Risk Management
continued
Trading
The Group’s market risk trading activities are principally conducted by Treasury. This Group activity is subject to a Trading Book Policy Statement, which is approved by the Board, and limits set by the Group Market Risk Committee.
Treasury trading primarily centres around two activities: proprietary trading and trading on the back of business flows. Both activities incur market risk, the majority being interest rate and foreign exchange rate exposure. The framework for managing the market risk in these activities requires detailed and tailored modelling techniques, which are the responsibility of the Treasury Market Risk team.
The Group employs several complementary techniques to measure and control trading activities including: Value at Risk (‘VaR’), sensitivity analysis, stress testing and position limits. The VaR model used, forecasts the Group’s exposure to market risk within an estimated level of confidence over a defined time period.
The average VaR value in 2006 was £4.2m. The calculation is based upon a confidence level of 99% with a one-day holding period. The principal areas of market risk taken are interest rate (outright positioning, basis, credit spread and volatility risk), and foreign exchange risk.
The current methodology for providing an aggregated VaR for the business uses conservative assumptions. In order to assess the effectiveness of VaR the Group uses a technique known as ‘back testing’, which compares the daily profit and loss from trading activities to the VaR estimate for that day. Daily standard deviation of trading profit and loss was £0.6m.
The Group recognises that the VaR methodology cannot guarantee the maximum loss that may be suffered in any trading period, particularly in the event of market turmoil. Therefore, stress testing is used to simulate the effect of selected adverse market movements.
The Group’s trading market risk exposure for the year ended 31 December 2006 is analysed in Note 42 on page 182 to the Accounts. The regulatory capital charge for market risk trading exposures represents only 1.93% of the Group’s capital base.
Derivatives
In the normal course of banking business, the Group uses a limited range of derivative instruments for both trading and non-trading purposes. The principal derivative instruments used are interest rate swaps, interest rate options, cross currency swaps, forward rate agreements, forward foreign exchange contracts and futures. The Group uses derivatives as a risk management tool for hedging interest rate and foreign exchange rate risk.
Examples of how derivatives are used in managing and mitigating market risk exposures arising from banking services and activities are:
- Fixed interest rate swaps are used to manage the interest rate risk of fixed rate mortgages; and
- Basis swaps are used to manage exposure between 1 month LIBOR and base rates.
The Group’s activity in derivatives is controlled within risk management limits set by the Board and overseen by the relevant Group Risk Committees. This framework recognises the principal risks including credit, operational, liquidity and market risk associated with derivatives. Details of derivative contracts outstanding at the year-end are included in Note 13 to the Accounts on pages 148 and 149.
Liquidity Risk (Funding)
Liquidity risk is the risk that the Group does not have sufficient financial resources to meet its obligations when they come due, or will have to do so at excessive cost. This risk can arise from mismatches in the timing of cashflows relating to assets, liabilities and off-balance sheet instruments.
The Group Liquidity Policy Statement is approved by the Board and defines the core principles for identifying, measuring, managing and monitoring liquidity risk across the Group. Detailed liquidity risk framework documents and limit structures are in place for the Group’s operations in the UK and Australia, where liquidity is managed on a Group basis, and for overseas banking units subject to specific regulatory requirements. The responsibility to direct the management of liquidity and to report against policy is delegated to the Group Capital Committee.
Policy is reviewed at least annually to ensure its continued relevance to the Group’s current and planned operations. Operational liquidity management is delegated to Treasury. The Group Funding & Liquidity Committee (a sub-committee of the Group Capital Committee) oversees the controls exercised by Treasury.
The Board requires that prudential liquidity limits should be set by the Group Funding & Liquidity Committee, both at aggregate levels and for individual currencies in which the Group has significant wholesale funding. These limits are established by way of cashflow mismatch and are quantified over two time horizons – from sight to eight days and from sight to one month.
For the purpose of calculation, marketable assets are subject to both instrument concentration limits and prudential discount factors. An assessment is also made for the possible outflow from customer deposits and committed facilities, determined by prudential behavioural modelling.
The Group’s approach to the management of liquidity goes beyond the Sterling Stock Liquidity approach used by the FSA, in that it includes measures of liquidity cover out to one month, and measures for currencies other than sterling. Whilst following this approach, the Group also adheres to the FSA’s Sterling Stock Liquidity policy, of which a key element is that a bank should hold a stock of high quality liquid assets that can be sold quickly and discreetly in order to replace funding that has been withdrawn due to an actual or perceived problem with the bank. The objective is that this stock should enable the bank to continue business, whilst providing an opportunity to arrange more permanent funding solutions.
