Financial Risk

INVESTMENT RISK

Investment risk is defined as the risk that actual investment returns will be lower than expected returns, and encompasses credit, equity, concentration and counterparty credit risks.

CREDIT RISK

Definition

Credit risk is defined as the risk that the bank will suffer an economic loss because a client fails to meet its obligations in accordance with agreed terms.

Risk appetite and governance

For FMO’s emerging markets loan portfolio, adverse changes in credit quality can occur due to specific client and product risk, or risks relating to the country in which the client conducts its business. The main source of credit risk arises from investments in emerging markets and off-balance instruments such as loan commitments and guarantees.

Management of credit risk is FMO’s core business, both in the context of project selection and project monitoring. In this process, a set of investment criteria per sector is used that reflects minimum standards for the required, among others, financial strength of FMO’s clients. This is further supported by credit risk models that are used for risk classification, the IFRS9 expected credit loss, and the determination of economic capital use per transaction. The lending process is based on formal and strict procedures. Funding decisions depend on both the amount of economic capital and the risk profile of the financing instrument. For credit monitoring, FMO’s clients are subject to annual reviews at a minimum. FMO also monitors clients that are labelled as Reason for Concern through a quarterly Watch List process to proactively manage loans before they become non-performing. For distressed assets, the Special Operations department actively manages workout and restructuring.

FMO has set internal appetite levels for non-performing loans and specific impairments on loans. If any of the metrics exceed the appetite levels, Credit will assess the underlying movements and analyze trends per sector, geography and any other parameter. Credit will also consider market developments and peer group benchmarks. Based on its analysis, Credit will propose mitigating measures to the IRC. If any of the indicators deteriorate further, Risk Management will be involved to assess to what extent the trend is threatening FMO’s capital and liquidity ratios and Risk Management may impose remedy measures.

Developments

In 2018 FMO began applying the IFRS9 accounting standard. As a result, impairments were determined by an expected credit loss (ECL) model, based on (among other parameters) probability of default (PDs) and loss given default (LGDs) from FMO’s credit models, with adjustments to make the estimations point in time rather than through the cycle. More on IFRS9 implementation can be found under section 'Significant accounting policies'.

Exposures and credit scoring

The following table shows FMO's total gross exposure to credit risk per year-end. The exposures, including derivatives, are shown gross, before impairments and the effect of mitigation through the use of third-party guarantees, master netting, and collateral agreements. Regarding derivative financial instruments, only the ones with positive market values are presented. The maximum exposure to credit risk increased during the year to €8,164,737 as of year-end 2018 (2017: €8,021,064). The decrease in short term deposits at the Dutch Central Bank was compensated by an increase in FMO’s credit exposure from loans to the private sector in emerging markets, which moved from €4,454,439 to €5,016,495.

In measuring the credit risk of the emerging market portfolio at client level, the main parameters are the credit quality of the counterparties and the expected recovery ratio in case of defaults. Credit quality is measured by scoring clients on various indicators of financial and company strength. FMO has a Client Risk Rating (CRR) methodology which was developed in 2012 together with Moody’s. The model follows EBA guidelines regarding the appropriate treatment of a Low Default Portfolio and uses an alternative to statistical validation to perform the risk assessment of the models when there is limited or no default data.

The CRR models are based on quantitative and qualitative factors and different based on the client type. The models for Banks and Non-Banking Financial Institutions (NBFIs) use factors including the financial strength of the client, management, franchise value, and the market and regulatory environment. The model for corporates uses factors including financial ratios, governance, and strategy. The Project Finance model uses factors focusing on the transaction characteristics, market conditions, political and legal environment, and financial strength of the borrower.

The models are reviewed periodically, with the last reviews taking place in 2017 and 2018. Based on these scores, FMO assigns ratings to each client on an internal scale from F1 (lowest risk) to F20 (default) representing the Probability of Default. This rating system is equivalent to the credit quality rating scale applied by Moody's and S&P. Likewise, the recovery ratio and the Loss Given Default are assigned by scoring various dimensions of the product specific risk. The probability of default and loss given default scores are also used as parameters in the IFRS9 expected credit loss model. Please refer to the section 'Significant accounting policies', for further details on the IFRS9 calculation methodology.

The total maximum exposure to credit risk of the gross loan portfolio increased to €5,016,495 per year-end 2018 (2017: €4,454,349 ). The majority of our gross loan portfolio (89%) remains in the F11 to F16 ratings categories. Overall the credit quality of FMO’s loan portfolio improved in 2018, with the proportion of the portfolio rated F17 or worse dropping from 12% to 8%, and the portion of the portfolio rated F13 or better increasing from 42% to 49%. This was due both to improved economic conditions, including country rating improvements, and a revision to the project finance model.

