Enterprise Risk

CAPITAL ADEQUACY

Definition

Capital is central to a bank’s ability to absorb unexpected losses and to be able to continue its operations. Therefore, FMO aims to maintain a strong capital position that meets regulatory requirements and supports its high investment grade rating.

Risk appetite and governance

FMO seeks to maintain a strong capital position, by means of an integrated capital adequacy planning and control framework. Capital adequacy metrics are calculated by Risk Management and regularly reviewed by the ALCO and senior management.

FMO uses both external regulatory capital ratios and an internal economic capital ratio to express its capital position. The regulatory ratios are calculated based on the standardized approach of the CRR and take credit, market, operational and credit valuation adjustment risk into account. The internal ratio is based on an economic capital model in which the most important element is credit risk. Other risks in FMO’s economic capital framework are operational, market, credit value adjustment, interest rate risk, reputation risk and the risks of conducting fund management activities under FMO Investment Management B.V (FIM).

FMO has a Capital Management Framework in place that brings together all elements to manage FMO’s current and future capital position in line with the RAF. The Capital Management Framework provides FMO’s management with views of the degree to which the strategy and capital position may be vulnerable to (unexpected) changes in conditions. These views may require a management intervention in order to cushion FMO against these unexpected events. Risk Management is responsible for flagging potential capital issues and proposing and quantifying possible interventions to ALCO.

Developments

FMO’s Total Capital ratio decreased from 25.8% at year-end 2017 to 25.5% at year-end 2018, which is well above the SREP minimum. Given that FMO has no additional tier 1 and limited tier 2 capital, the Total Capital ratio is more restrictive than the CET-1 ratio. The Capital ratio decreased in 2018 primarily due to an increase in risk weighted assets caused by an appreciating dollar from 1.20 EUR/USD per yearend 2017 to 1.15 EUR/USD per yearend 2018 and the general increase in FMO’s portfolio. The growth in FMO’s eligible capital due to the addition of profit compensated the most of this, but not fully. Please see in the sections below more details on the methodology used for calculating the capital ratios.

Since January 2018, under IFRS 9, the effects of exchange rate movements are mostly recognized through the profit and loss account, rather than through other comprehensive income (OCI). Given FMO’s open FX position in the private equity portfolio – which is in place to stabilize FMO’s capital ratios – the underlying performance can be outweighed in years of large FX movements. Regarding regulatory changes that may likely affect FMO’s capital calculation, please refer to the regulatory risk section.

Regulatory capital

Under the CRR/CRD-IV banks are required to hold sufficient capital to cover for the risks it faces. FMO reports its capital ratio to De Nederlandsche Bank N.V. (DNB) on a quarterly basis according to the standardized approach for all risk types. Per December 31, 2018, FMO's available qualifying capital equals €2,877,206 (2017: €2,693,622) which makes FMO well prepared to mitigate for potential losses.

Following specific provisions in the CRR, FMO is required to deduct from its regulatory capital significant and insignificant stakes for subordinated loans and (in)direct holdings of financial sector entities above certain thresholds. These thresholds correspond to approximately 10% of regulatory capital. Exposures below the 10% thresholds are risk weighted accordingly.

FMO performs an annual Internal Capital Adequacy Assessment Process (ICAAP) in which it assesses the capital adequacy in light of all material risk types, stress testing and future regulation. As part of the Supervisory Review and Evaluation Process (SREP), DNB sets the minimum capital requirements. For 2019, The Dutch Central Bank has set a prudential requirement for FMO in terms of total capital at 17.5% and CET1 of 14.0%. The total prudential requirement consists of the total SREP capital ratio (14.0% and 10.5% CET1), the combined buffer requirement (2.5% in 2019) and a Pillar 2 Guidance (1%).

• The combined buffer requirement applicable to FMO comprises of the capital conservation buffer and the institution specific countercyclical buffer (currently minimal). Both are formally applicable as of 1 January 2016. The buffers have been phased in over a period of four years, whereby the capital conservation buffer was 1.875% in 2018 and is 2.5% in 2019.

• The Pillar 2 guidance (P2G) indicates to banks the adequate level of capital to be maintained over and above the existing capital requirements, in order to have sufficient capital buffer to withstand stressed situations, in particular in context of the adverse scenario in the supervisory stress tests. The P2G is a non-binding requirement and no automatic restrictions are imposed on distributions such as dividends and bonuses. Nevertheless, credit institutions are expected to comply with P2G.

