3 Risk developments

For a detailed overview of FMO’s risk governance and risk management approach please refer to the section "Risk Management" in FMO’s consolidated annual accounts as at December 31,2018. The risk developments in the first half year of 2019 are disclosed below.

3.1 Capital adequacy

FMO complies with the CRR/CRD-IV requirements and reports its capital ratios to the Dutch central bank on a quarterly basis. FMO calculates the external capital requirement for its entire portfolio based on the standardized approach. At the end of June 2019, the Total Capital ratio decreased to 24.8% from 25.5% as per December 2018. The decrease in capital ratio is mainly driven by increased risk weighted assets for credit and counterparty risk and a larger open foreign exchange position.

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.

3.2 Credit risk

FMO's non-performing loan portfolio (loans at amortized cost and loans at FVPL) decreased from EUR 417,000 at year-end 2018 to EUR 373,000 as of June 30, 2019. The ratio of non-performing loans compared to the total loan portfolio decreased in the course of 2019 from 8.1% to 7.3% as a result of write-offs and prepayments of credit impaired assets, while no exposure became non performing during the period. In parallel, the coverage ratio (impairments under stage 3 divided by non-performing loans) increased from 36% to 41%.

All Interest Bearing Securities (credit quality of AA+ or higher) and Banks (credit quality of BBB- or higher) are classified as Stage 1. An amount of EUR 63 thousand is calculated for the ECL of both asset classes as per June 30, 2019.

The following table shows the credit quality and the exposure to credit risk of the loans to the private sector at amortized cost at June 30, 2019. No material change is identified compared to the year-end 2018.

The following table shows the credit quality and the exposure to credit risk of the financial guarantees at June 30, 2019.

The following table shows the credit quality and the exposure to credit risk of the loan commitments to private sector at June 30, 2019. These represents contract signed but not disbursed yet.

• 1 Total financial guarantees represent EUR 76,012 classified as contingent liabilities and EUR 371,479 classified as irrevocable facilities, as per Section 6 Commitments and Contingent Liabilities.
• 2 Loan commitments for which no ECL is calculated (Fair Value loans or expired availability date).

The following tables shows the movement in ECL for the period June 30, 2019. No material change is identified compared to the year-end 2018.

The modelling methodologies, assumptions and inputs applied in determining ECL in the current period are consistent with those applied in the financial year ended December 31, 2018

3.3 Equity risk

Despite the increase in the equity portfolio due to new acquisitions during first half year of 2019, the results from equity investments amounted to a loss of EUR 3 million (H1 2018: EUR 44 million gain). The loss is a result of challenging economic, political and monetary developments in our main geographies - India, South Africa, Turkey and Nigeria. Moreover, valuations of investments in the financial sector have been under pressure. As large part of FMO's equity portfolio is denominated in USD, the average appreciation of EUR to USD exchange rate was relatively lower compared to the same period last year, generating lower foreign exchange gains in comparison to first half year of 2018. Refer to Note 10, Results from Equity Investments, for more information.

3.4 Concentration risk

FMO expects moderate economic growth in emerging and developing economies on short term. However, there may well be differences among countries, as outlooks for countries are formed by the interaction between country-specific characteristics and external developments. Among the important geographies for FMO, there are two countries that are currently going through a crisis, Turkey and Argentina. Both local currencies have been depreciating over the first half of 2019. From year-end 2018 until half year 2019, the Turkish Lira and Argentinian Pesos have respectively depreciated by nearly 9% and 12%, compared to EUR.

Turkey is an important market for FMO. The country has been hit by a FX-crisis in the summer of 2018 and the Turkish economy and the banking sector are struggling to absorb the impact of the FX-crisis. Turkey received downgrades by external rating agencies.  As a consequence, the internal rating decreased to F14 in 2018 (2017: F12), lowering the country limit and increasing the country limit utilization. As of June 30, 2019, FMO's exposure including impairments is EUR 355 million for debt and EUR 68 million for equity, excluding committed not disbursed and guarantees received. Exposure is diversified in Financial Institutions, Energy, Agribusiness, Food and Water sectors. FMO has no direct exposure to the sensitive construction industry or real estate. FMO monitors its portfolio closely in Turkey and did not encounter non-performing loans in the country so far but saw a decrease in its fair value of the private equity portfolio, primarily due to the currency depreciation.