Credit quality analysis

Apart from its on-balance finance activities, FMO is also exposed to off-balance credit-related commitments. Guarantees, which represent contingent liabilities to make payments if a customer cannot meet its obligations to third parties, carry similar credit risks as loans. Most of the guarantees are quoted in US Dollars. Guarantees on export facilities are collateralized by the underlying letters of credit, and therefore carry less credit risk than direct uncollateralized borrowing. The following table shows the credit quality and the exposure to credit risk of the financial guarantees for the period.

Additionally, irrevocable facilities represent commitments to extend finance to clients and consist of contracts signed but not disbursed yet which are usually not immediately and fully drawn.

The following table shows the credit quality and the exposure to credit risk of the loan commitments which are part of the irrevocable facilities for the period.

• 1 Loan commitments for which no ECL is calculated (Fair Value loans or expired availability date).

Non-Performing Loans

Non-Performing Loans (NPL) are defined as loans with a counterparty-specific impairments (Stage 3) and/or loans with interest, principal, or fee payments that are past due 90 days or more (Stage 2 or Stage 3), or clients that FMO judges to be “unlikely to pay”. Unlikely to pay indicators include, among others, distressed restructuring, bankruptcy, or central bank intervention. Non-performing status is determined at the client level. Therefore, if one facility to a client is non-performing, all facilities to the client are deemed non-performing (Stage 2). Forborne non-performing clients, as defined in the section 'Modified financial assets', have an additional one-year probation period before returning to performing status (Stage 2). FMO’s NPL ratio increased from 5.6% to 8.1% as a result of several factors, including new NPLs, relatively fewer write-offs, and an adjustment of the non-performing definition. In preparation for the implementation of the EBA Guideline on Management of Non-Performing and Forborne Exposures in 2019, FMO aligned the non-performing loan definition with the definition used for regulatory reporting. This was implemented in Q2 2018, which resulted in an increase in the NPL ratio (ceteris paribus) from 4.8% to 6.3%, primarily due to the application of probation periods and no longer reducing NPL exposures based on guarantees received.

The following figure summarizes the criteria used to identify a loan as non performing:

New NPLs in 2018 cannot be attributed to a specific factor or country, and the vintage years range from 2012 to 2016. Overall NPLs remain concentrated in the Industry, Manufacturing and Services (IMS) sector (53% of NPLs) and while India (25% of NPLs) remains the country with the most NPLs, the concentration in India remaines high and it has slightly decreased since 2017 when it was 27% of NPLs. No other country represents more than 10% of NPLs. Activities in the IMS sector were terminated during 2017 following a strategic reorientation. The NPL ratio for current focus sectors is 4.5%. This NPL level partially reflects long recovery periods, which are inherent in FMO’s markets.

Among the NPLs, the loans with interest and/or principal payments that are past due more than 90 days amount to 4.1% (2017: 4.8%) of the gross loan portfolio. Past due information related to FMO’s portfolio loans and receivables are presented in the table below. This categorization does not apply to financial assets other than loans, including interest-bearing securities and short-term deposits.

Stage 3 loans are impaired loans with a specific charge off set by the Investment Review Committee (IRC). Not all non-performing loans are in Stage 3. If the IRC judges that the client is likely to pay they may remain in Stage 2 with a lifetime expected credit loss booked as the impairment charge. At end of year 2018, €15.8 mln of exposure was 90 days past due but remaining in Stage 2. As with non-performing loans, impairments are concentrated in the IMS sector. Geographically there is an elevated level of impairments in Latin America, due to a large impairment for an Agribusiness client in Argentina.

Modified financial assets

When the terms and conditions of a loan have been modified significantly, leading to changes in cashflows, FMO considers these loans as restructured. Changes in terms and conditions usually include extending the maturity, changing the interest margin and changing the timing of interest payments.

Furthermore, when the terms and conditions are modified due to financial difficulties amongst others delay in payments, central bank intervention or prospects of bankruptcy, these loans are qualified as forborne. Forbearance must include concessions to the borrower, such as release of securities, changes in covenants that implies giving away payment rights. Forborne loans are assessed to determine if they qualify for de-recognition and if that is the case, they are recognized as a new loan with valuation differences through profit and loss. The watch-list process and the Credit department review modified loans periodically. When a loan is deemed no longer collectible, it is written off against the related loss allowance. In 2018, FMO’s (partial) write-offs equaled to €18,3 mln due to 7 loans (2017: 9) corresponding to 0.4% (2017: 2.0%) of FMO's portfolio.