The FSA has a prescriptive regime for retail banks that specifies the formula for determining both the quantum and type of assets qualifying for Sterling Stock Liquidity. Sterling Stock Liquidity is regarded as a cost of doing business. It is not regarded as an operational liquidity pool as it will always be required in case of emergency. From an operational perspective, the Group will place greater reliance on market access to funding sources and the retention of a pool of diversified assets that can be sold in an efficient and discreet manner.
The Group also adheres to the requirements of other regulatory authorities including the Australian Prudential Regulatory Authority and the Irish Financial Regulator in whose jurisdictions the Group has branches or subsidiaries.
The funding capacity of the Group is dependent upon factors such as the strength of the balance sheet, earnings, asset quality, ratings and market position. The Group Funding & Liquidity Committee assesses the Group funding mix to ensure that adequate diversity is maintained. It is Group policy to manage its balance sheet profile to ensure customer deposits sourced outside of Treasury represents a significant component of its overall funding, and the Group Funding & Liquidity Committee directs and co-ordinates the activities of the operating divisions in raising liabilities from a range of sources. Within Treasury, the Group avoids undue concentration by maintaining both a widespread mix of counterparties and inward credit lines and a core set of bank and non-bank depositor relationships providing a stable source of funding. The Group Funding & Liquidity Committee approves the appropriate balance of short to medium term funding.
The Group has established a Liquidity Contingency Planning Framework to identify liquidity stress situations at an early stage.
General Insurance & Long Term Assurance Business Risks
The general insurance and long term assurance business contracts underwritten by the Group expose the Group to both investment and insurance risk.
Insurance risk is the potential for loss, arising out of adverse claims, expense and persistency experience, from both life and general insurance contracts.
Investment risk is the potential for financial loss arising from the risks associated with the investment management activities of the Group. Investment risk includes market, credit and liquidity risks. The loss can be as a result of:
- Direct risks relating to changes in the value of Group assets in support of the general insurance and long term insurance contracts;
- Indirect risks arising from policyholder funds where the assets and policyholder liabilities are matched; and
- Indirect risks associated with the management of assets held on behalf of third parties.
The Group Insurance Risk Committee, one of the Executive Risk Committees described on page 81, considers regular reports on specified aggregate insurance risks across all of the Group’s insurance and investment businesses. The Committee takes a technical and expert perspective on insurance risks within these businesses. It oversees the development, implementation and maintenance of the overall insurance risk management framework, covering insurance risk in each business individually, as well as in aggregate. As part of the overall Group risk management framework, the Group Insurance & Investment Risk team provides regular support to the Group Market Risk Committee and to the Group Credit Risk Committee on the inter-relationship between insurance risk and investment risks (market, credit and liquidity risks respectively) arising within these businesses, and the development of appropriate policies and standards for the management of those risks.
The majority of the Group’s long term insurance and investment contract liabilities are managed within the HBOS Insurance & Investment division and Insight Investment with approximately 3% (2005 4%) operated by the life businesses outside the UK. Day to day management of insurance and investment risk is undertaken both by divisional and business management supported by specialist risk functions. Use is made of the statutory actuarial roles, both to help ensure regulatory compliance in respect of the authorised insurance companies in the Group and to help meet Group standards in respect of the operation of comprehensive Insurance and Investment Risk Management frameworks.
Long Term Assurance
The insurance and investment business that is transacted by the life insurance companies within the Group comprises unit linked business, other non profit business and with-profits business (described as insurance contracts and investment contracts with discretionary participating features (‘DPF’) written within the with-profits fund).
Several companies within the insurance and investment business transact either unit linked and/or other non profit business, but all with-profits business is underwritten by Clerical Medical Investment Group Limited (‘Clerical Medical’), part of HBOS Financial Services Limited.
The key characteristics of long term assurance that give rise to insurance and investment risk are its long term nature, the guarantees provided to policyholders, the dependency on the performance of investment markets and the extent to which assets backing the contractual liabilities are matched.
The quality, mix and volume of business have a significant influence on the extent of insurance and investment risk assumed by the Group and resulting profits. The quality of business written is influenced by variations in product terms as well as the average premium size, age and term profile within the particular products. Accordingly, the mix in products written may impact on profits, depending on the nature, extent and profitability of new business in addition to existing business. This risk is managed through the application of clear pricing policies that require full financial assessment for each new product, incorporating consideration of expected hurdle rates of return.
Additionally, variations in administration and development costs may impact the available profit margin within the product charges. To manage this risk, there is a regular process of expense budgeting and reporting with appropriate targets set for new insurance and investment products that are developed.
The risks associated with particular sections of the long term assurance business are set out below.