Besides Turkey, Argentina is also going through a crisis. Over the course of 2018, GDP declined by 2.5% and is forecasted to decline by another 1.2% according to the IMF. Argentina is currently reforming its economy in order to comply with the largest IMF programme in the country’s history ( USD 57 billion). Additionally, the upcoming presidential elections planned in October 2019 already have caused turmoil in the market, far most marked by the strong currency depreciation after the results of the primary elections, where opposition candidate won 47% of the votes versus 32% of the votes for the ruling president.

As of June 30, 2019, the exposure including impairments is EUR 245 million for debt and EUR 42 million for equity, excluding committed not disbursed and guarantees received. Exposure is diversified among FMO’s sectors, with largest exposure in the Energy sector, followed by Agribusiness, Food and Water and Financial Institutions.

Despite FMO's debt exposure in Argentine Peso is hedged in line with risk appetite, the currency crisis can affect the underlying economy. Therefore, ongoing developments in Argentina are being closely monitored by FMO.

Overall, FMO keeps a well-diversified portfolio across a wide range of countries, which is assured through its limits framework on countries and sectors. Diversification across countries and sectors is a key strategy to safeguard the credit quality of the portfolio. Through its framework, FMO is able to absorb potential losses which may emerge from country crises as stated above.

3.5 Compliance risk

In the first half of 2019, no significant integrity incidents related to FMO employees have been reported and there were no integrity incidents at existing clients outside FMO’s risk appetite.

Following the DNB onsite examination in 2018, FMO responded by setting up a Financial Economic Crime (FEC) enhancement programme to address the findings and recommendations of DNB. The FEC programme includes remediation of Know Your Customer (KYC) files, which has started and will run through 2020.

3.6 Regulatory risk

This section describes the latest insights and regulatory publications that could impact FMO’s future risk position in addition to those described on page 159 of the 2018 Annual Report.

In January 2019 the Basel Committee published the new minimum capital requirements for market risk (bcbs 457). In this publication the Basel Committee created a “Simplified Standardized Approach” for market risk, which would allow FMO to apply a factor of 1.2 to its current market risk capital charge for its open FX positions. The simplified standardized approach, and specific eligibility thresholds, were not included in the final CRR-2 text. The European Commission will publish a Delegated Act in 2019 on the capital requirements for market risk, which will align with the final Basel Standard. Whether FMO is eligible to use the Simplified Standardized Approach, or the more complex Sensitivity Approach, will be determined in the Delegated Act. The potential capital charge using the Sensitivity Approach will depend on the final new risk weights and the type of liquid currency exposures FMO has after the look-through implementation (as described in the paragraph below).

In January 2019 the European Banking Authority (EBA) published a guideline (EBA/GL/2019/01) specifying which types of exposures are to be associated with particularly high risk. The guideline requires that institutions that apply the standardized approach for credit risk should label exposures with a particular high risk in case these exposures show structural differences that are not reflected in the existing flat risk weights. Applying the criteria in the guideline, FMO has determined that all subordinated debt exposures, and all project finance with a client rating worse than F13 (BB-) will be labelled as high risk items. The guideline applies as of July 1, 2019

In May 2019, the European Council adopted a comprehensive legislative package of reforms to CRR, CRD IV, the BRRD and the SRM Regulation (the "EU Banking Reforms"), including measures to increase the resilience of EU institutions and enhance financial stability. Most of the rules will start applying in mid-2021. The most relevant reform for FMO is the requirement to apply a look through for investments in equity and debt funds. In short, investments in Collective Investment Undertakings (CIUs, or Funds) are no longer automatically labelled as ‘high risk’ with a 150% risk weight. Instead, risk weights will be determined using the look-through approach (LTA) or mandate-based approach (MBA) which requires an institution to look at the funds underlying investments and calculate the risk weights based on funds actual investments and leverage.

In June 2019, in accordance with the EBA Guidelines on Management of Non-Performing and Forborne Exposures, FMO submitted a NPE (non-performing exposure) Strategy and Operational Plan to the Dutch Central Bank. This was required as FMO’s NPE ratio was above the 5.0% threshold at the end of 2018.