The following table provides a summary of FMO’s forborne assets, both classified as performing and not, as of December 31, 2018.

The following table shows the movement of gross carrying amount and ECL impact of previously forborne financial assets, which were restored from the forborne status during 2018.

For loans restored from forborne status which were transferred to Stage 1, the ECL decreased slightly from €290 to €229. For loans restored from forborne status which entered into Stage 2/3, the ECL increased to €9,260 due to one loan which was judged as impaired despite it exited from the forbearance status.

The table below includes Stage 2 and Stage 3 assets for which terms and conditions were modified during 2018 with the related net modification profit. €3,729 profit is related to not derecognized loans and €1,595 loss is related to derecognized loans.

Credit mitigation

As per December 31, 2018, the total carrying value of the FMO’s loan portfolio is €5,016,496, of which €520,279 is guaranteed by either the Dutch government or highly rated guarantors, of which the following table shows a breakdown of guarantee amounts received and carrying values of guaranteed loans per credit ranking of the guarantors.

FMO also obtained security used to mitigate credit risk for part of the loan portfolio. This security mainly consists of real estate, business assets, bank account shares or financial instruments. Due to the nature of the markets in which FMO operates, it has proven difficult to assign reliable fair values to the security for those loans due to limited liquidity. Furthermore, the complexity of some jurisdictions in which FMO operates may make the enforcement of the security challenging. It is also worth mentioning that FMO, as a development bank, aims to work with clients through financial difficulties focusing on their long-term recovery rather than seeking immediate foreclose. Therefore, the security is an effective tool at enhancing the negotiation power of FMO when restructuring the terms of the loans and, only as a last resort, enforcing it to procure recovery.

EQUITY RISK

Definition

Equity risk is the risk that the fair value of an equity investment decreases. It also includes exit risk, which is the risk that FMO’s stake cannot be sold for a reasonable price and in a sufficiently liquid market.

Risk appetite and governance

FMO has a long-term view on its equity portfolio, usually selling its equity stake within a period of 5 to 10 years. FMO can accommodate an increase in the average holding period of its equity investments and thereby wait for markets to improve again to realize exits. The equity portfolio consists of both direct or co-direct investments, primarily in the financial institutions and Energy sectors, and indirect investments in private equity funds. The two types of investments require different risk assessments and selection criteria. The Private Equity department is responsible for assessing opportunities and performing extensive due diligence before investment decisions are made. Equity investments are approved by the Investment Committee in terms of specific obligor as well as country risk. The Investment Review Committee assesses the valuation of equity investments on a quarterly or semiannual basis. Diversification across geographical area, sector and equity type across the total portfolio is evaluated before new investments are made. The performance of the equity investments in the portfolio is periodically analyzed during the fair value process. Based on this performance and the market circumstances, exits are pursued in close cooperation with the co-investing partners.

Developments

The private equity portfolio in EUR terms benefited from a stronger USD but the underlying valuations were under pressure from local currency depreciation against the USD (such as TRY, ARS, ZAR etc.). Regarding global market conditions, 2018 was characterized by two main economic crises relevant to FMO in Turkey and Argentina. Impacts in Argentina have been limited since FMO’s equity portfolio is limited to two co-investments and minor indirect exposures through some of funds. Moreover, the agricultural sector in Argentina is denominated in USD or is USD-linked, which might create arbitrage opportunities in case of devaluation of Argentine peso. As such, FMO continues to invest in Argentina and made two new commitments in December 2018. Regarding Turkey, at the end of 2018, FMO’s equity portfolio consisted of seven investees in which two co-investments and five funds with a total exposure of 86mln EUR and committed amount of 106mln EUR. A value loss was recorded for this year primarily driven by the acute and sharp depreciation of the TRY. However, early signs of value recovery can be seen on the back of TRY recovery. FMO will continue monitoring challenging situations across the globe on a quarterly basis as part of the fair value process and during the annual reviews of investees.

