Risk Management
continued
Management of key risks
The Group is committed to developing its risk management techniques and methodologies, both to maintain high standards of risk management practice and to fulfil the requirements of UK and international regulators.
Credit Risk
Credit risk is the risk of financial loss from a counterparty’s failure to settle financial obligations as they fall due.
The Group Credit Risk Committee, one of the Executive Risk Committees, is chaired by the Group Risk Director and comprises senior executives from across the operating divisions and Group Functions. It meets monthly and reviews the Group’s lending portfolio. It also assists the Board in formulating the Group’s credit risk appetite. The Group Credit Risk Policy Statement, to be applied across all businesses subject to credit risk, is approved by the Board on an annual basis.
Group Credit, a specialist support function within Group Risk, provides centralised expertise in the area of credit risk measurement and management techniques. In addition to reporting on the performance of each divisional portfolio to the Group Credit Risk Committee, Group Credit exercises independent oversight over the effectiveness of credit risk management arrangements and adherence to agreed policies, standards and limits.
Day to day management of credit risk is undertaken by specialist credit teams working within each division in compliance with policies approved by the Board. Typical functions undertaken by these teams include credit sanctioning, portfolio management and the management and collection of high risk and defaulted accounts.
To mitigate credit risk, a wide range of policies and techniques are used across the Group:
- For Retail portfolios, use is made of software technology in credit scoring new applications. In addition, where practical, behavioural scoring is used to provide an assessment of the conduct of a customer’s accounts in granting extensions to, and setting limits for, existing facilities. Affordability is an increasingly important measure and is reviewed in combination with either application and/or behavioural scores. Collections activity for credit card, current accounts and personal loans is centralised for the various products and software systems are used to prioritise action. Mortgage collection is conducted through a number of payment collection departments. Small business customers may be rated using scorecards in a similar manner to retail customers.
- For Corporate portfolios, a full independent credit assessment of the financial strength of each potential transaction and/or customer is undertaken, awarding an internal credit risk rating. Internal ratings are reviewed regularly. The sameapproach is also used for larger SME (small to medium enterprise) customers.
- Within HBOS Treasury Services (‘Treasury’), largely incorporating the Group’s wholesale, sovereign and banking related exposures, focused credit risk policies are established and reviewed by the Group Wholesale Credit Committee (‘GWCC’), a sub-committee of the Group Credit Risk Committee.
An additional measure within the credit risk framework is the establishment of product, industrial sector and country limits to avoid excessive concentrations of risk particularly within volatile economic sectors or individual countries. Material portfolio areas, such as the mortgages portfolios, have approved sub-sector limits to ensure that they remain within our plans and tolerance for risk. All such limits are set and monitored by the Group Credit Risk Committee. The controls applied to lending assessment processes consider environmental risk and the potential impact this may have on the value of the underlying security.
Standards have been established across the Group for the management of credit risk. All divisions are committed to continuously improving credit risk management and there have been significant levels of investment in the development of credit risk rating tools, including portfolio risk measurement systems in preparation for the introduction of the Basel II Accord.
Within the insurance and investment businesses, formal policies and an overall risk appetite, approved by the Board of the relevant insurance subsidiary, are in use together with a regular monitoring process to help ensure compliance.
Market Risk
Market risk is defined as the potential loss in value or earnings of the organisation arising from:
- changes in external market factors such as interest rates (interest rate risk), foreign exchange rates (foreign exchange risk), commodities and equities; and
- the potential for customers to act in a manner which is inconsistent with business, pricing and hedging assumptions.
The objectives of the Group’s market risk framework are to ensure that:
- market risk is taken only in accordance with the Board’s appetite for such risk;
- such risk is within the Group’s financial capability, management understanding and staff competence;
- the Group complies with all regulatory requirements relating to the taking of market risk;
- the quality of the Group’s profits is appropriately managed and its reputation safeguarded; and
- those making decisions have appropriate information on market risk, such that the taking of market risk enhances shareholder value.
Risk appetite is set by the Board which allocates responsibility for oversight and management of market risk to the Group Market Risk Committee, one of the Executive Risk Committees, and chaired by the Group Risk Director.
The Group devotes considerable resources to ensuring that market risk is comprehensively captured, accurately modelled and reported, and effectively managed. Trading and non-trading portfolios are managed at various organisational levels, from the HBOS Group overall, down to specific business areas. Market risk measurement and management methods are designed to meet or exceed industry standards, and the tools used facilitate internal market risk management and reporting, as well as external disclosure requirements.
