2,544 (1,264) 10 (42,675) 58

59 35 LIQUIDITY RISK (CONTINUED) Analysis of financial liabilities contractual undiscounted cash flows The table below presents the cash flows payable by the Bank under contractual financial liabilities, including derivative financial liabilities, by remaining contractual maturities as at the reporting date. The amounts disclosed in the table are the contractual undiscounted cash flows in comparison with the carrying amounts of financial liabilities, comprising discounted cash flows as at the reporting date. The analysis as at 31 December 2010 was as follows: Carrying amount Contractual cash flows Up to 1 month From 1 to 3 months From 3 to 12 months From 1 to 5 years Non-derivative financial instruments Deposits and balances due to financial institutions 55 (55) (55) Current accounts and deposits due to customers 400,312 (400,407) (396,753) (127) (3,060) (467) Total 400,367 (400,462) (396,808) (127) (3,060) (467) The analysis as at 31 December 2009 was as follows: Carrying amount Contractual cash flows Up to 1 month From 1 to 3 months From 3 to 12 months From 1 to 5 years Non-derivative financial instruments Deposits and balances due to financial institutions 633 (633) (633) Current accounts and deposits due to customers 223,299 (223,362) (220,791) (512) (2,008) (51) Total 223,932 (223,995) (221,424) (512) (2,008) (51) Analysis of financial assets contractual undiscounted cash flows The table below presents the cash flows payable to the Bank under contractual financial assets, including derivative financial assets, by remaining contractual maturities as at the reporting date. The amounts disclosed in the table are the contractual undiscounted cash flows in comparison with the carrying amounts of financial assets, comprising discounted cash flows as at the reporting date. The analysis as at 31 December 2010 was as follows: Non-derivative financial instruments Carrying amount Contractual cash flows Up to 1 month From 1 to 3 months From 3 to 12 months From 1 to 5 years Loans and advances due from financial institutions 436,243 (436,282) (402,011) (17,638) (16,612) (21) Loans and advances due from customers 182 (195) (30) (11) (48) (106) Total 436,425 (436,477) (402,041) (17,649) (16,660) (127) 59

60 35 LIQUIDITY RISK (CONTINUED) The analysis as at 31 December 2009 was as follows: Non-derivative financial instruments Carrying amount Contractual cash flows Up to 1 month From 1 to 3 months From 3 to 12 months From 1 to 5 years Loans and advances due from financial institutions 255,148 (255,203) (227,159) (61) (27,971) (12) Loans and advances due from customers 109 (112) (37) (8) (35) (32) Total 255,257 (255,315) (227,196) (69) (28,006) (44) 36 INTEREST RATE RISK Exposure to interest rate risk The Bank s exposure to interest rate risk is characterised by the maturity of assets and liabilities subject to interest rate risk based on the shorter of the remaining maturity dates of financial instruments subject to interest rate risk and the interest rate review dates. The repricing maturity analysis of assets and liabilities as at 31 December 2010 was as follows: Up to 1 month From 1 to 3 months From 3 to 6 months From 6 to 12 months From 1 to 5 years Interest free Total Assets Cash and demand deposits with the Bank of Latvia - 7, ,551 Loans and advances due from financial institutions 363,599 17, , ,243 Loans and advances due from customers Available-for-sale assets Intangible assets, property and equipment Deferred tax asset Income tax receivable Other tax receivable Other assets Total assets 363,611 24, , ,185 Liabilities and shareholder s equity Deposits and balances due to financial institutions Current accounts and deposits due to customers 68, , , ,312 Provisions Other liabilities Shareholder s equity ,398 44,398 Total liabilities and shareholder s equity 68, , , ,185 Interest rate risk 295,351 24,571 (168) (2,435) (168) (317,151) 60

61 36 INTEREST RATE RISK (CONTINUED) The repricing maturity analysis of assets and liabilities as at 31 December 2009 was as follows: Up to 1 month From 1 to 3 months From 3 to 6 months From 6 to 12 months From 1 to 5 years Interest free Total Assets Cash and demand deposits with the Bank of Latvia 9, ,383 Loans and advances due from financial institutions 218, , ,148 Loans and advances due from customers Available-for-sale assets Intangible assets, property and equipment Deferred tax asset Income tax receivable Other assets Total assets 228, , ,158 Liabilities and shareholder s equity Deposits and balances due to financial institutions Current accounts and deposits due to customers 47, , , ,299 Provisions Other liabilities Shareholder s equity ,899 42,899 Total liabilities and shareholder s equity 47, , , ,158 Interest rate risk 181,513 (296) 304 (1,706) 11 (179,826) 61