FMO continued to add value to private equity investees during 2018 through corporate governance, environmental and social impacts. In line with the strategy, FMO continued to focus on portfolio management, exits and building up a direct portfolio:

• Portfolio management/exits: during 2018 there were a number of significant exits as well as good cash collection from fund investments (particularly tail-end funds with vintages 2007-2009);

• Direct investments: 2018 was a transition year in which time was invested in building relationships, market presence and market strategies. Overall, the level of new investments was lower than budgeted for because prices, especially in the renewable energy sector, were high. Also, it was actively decided not to invest in cases where the potential return was too challenging. Furthermore, the portfolio management activities and exits – of which some also did not materialize - were also time consuming. Despite of that, more than 60% of the new investments in 2018 were direct and/or co-investments. The efforts of 2018 are also expected to result in a further increase in the level of direct investments in 2019;

• Other initiatives which resulted in 2018 being a transition year: FMO prepared to become more active as a venture capital investor. Venture capital is a new asset class requiring different skills, procedures and market approach so time was invested in developing these during 2018. The strategic rationale for the venture capital program is linked to the high potential of development impact in the asset class (e.g. reducing inequalities by using technologies), strategic relevance for FMO’s 2025 strategy and the return potential. 

Exposures

The total outstanding equity portfolio at December 31, 2018, amounts to €1,797,519 (2017: €1,710,315) of which €897,436 (2017: €854,747) is invested in investment funds.

CONCENTRATION RISK

Definition

Concentration risk is the risk that FMO’s exposures are too concentrated within or across different risk categories. Concentration risk may trigger losses large enough to threaten the institution’s health or ability to maintain its core operations or lead to material change in an institution’s risk profile.

Risk appetite and governance

Strong diversification within FMO’s emerging market portfolio is ensured through stringent limits on individual counterparties (single and group risk limits), sectors, countries and regions. These limits are monitored by Risk Management, reviewed regularly and approved by the IRC. Diversification across countries, sector and individual counterparties is a key strategy to safeguard the credit quality of the portfolio. 

Developments

Overall economic conditions in emerging markets remained favorable in 2018, with economic growth continuing in most markets. However, concerns did emerge, particularly towards the end of the year, including a strengthening US Dollar vis-à-vis emerging market currencies, interest rate hikes by the Federal Reserve, the increasing threat of a trade war between the US and China or other countries, and slower growth in several key emerging markets.

2018 did witness two economic crises relevant to FMO in Turkey and Argentina. These were closely monitored by Front Office, Credit, and the IRC. Regarding the loan portfolio, at the end of 2018, FMO had 18 clients in Turkey with a total loan exposure of €367 million. The Turkish Lira has shown accelerated depreciation in the first half of August and caused upset in international markets. Consequently, Turkey’s country rating was downgraded to F14 (2017: F12). In Argentina, FMO had 11 clients at the end of 2018 for a total loan exposure of €157 million where the country rating has been stable over the course of 2018 at F15. Overall FMO’s portfolio in both countries remained healthy, with only one non-performing loan in each country, both due to client-specific circumstances unrelated to the current economic crises. This performance can be attributed to the fact that before the crises FMO’s financial sector clients had strong financials, while energy and agricultural clients in many cases have a natural hedge in place, either via export revenues, or via government guaranteed US dollar incomes (through power purchasing agreements, for example). Also, the developments in Ukraine were followed closely given the ongoing conflict with the Russian Federation. Moody’s reacted positively to the release of new IMF credit, which resulted in an upgrade of Ukraine’s country rating to F17 (2017: F18). FMO had 9 clients in Ukraine with a total exposure of €68 million in the loan portfolio at the end of 2018. Regarding developments on equity investments, please refer to the equity risk section.

Country, regional and sector exposures

Country risk arises from country-specific events that adversely impact FMO’s exposure in a specific country. Within FMO, country risk is broadly defined. It includes all relevant factors that have a common impact on FMO’s portfolio in a country such as economic, banking and currency crises, sovereign defaults and political risk events.

To ensure diversification within FMO’s emerging market portfolio across regions, a country limit framework is in place to minimize concentration risk from the perspective of the portfolio as a whole. Country limits range from 8% to 22% of FMO’s capital, depending on the country rating, where FMO sets higher limits in less risky countries. The assessment of the country rating (F-rating scoring in line with internal credit risk rating) is based on a benchmark of external rating agencies and other external information.

In determining the limit usage within a country for loans, the committed portfolio amount as well as underlying transaction specific elements - which may lead to effective reduction of country risk - are considered. The figure below provides an overview of the diversification over the countries of FMO’s gross outstanding in the loan portfolio.

In general, the loan portfolio remains well diversified across different countries. The single largest country exposure is under 10% of the total loan book. The three largest country exposures in the loan book at the end of 2018 were Turkey, India and Georgia, together 21% of the total exposure. Following the rating downgrades of S&P, Moody’s and Fitch, Turkey has now an internal rating of F14 (2017: F12). The ratings of Georgia and India did not change throughout the year. The loan portfolio in Georgia increased with €100 million due to new transactions in the financial sector clients. Other noteworthy changes in country ratings are the downgrades of Costa Rica to F14 (2017: F13) and Nicaragua to F16 (2017: F15) and the upgrade of Mongolia to F16 (2017: F17).