Market risk is controlled across the Group by setting limits using a range of measurement methodologies. The principal methodologies are Value-at-Risk (‘VaR’), Net Interest Income (‘NII’) at Risk and scenario analysis. NII at Risk is a technique that provides estimates of the potential negative change in the forecast NII of a portfolio over a specified time horizon for a specific interest rate environment. VaR is a technique that produces estimates of the potential negative change in the market value of a portfolio over a specified time horizon at given confidence levels. Scenario analysis is performed in order to estimate the potential economic loss that could arise from extreme, but plausible stress events. In 2006 the Group introduced market value methodology for its banking businesses to expand on the Group’s capabilities in capturing market risk.
Detailed market risk framework documents and limit structures have been developed for each division. These are tailored to the specific market risk characteristics and business objectives of each operating division. Each divisional policy requires appropriate divisional sanction, and is then forwarded to the Group Market Risk Committee for approval on at least an annual basis.
Market risk within the insurance and investment businesses arises in a number of ways and depending upon the product, some risks are borne directly by the customer, and some by the insurance and investment company. In the case of the risk borne by the customer, this is controlled by adherence to, and regular monitoring of, investment mandates and, if appropriate, unit pricing systems and controls. In the case of the company, the overall risk appetites and policies are approved by the company’s Board and monitored thereafter.
Market risk, principally interest rate and equity, also arises from the Group’s defined benefit pensions obligations. These sensitivities are regularly measured and are reported to the Group Market Risk Committee every month.
Group Items (centrally managed net free reserves, subordinated debt and structural foreign exchange) are managed within separate policies and limits/mandates, as set by the Group Capital Committee.
Interest Rate Risk
The primary market risk faced by the Group is interest rate risk. Interest rate risk exists where the Group’s financial assets and liabilities have interest rates set under different bases, or which reset at different times.
The Board limit for structural interest rate risk is expressed in terms of potential volatility of net interest income in adverse market conditions. Risk exposures will be monitored using one or a combination of the following measures:
- Net Interest Income at Risk. This methodology combines an analysis of the Group’s interest rate risk position overlaid with behavioural assessment and repricing assumptions of planned future activity. The change to forecast NII is calculated with reference to different interest rate scenarios. These scenarios range from next most likely rate move to a significant parallel shock.
- Present Value of a Basis Point (‘PVBP’). PVBP is a measure of market value sensitivity and quantifies the change in present value of cash flows for a one basis point change in interest rates.
- Market Value Measures (Banking Book). A dynamic balance sheet mark to market is a risk measurement that considers future business and customer behaviour implications to capture the optionality embedded within the banking books.
- Duration. Duration provides a single measure of a portfolio’s ‘average maturity’ as calculated when considering all future cash flows of that portfolio, discounted at current market rates.
The Board has delegated authority to the Group Market Risk Committee to allocate limits to business areas as appropriate within the overall risk appetite, as approved by the Board each year. In turn, the Group Market Risk Committee has granted limits, which represent the risk tolerance for each division.
Interest rate risk arising in the course of business is required to be transferred to Treasury from the banking divisions. The residual risk in the banking divisions is primarily that related either to behavioural characteristics or to basis risk arising from imperfect correlations in the adjustment of rates earned and paid on different instruments with otherwise similar characteristics.
Sensitivity to interest rate movements is shown in Note 41 to the Accounts on pages 180 and 181 which provides the year end repricing profile for the Group’s financial assets and liabilities in the non-trading book, which includes lending, funding and liquidity activities. The methodology used in analysing the year end repricing profile does not take into consideration the effects of behavioural and basis risk issues, hence for internal management of risk the Group relies on a number of methodologies, as described above.
Foreign Exchange Risk
The Group Funding & Liquidity Committee is responsible for oversight and management of structural foreign currency risk. The Group Funding & Liquidity Committee manages foreign currency exposures based on forecast currency information provided by the operating divisions, and mandates Treasury to execute transactions and undertake currency programmes to manage structural currency risk. The risk position is monitored monthly by the Group Market Risk Committee.
Transaction exposures arise primarily from profits generated in the overseas operations, which will be remitted back to the UK and then converted into sterling.
Translation exposures arise due to earnings that are retained within the overseas operations and reinvested within their own balance sheets.
Structural foreign exchange exposures are set out in Note 43 to the Accounts on page 182.