FMO's regulatory target capital ratio incorporates the fully phased-in capital requirement by DNB supplemented with (i) a management buffer, and (ii) a dynamic FX buffer. The dynamic FX buffer is in place to cover variations in the regulatory capital ratio following changes in the EUR/USD exchange rate that are not already covered by the structural hedge. This structural hedge functions as a partial hedge against an adverse effect of the exchange rate on the regulatory capital ratios. Further information regarding the structural hedge is provided in the currency risk section.

Economic capital

In addition to regulatory capital, for Pillar 2, FMO applies an economic capital (EC) model. Economic capital is calculated using a conservative confidence interval of 99.99%. This level is chosen to support a AAA rating, and the bank’s actual growth is steered to ensure that this will remain the case. The economic capital model differs in two elements from the regulatory capital ratios. First, the EC model captures risks that are not covered under Pillar 1: reputational risk, interest rate risk in the banking book (IRRBB) and the risks of conducting fund management activities under FMO Investment Management B.V (FIM). Second, the EC model applies an internal model approach for credit risk resulting from FMO’s emerging market loan portfolio. FMO’s portfolio is invested in emerging markets, which results in a profile with higher credit risk exposure than generally applies to credit institutions in developed economies. The internal model is tailored towards these higher credit risks, leading to a higher capital requirement than the standardized approach.

The most important parameters for the EC for calculating credit risk capital requirements are the probability of default and loss given default calculated using FMO’s internal credit risk rating. Please refer to the credit risk section for more information regarding the internal credit risk rating system.

• 1 Surplus provisioning for the loan portfolio refers to the difference between the total provisioning minus total expected loss.

Leverage ratio

The leverage ratio represents a non-risk-adjusted capital requirement. Since January 2014, the CRR/CRD IV rules have required that credit institutions calculate, monitor and report on their leverage ratios, defined as tier 1 capital as a percentage of total exposure. FMO’s leverage ratio equals 31.1% (2017: 26.6%) which is far above the minimum requirement of 3% proposed by European authorities.

REPUTATION RISK

Definition

Reputation risk is the risk of damage to FMO’s reputation as a result of any event and could arise from other risks inherent in FMO’s activities.

Risk appetite and governance

It is the mandate of FMO to invest in developing and emerging markets, which exposes the institution to reputation risk. FMO has a moderate appetite for reputation risk, accepting that reputational impact of activities may incidentally lead to negative press coverage, NGO attention, undesirable client feedback, or isolated cases of financial losses, as long as these activities clearly contribute to FMO’s mission and its goals related to the SDGs. Outside of this, FMO has a limited appetite for additional reputation risk that, in extreme cases, may prompt key stakeholders to intervene in the decision-making or running of FMO’s daily business.

Reputation risk overarches the categories of financial and non-financial risks and is a secondary risk which manifests itself from one of the underlying risk types. Thus, reputation risk is also managed via the primary risks which could give arise to reputation risk issues. 

Reputation risk is inevitable given the nature of FMO’s business and operations. FMO, however, actively mitigates the risk as much as possible through strict and clear policies, thorough upfront assessments, consultations with stakeholders, and when necessary, through legal agreements with clients. Regarding non-financial risks, FMO has the Sustainability Policy in place. Additionally, statements on human rights, land rights, and gender positions have been published. Furthermore, FMO manages issues from the perspective of learning lessons and prevention. An additional means to serve this purpose is the Independent Complaints Mechanism (ICM). The ICM ensures the right to be heard for complainants who feel affected by an FMO's financed operation. Therefore, the ICM provides a tool to seek alternative ways to resolve disputes between stakeholders and FMO's clients and, at the same time, strengthens the adherence to FMO's policies and procedures by providing a feed-back loop. Through transparency and a willingness to respond to challenges, FMO aims to remain accountable and to mitigate potential reputation risk.

Developments

In 2018, FMO officially established an issue management system, which was approved by the MB. Within this system, decision-making processes have been clarified to identify, measure, and address issues and crisis communications. The Issue Management Committee was also set up this year. This Committee convenes on a regular basis and takes decisions on FMO’s responses to issues and reputational risks.

FMO launched a storytelling campaign in 2018, in which FMO presents its missions and vision around the tagline ‘Doing makes the difference’. This campaign also contributes to explaining to external stakeholders the motivation of FMO’s mandate, why it is important, and how this mandate comes with challenges.