On top of country risk limits, FMO has in place additional limits to ensure adequate diversification across sectors and egions. Below an overview of the gross exposure of loans distributed by region and sector is given. For equity exposures, please refer to the equity risk section.

Single and group risk exposures

Regarding single and group risk exposures, FMO has set stringent internal limits where the maximum loss possible for one single client or group is set as a percentage of FMO’s shareholders’ equity. At year-end, all exposures are well within these limits. These internal single and group risk limits are set to be more stringent than the regulatory limits such as the ones foreseen under CRR norm of 25% of eligible capital.

COUNTERPARTY CREDIT RISK

Definition

Counterparty credit risk in the treasury portfolio is the risk that FMO will suffer economic losses because a counterparty fails to fulfil its financial or other contractual obligations from open positions in the portfolio.

Risk appetite and governance

The main responsibility of FMO’s Treasury department is to fund the core business of FMO and to efficiently and effectively mitigate risks in line with the Treasury’s mandate. The main goal of the treasury portfolio is to maintain a liquidity buffer such that FMO can serve its liquidity needs in both on-going business and in stressed circumstances. FMO’s Treasury department is, therefore, a servicing unit. It does not have its own trading book or actively takes open positions in the pursuit of profits. FMO aims to balance between keeping losses within its limited risk tolerance and supporting FMO's business strategy, thereby minimizing credit risk and concentration risk in the treasury portfolio, derivative portfolio, and several bank accounts.

The Treasury department is responsible for day-to-day counterparty risk management. Risk Management is the ‘second line of defense' and responsible for assessing, quantifying, and monitoring counterparty risk daily. Limit excesses and material findings are reported to the ALCO on a monthly basis, together with recommended mitigations and/or actions. The Risk Management department is also responsible for updating related policies and processes and for setting up limits, including minimum credit rating requirements, exposure limits, as well as transaction limits. The policies, processes, relevant parameters, and limits are reviewed and approved by the ALCO annually.

Developments

In preparation for the coming Brexit, FMO has established a working group to closely monitor all developments, assess potential impact, propose suitable mitigations, and act accordingly. An action plan (Brexit Action Plan) was proposed by the working group and reviewed by the ALCO. The plan is frequently revisited and adapted with new developments of the Brexit. This assures a smooth continuation of FMO’s treasury activities, even in the worst case of a no deal Brexit, and makes sure that counterparty credit risk is efficiently managed. For more details on the Brexit, please refer to section 'Legal Risk'.

Exposures

Counterparty risk exposures in FMO’s treasury portfolios originate from short-term investments (deposits, investment in money market funds, CPs, and collaterals related to transacted derivatives), interest-bearing securities (bonds), and transacted derivatives for hedging purpose. The tables below show outstanding positions as of 31st December.

Supra-nationals are international organizations or unions in which member states transcend national boundaries pertaining to the wider grouping. As per year-end 2018, the largest exposure in this category is to the European Investment Bank (EIB).

FMO mitigates its counterparty credit risk through various means. Minimum requirements of credit quality are set for counterparties of treasury activities. Netting and collateral agreements are also utilized to reduce counterparty credit risk originating from derivative transactions. FMO has Credit Support Annexes (CSAs) with all derivative counterparties. Additionally, part of the derivative portfolio, particularly EUR and USD interest rate swaps, is cleared through central counterparties, as required by the European Market Infrastructure Regulations (EMIR).

The exposure of derivative financial instruments is presented for only derivatives with positive market value, if possible, netted with derivatives with a negative market value if it concerns the same counterparty. For this reason, the total amount shown in the table above does not equal the exposure presented in the other tables.

The disclosures as set out in the tables below include financial assets and financial liabilities that:

• are offset in the consolidated balance sheet of FMO; or

• are subject to an enforceable master netting arrangement or similar agreement that covers similar financial instruments, irrespective of whether they are offset in the consolidated balance sheet.

FMO receives and pledges only cash collateral with respect to derivatives.

LIQUIDITY RISK

Definition

Liquidity risk is defined as the risk for FMO not being able to fulfil its financial obligations due to insufficient availability of liquid means.