62 36 INTEREST RATE RISK (CONTINUED) Average weighted effective interest rates The table below shows interest rate sensitive assets and liabilities as at 31 December 2010 and 2009 and the corresponding average weighted effective interest rates in 2010 and Interest rate sensitive assets Carrying amount 2010 average weighted effective interest rate Carrying amount 2009 average weighted effective interest rate Demand deposits with the Bank of Latvia 7, % 9, % Loans and advances due from financial institutions 381, % 219, % Loans and advances due from customers % % Total 388, ,466 Interest rate sensitive liabilities Deposits and balances due to financial institutions Current accounts and deposits due to customers 71, % 49, % Total 71,820 49,640 Sensitivity analysis The following table demonstrates the sensitivity to reasonably possible changes in interest rates of the Bank s net interest income. The analysis assumes that all other variables remain constant. The sensitivity of net interest income is the effect of the assumed changes in interest rates on net interest income for one year following the reporting date, based on the interest rate sensitive nontrading financial assets and financial liabilities held as at 31 December 2010 and Increase in basis points Sensitivity of net interest income Decrease in basis points Sensitivity of net interest income As at 31 December 2010 EUR (9) USD (299) LVL (104) RUB (100) Total effect 472 (512) As at 31 December 2009 EUR (232) USD (61) LVL , (462) RUB (13) Total effect 2,026 (768) There is a mismatch between sensitivity of net interest income as a result of assumed increase and decrease in interest rates, since for some assets and liabilities zero interest rates has been reached. There were no financial instruments held by the Bank as at 31 December 2010 and 2009, whose changes in fair value related to movement of the interest rates would affect other comprehensive income. 62

63 37 CAPITAL ADEQUACY CALCULATION The below capital adequacy calculation as at 31 December 2010 is performed in accordance with the Regulation of the Financial and Capital Market Commission for Calculating the Minimum Capital Requirements. The capital adequacy ratio as at 31 December 2010 and 2009 was 39.1% and 58.9% respectively. The Bank s equity as at 31 December 2010 and 31 December 2009 used for capital adequacy calculation in line with the Regulations of the Financial and Capital Market Commission for Calculating the Minimum Capital Requirements was as follows: 31/12/ /12/2009 Tier 1 capital Paid-in share capital 8,200 8,200 Share premium 4,470 4,470 Reserves 1 1 Retained earnings 30,227 28,140 Profit for the reporting year 1,497 2,087 Intangible assets (275) (51) Total Tier 1 capital 44,120 42,847 Equity used for capital adequacy calculation 44,120 42,847 63

64 37 CAPITAL ADEQUACY CALCULATION (CONTINUED) The capital adequacy calculation in accordance with the Requirements of the Financial and Capital Market Commission for Calculating the Minimum Capital as at 31 December 2010: Capital requirement calculation for credit risk in the banking book Risk exposure Risk degree Risk weighted value Capital requirement for credit risk in the banking book Assets Balances due from the Bank of Latvia and claims against central government in the national currency that are financed in the national currency 815 0% - - Balances due from and the Bank of Latvia in the national currency that are not financed in the national currency 6,478 50% 3, Balances due from and the Bank of Latvia in foreign currency (EUR) % Total balances due from the Bank of Latvia and claims against central government 7,497 3, Claims against regional government % 18 1 Total claims against regional government Secured balances due from credit institutions Balances due from credit institutions with original maturities of three months or less 435,738 20% 87,148 6,972 Balances due from credit institutions with original maturities of more than three months % Total balances due from institutions 436,243 87,653 7,012 Unsecured balances due from private individuals % Cash on hand 277 0% - - Prepaid expense and accrued income % 88 7 Shares and other non-fixed income securities % 11 1 Other assets % Property and equipment % Total other items 1, Total assets 444,908 91,987 7,359 Contingent liabilities Balances due to institutions with security not recognised for credit risk mitigation 4,815 20% Balances due to companies with security not recognised for credit risk mitigation 5 20% 1 - Balances due to companies with security not recognised for credit risk mitigation 1, % 1, Balances due to private individuals with security not recognised for credit risk mitigation % 12 1 Total contingent liabilities 6,065 2, Total assets and contingent liabilities 450,973 94,196 7,536 64

65 37 CAPITAL ADEQUACY CALCULATION (CONTINUED) The capital adequacy calculation in accordance with the Requirements of the Financial and Capital Market Commission for Calculating the Minimum Capital as at 31 December 2009: Capital requirement calculation for credit risk in the banking book Risk exposure Risk degree Risk weighted value Capital requirement for credit risk in the banking book Assets Balances due from the Bank of Latvia in the national currency that are financed in the national currency 646 0% - - Balances due from and the Bank of Latvia in the national currency that are not financed in the national currency 10,136 20% 2, Total balances due from the Bank of Latvia 10,782 2, Secured balances due from credit institutions 24,492 0% - - Balances due from credit institutions with original maturities of three months or less 227,276 20% 45,455 3,637 Balances due from credit institutions with original maturities of more than three months 3, % 3, Total balances due from institutions 255,148 48,835 3,907 Unsecured balances due from private individuals % Cash on hand 351 0% - - Prepaid expense and accrued income % 71 6 Shares and other non-fixed income securities 9 100% 9 1 Other assets % Propertyand equipment % Total other items 1, Total assets 267,107 51,688 4,135 Contingent liabilities Balances due to companies with security not recognised for credit risk mitigation % 65 5 Balances due to private individuals with security not recognised for credit risk mitigation % 19 2 Total contingent liabilities Total assets and contingent liabilities 267,191 51,772 4,142 The minimal capital requirement for credit risk is calculated as eight per cent of the risk weighted value. The risk weighted value is calculated by multiplying the risk exposure by the risk degree defined for the respective counterparty s liabilities, applying the respective correction degree to determine the value of exposures. The risk degree for the counterparty s liabilities is determined on the basis of the respective credit quality group, which depends on the credit ratings granted by external rating agencies. 65