Risk appetite and governance

FMO’s risk appetite is to maintain adequate liquidity buffers to fulfil FMO’s current and future financial obligations. The appetite follows a similar rationale as for capital and it is aimed to maintain enough liquidity to ensure FMO would never need to fall back on the guarantee provided by Dutch State to our investors. To realize this ambition, minimum liquidity requirements apply as prescribed by the regulator.

FMO’s Liquidity Risk Policy Framework is built on four Pillars.

1. Minimum liquidity buffer under stress;

2. Maturity matched funding;

3. Diversified funding;

4. Meet regulatory requirements.

Based on these four pillars. FMO’s risk appetite levels are defined for a 7-month minimum survival period under stress, a liquidity coverage ratio (LCR) to exceed 135%, a Net Stable Funding Ratio (NSFR) to exceed 105%, and restrictions on failed funding periods and cost of wholesale funding above peers. Additional thresholds such as matching funding and liquidity in specific currencies are also in place for managing and monitoring the risk profile of the bank. These monitoring metrics are delegated to Director Risk Management and Director Treasury and are subject to a formal sign-off procedure and reported to the ALCO. The ALCO is also responsible to approve the Liquidity Risk Policy Framework.

FMO traditionally has a conservative liquidity policy and funding strategy that is well suited to its business. Stress tests are conducted on FMO’s liquidity position on weekly basis to ensure this conservative position is maintained. For the annual Internal Liquidity Adequacy Assessment Process (ILAAP), FMO performs additional stress tests including a severe stress scenario provided by DNB and includes reverse stress testing. A continuous review is performed on the liquidity position, FMO’s assumptions, internal expectations and external market conditions to ensure that FMO’s liquidity planning is accurate.

The Liquidity Contingency Plan sets out FMO’s strategy for addressing liquidity needs in the case of a crisis, ensuring that various sources of emergency liquidity are available to meet all current and future financial obligations, whilst avoiding excessive funding costs, incurring unacceptable losses and significantly changing the business profile. The liquidity sources include a long-term bond portfolio and a portfolio of short-term instruments such as cash, Money Market Funds, Commercial Paper (CP) and Treasury Bills. The long-term bonds and CP can be used as collateral in repurchase agreements to obtain short-term cash from the Dutch Central Bank or from commercial parties.

Developments

FMO reviewed its 2019-2022 funding strategy to increase diversification across funding sources and instruments. Moreover, the Sustainability Bonds Framework has also been updated to include new categories for green and social projects and to allow FMO to issue Green Bonds, Social Bonds or Sustainability Bonds. As a result of this, on February 2019, FMO issued its inaugural green bond, a 5-year fixed rate USD500mln transaction, having previously pioneered the Sustainability Bond market with three EUR-denominated, and one SEK-denominated, sustainability bond issuances. The transaction was characterized by high quality and diverse orderbook supported by strong demand from green motivated investors. Bank treasuries took 51% of allocations, followed by central banks and official institutions (31%), asset managers (15%), insurance and pension funds (2%) and private banks (1%). The proceeds will be mainly allocated to Renewable and Energy Efficiency projects contracted in 2018. Additionally, over the course of 2018, FMO has increased financing through local currency-linked notes compared to previous years, which also supports FMO in its development mandate. 

Regarding liquidity risk indicators, in 2018, FMO has incorporated in the LCR model all the latest regulatory updates, including the guidelines provided by DNB on article 23 of the LCR Delegated Act.

Liquidity position

Throughout the course of 2018 FMO's liquidity position has been comfortably within the corresponding appetite levels regarding both internal and regulatory metrics.

The following table shows the categorization of the balance sheet per maturity bucket. This table shows the timing of the undiscounted principal cash flows, and not the market values, per instrument. The totals per instrument may therefore differ from the totals on the balance sheet. Expected cash flows resulting from irrevocable facilities being drawn are not included in the liquidity gap. For internal liquidity planning and management, cash flows from irrevocable facilities are included in the cash flow forecasts.

The tables below are based on the final availability date of the contingent liabilities and irrevocable facilities.

• 1 FMO expects that not all of these off-balance items will be drawn before expiration date.

FMO complies with DNB’s Pillar 2 liquidity requirements methodology for Less Significant Institutions (LSIs) which have been applied from the supervisory review and evaluation process (SREP). The liquidity requirements are a survival period of at least 6 months based on internal stress testing methodology, a Net Stable Funding Ratio (NSFR) of 100% and, until 2018, a specific Liquidity Coverage Ratio (LCR) requirement of 125% (100% since 2019). FMO's internal liquidity appetite levels include a safety cushion over and above these minimum requirements as described in the section above. Following the risk appetite, FMO's liquidity position has been well above regulatory requirements and internal appetite levels throughout 2018. Per reporting date, FMO has a survival period of 9 months (2017: over 12 months), an LCR of 965% (2017: 542%) and a NSFR of 112% (2017: 128%).

FMO’s major liquidity exposures are in EUR and USD currencies. However, some transactions are denominated – and may be settled - in local currencies. These exposures are specifically hedged using financial instruments to minimize liquidity and settlement risks.

Funding and sustainability bonds

Treasury aims to ensure good market access by diversifying FMO’s funding sources. The result of this is a balanced funding mix in terms of geography, instrument and maturity.

Eurodollar (i.e. USD investors outside the United States) constitute key markets for FMO. Treasury has identified USD and EUR as strategic funding markets. Other markets to attract funding include Australia, Sweden and local frontier currencies. Typical investors in FMO paper, either through public or private issues, are hold to maturity investors. A final important factor to note about FMO funding, except for our Tier II issuance, is that it is plain vanilla; it is all senior unsecured funding. The liquidity profile of our funding notes is therefore very straightforward.

Sustainability bonds are also an important part of FMO’s funding strategy, that accounts for a 24% of the total capital market issuances as of December 2018. In January 2018, FMO has increased the outstanding SEK Sustainability Bond maturing by 29-Nov-23 with SEK 1.0 billion (USD 125 million) to SEK 2.7 billion. Moreover, the inaugural EUR 500 million Sustainability Bond launched in November 2013 matured this year. Finally, as per December 2018, FMO's Sustainability Bonds Framework has been updated as described in the developments section.

MARKET RISK

Market Risk is the risk that the value and/or the earnings of the bank decline because of unfavorable market movements. At FMO, it encompasses interest rate risk and currency risk.

INTEREST RATE RISK IN THE BANKING BOOK

Definition

Interest rate risk is the risk of potential loss due to adverse movements in interest rates. Changing interest rates mainly influence the fair value of fixed interest balance sheet items.

Risk appetite and governance

FMO has no trading book and all assets (loans and investments) are part of the banking book. FMO’s policy is to match assets and liabilities within set boundaries. As the loan portfolio is more granular, loans are pre-funded and new funding is obtained periodically and matched to the asset portfolio in terms of expected maturity and interest rate sensitivity. Interest rate risk arises from the residual tenor mismatch, mismatch in fixed rate assets funded by floating rate liabilities, and differences in reference rates or currencies resulting in basis risk. FMO has little optionality in its portfolio and has no material exposure to rates-driven prepayment risk. The volatility of the market value of assets and liabilities over the holding period due to interest rate movements is of lesser concern as these are held until maturity.

Interest rate risk management falls under the responsibility of the ALCO. The day-to-day management of interest rate risk, particularly quantification and monitoring, is delegated to Risk Management. Treasury department acts as the first line of defense and is responsible for daily transacting activities. Interest rate risk is monitored using earnings-based metrics and value-based metrics.

Earnings-based methods capture short-term effects of interest rate re-fixing or re-pricing that may impact net interest incomes. The metrics below are used for this purpose.

• The interest rate gap provides a static overview of the full balance sheet’s repricing and refinancing characteristics. The gap is monitored over different time buckets where limits are in place both per bucket and on cumulative level, for all currencies (aggregate and currency-by-currency).

• Earnings-at-Risk (EaR) provides a dynamic projection of net interest income sensitivity to yield curve shocks. FMO monitors EaR on a 2-year forward looking basis and applies different scenarios simultaneously that allow for identification of basis risk as well.

Economic value methods capture changes in net present values of assets, liabilities and off-balance sheet items to changes in yield curves. Value-based metrics measure long-term effects of interest rate changes over the full tenor of the balance sheet. The following economic value metrics are calculated:

• Basis Point Value (BPV) provides the change in market value of assets, liabilities and interest-rate risk sensitive off-balance items for a one basis point change in yield curves. Limits are in place for the whole balance sheet, and for main currencies (EUR and USD) separately.

• Equity Value at Risk (EVaR) provides changes in the economic value of the shareholder’s equity given certain shifts in yield curves. The impacts of both a 200 basis-points parallel shift and a 200 basis-points gradual shift are reported.

The interest rate gap and BPV exposure are monitored on weekly basis against limits set by the ALCO. Limits are defined dynamically to accommodate a 200 basis-points shock within 5% of shareholder’s equity. The EVaR limit is defined in the Risk Appetite Framework and set at 5% of shareholder’s equity. The EaR is used for monitoring purposes only and thresholds are defined based on 5% of projected net interest income.