66 37 CAPITAL ADEQUACY CALCULATION (CONTINUED) Capital requirement calculation for operational risk Basic indicator Multiplier Capital requirement for operational risk As at 31 December , ,351 As at 31 December , ,569 The capital requirement for operational risk is calculated by multiplying the basic indicator by The basic indicator is the arithmetic average of audited net income for the last three years. Summary of capital requirements and capital adequacy ratio 31/12/ /12/2009 Equity to be used in the capital adequacy ratio 44,120 42,847 Total of capital requirements, including: (9,018) (5,816) Capital requirement for credit risk in the banking book (7,536) (4,142) Capital requirement for currency risk (Note 34) (131) (105) Capital requirement for operational risk (1,351) (1,569) Surplus of available equity over capital requirement 35,102 37,031 Capital adequacy ratio 39.14% 58.94% 38 INTERNAL CAPITAL ADEQUACY CALCULATION For the purpose of calculating internal capital adequacy, the Bank calculates equity in accordance with the Regulations for Calculating the Minimum Capital Requirements issued by the Financial and Capital Market Commission. Calculation of the equity for the purpose of calculating internal capital adequacy as at 31 December 2010 is provided in Note 37. Internal capital adequacy ratio of the Bank as at 31 December 2010 was 24.3%. As at 31 December 2009, internal capital adequacy ratio of the Bank was 40.1%. The calculation of internal capital adequacy as at 31 December 2010 in accordance with the Bank s Capital Management Policy was as follows: In order to determine the internal capital adequacy, the Bank calculates credit risk, foreign currency risk and operational risk capital requirements in accordance with the Regulations for Calculating the Minimum Capital Requirements issued by the Financial and Capital Market Commission. In order to determine the amount of capital required to cover interest rate risk in the non-trading portfolio, the Bank applies the simplified method provided in the Normative Requirements of Capital Adequacy Assessment Process Formation issued by the Financial and Capital Market Commission, and calculates the risk of a decrease in economic value due to sudden and unexpected change in the interest rates 200 bpp according to requirements on interest rate risk. 66

67 38 INTERNAL CAPITAL ADEQUACY CALCULATION (CONTINUED) The amount of capital required to cover interest rate risk in the non-trading portfolio is determined as 100% of the amount of decrease in the Bank s economic value. In the assessment of capital adequacy, the Bank assesses concentration risk and estimates the amount of capital required to cover concentration risk in the loan portfolio and receivables from credit institutions counterparties and central banks. The Bank is required to perform an assessment of concentration risk in the loan portfolio if the size of the portfolio exceeds 5% of the Bank s assets. The Bank calculates the capital requirement for concentration risk considering the level of risk inherent in receivables from credit institutions counterparties and central banks. The amount of capital required to cover concentration risk is calculated by applying a concentration index to the capital requirement of credit risk calculated for receivables from credit institutions and central banks. The Bank determines the amount of capital requirement for internal capital with respect to risk of laundering of proceeds derived from criminal activity and terrorist financing by applying the simplified method provided for in the Normative Requirements of Capital Adequacy Assessment Process Formation issued by the Financial and Capital Market Commission, based on the following ratios and quantitative assessments: share of deposits of non-residents in the total amount of deposits, share of deposits placed by clients requiring due diligence, changes in the amount of non-resident deposits (in per cent compared to the previous year), volume of trust operations liabilities under management against total assets, quality of the internal control system in the area of prevention of laundering of proceeds derived from criminal activity and terrorist financing. Quantitative assessment is obtained by summing the above assessments and it is used to arrive at the ratio for calculating the amount of capital required to cover the risk, based on the total amount of deposits and liabilities under management. The amount of capital required to cover other risks (including reputational risk, strategy and business risk) is determined by multiplying the total of the minimum regulatory capital requirements by ratio Reserve capital is calculated by multiplying the total of the minimum regulatory capital requirements by ratio

68 38 INTERNAL CAPITAL ADEQUACY CALCULATION (CONTINUED) Summary of internal capital requirements and ratio of internal capital adequacy Equity to be used in calculating the internal capital adequacy ratio 44,120 (Note 37) Total internal capital requirements, including: (14,505) Capital requirement for credit risk in the banking book (Note 37) (7,536) Foreign currency capital requirement (Note 34) (131) Operational risk capital requirement (Note 37) (1,351) Interest rate risk capital requirement (257) Risk concentration capital requirement (875) Capital requirement with respect to risk of laundering of (3,002) proceeds derived from criminal activity Capital requirement for covering other risks (451) Capital reserve (902) Equity excess after covering capital requirements 29,615 Internal capital adequacy ratio 24.33% 39 EVENTS AFTER REPORTING DATE As of the last day of the reporting year until the date of signing these financial statements there have been no events requiring adjustment of or disclosure in the financial statements or notes thereto. 68

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