Developments  

In 2018 FMO introduced limits to the interest rate gap to better manage repricing and refinancing risk. The limits are set both per time bucket and on cumulative levels.

Also, in 2018, FMO has incorporated in its models for calculating interest rate risk metrics all the required changes as specified in the Guidelines on the management arising from non-trading book activities published on July 19^th 2018 by the European Banking Authority (EBA).

Exposures

The following table summarizes the interest re-pricing characteristics for FMO’s assets and liabilities.

• 1 Fair value of individual components (e.g. individual swap legs) of derivative financial instruments is allocated to the relevant interest re-pricing category.

• 1 Fair value of individual components (e.g. individual swap legs) of derivative financial instruments is allocated to the relevant interest re-pricing category.

CURRENCY RISK

Definition

Currency risk is defined as the risk that changes in foreign currency exchange rates have an adverse effect on the value of FMO’s financial position and future cash flows. FMO also reviews currency risk in terms of impact on the capital ratios.

Risk appetite and governance

FMO offers loans and attracts funding in a wide range of currencies. This is done to provide financing in the currency best fitting FMO’s clients and to reduce currency risks on their side. To ensure proper diversification, FMO attracts funding in different currencies, both on-shore and off-shore, including emerging market and frontier market currencies which contribute to FMO’s goal to develop local currency markets.

FMO has limited appetite for currency risk. Exposures are hedged through matching currency characteristics of assets with liabilities, or through derivative transactions such as cross-currency swaps and FX forwards conducted with either commercial parties or with The Currency Exchange Fund (TCX Fund N.V.). Most currency exposures are hedged to US dollars on a micro-hedge basis, whereby the US dollar position is managed on a portfolio basis accordingly. FMO does not take any active positions in any currency for purpose of making a profit. Each individual currency is managed within a strict position limit and an overall appetite level is set at 1% of shareholder’s equity for the total open position across all currencies. Both the individual and overall open positions are monitored by Risk Management on a daily basis. Additionally, FMO maintains a deliberately unhedged foreign currency position for the purpose of structural hedge which is reported by Risk Management to the ALCO monthly. Please refer to structural hedge sub-section for further details.

Developments

No material developments materialized in 2018.

Exposures

The table below illustrates that the currency risk sensitivity gap per December 2018 is almost completely part of FMO's equity investments and investments in associates.

• 1 Fair value of individual components (e.g. individual swap legs) of derivative financial instruments is allocated to the relevant currency category.

• 1 Fair value of individual components (e.g. individual swap legs) of derivative financial instruments is allocated to the relevant currency category.

As described above, FMO’s loan assets in local currencies, such as Indian Rupee (INR), are fully swapped to US dollar on a cash flow basis. The positions in these currencies are therefore fully hedged. For IFRS reporting, however, the loans are recorded at (amortized) cost, while the related swaps are recorded at fair value, leading to an accounting mismatch in these currencies.

• 1 The sensitivities employ simplified scenarios. The sensitivity of profit & loss account and shareholders’ equity to possible changes in the main foreign currencies is based on the immediate impact on the financial assets and liabilities held at year-end, including the effect of hedging instruments.
• 2 Shareholders’ equity is sensitive to the currency sensitivity gap, including the equity investments valued at cost minus impairments.

Structural Hedge

FMO maintains a deliberately unhedged foreign currency position for purpose of managing the volatility of the capital ratio (structural hedge). These foreign currency positions stem from the private equity investments, and act as a hedge against an adverse effect of the exchange rate on the regulatory capital ratios. A depreciation of FMO's reporting currency (Euro) can significantly affect the capital ratio since FMO’s assets - and hence also the risk weighted assets - are mainly denominated in foreign currencies. The long open position in the equity portfolio thereby functions as a partial hedge for FMO’s regulatory capital ratios. In addition, the uncertainty in the size and the timing of the cash flows for equity investments makes micro- hedging less effective, hence these positions are better fit for use as a capital ratio hedge. With respect to equity investments, the expected returns in local currencies are assessed in terms of their sufficiency to compensate for the currency risk.

Article 352(2) of the CRR allows DNB to authorize, on an ad-hoc basis, the exclusion of FX positions taken deliberately by firms to hedge against the adverse effect of exchange rates on capital ratios where those positions are of a non-trading or structural nature (i.e. the waiver), where properly substantiated and justified. As of 2018, FMO does not have a waiver for its structural hedge positions under Article 352(2) of the CRR.