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. FMO aims to maintain a strong capital position that meets regulatory requirements and supports its AAA rating.

Risk appetite and governance

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

FMO uses both regulatory capital ratios and an internal economic capital ratio to determine its capital position. The regulatory ratios (Total Capital Ratio and CET1 Ratio) are calculated based on the standardized approach of the CRR and take credit, market, operational and credit valuation adjustment risks into account. The internal ratio (Economic Capital 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 is responsible for flagging potential capital issues and proposing and quantifying possible interventions to ALCO.

Developments

FMO’s Total Capital Ratio decreased from 25.5% at year-end 2018 to 22.5% at year-end 2019, which is well above the SREP minimum and the other regulatory requirements. 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 2019 primarily due to the implementation of the EBA Guideline on exposures to be associated with high risk (EBA/GL/2019/01) which caused an increase in risk weighted assets. An additional driver was the volume of new production and the resulting increase in the investment portfolio. The growth in FMO’s eligible capital due to the addition of profit partially compensated the above effects. Please see more details on the methodology used for calculating the capital ratios in the sections below. The Economic Capital Ratio decreased from 16.0% to 14.7% mainly due to increase in the investment portfolio and to a major credit risk internal model review that took place during 2019 (refer to the credit risk section).

FMO’s profitability may come under pressure due to the recent COVID-19 crisis, which full blown consequences are yet to be assessed. Portfolio growth may be lower as expected due to limited demand following economic slowdown.  It is likely that NPLs and provisioning levels will increase and fair value  of the private equity (PE) portfolio will be adjusted downward, which will have direct impact on FMO’s P&L. As a consequence, FMO’s capital ratios may be downwardly adjusted. FMO is closely monitoring the latest developments and is preparing mitigation actions for various scenarios.

Regulatory capital

Under the CRR/CRD-IV banks are required to hold sufficient capital to cover for the risks they face. FMO reports its capital ratio to the Dutch Central Bank (DNB) on a quarterly basis according to the standardized approach for all risk types. Per December 31, 2019, FMO's available qualifying capital equals €2,929 € (2018: €2,877) which makes FMO well prepared to absorb 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 considering 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 2020, The Dutch Central Bank has set a prudential requirement for FMO in terms of total capital at 16.8% and CET1 of 13.3%. The total prudential requirement consists of the total SREP capital ratio (13.3%), the combined buffer requirement (2.5%) 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 insignificant). As of 2019, the capital conservation buffer has been fully recognized at 2.5%.

The Pillar 2 guidance (P2G) determines the adequate level of capital to be maintained above the existing capital requirements in order to have sufficient capital buffer to withstand stressed situations (derived from the adverse scenario of the supervisory stress tests). The P2G is a non-binding requirement and no automatic restrictions on distributions of dividends or bonuses are imposed. 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 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 more risk sensitive, leading to a higher capital requirement than the standardized approach. The most important parameters 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 2014, the CRR/CRD IV rules 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 28.5% (2018: 31.1%) 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. 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 develop into reputation risk issues.

Risk appetite and governance

The mandate of FMO to invest in developing and emerging markets inherently 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. 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 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

FMO continued the storytelling campaign that was launched in 2018, where FMO presents its mission around the tagline ‘Doing makes the difference’. New stories were shared to explain the importance of FMO’s mandate, its motivation and challenges to external stakeholders. The aim is to create a better understanding of the delicacy and complexity of FMO’s work and how it deals with inherent dilemmas.

In 2019, FMO focused on transparency and stakeholder engagement with respect to human rights practices. The publication of the Human Rights Report was well received by stakeholders, leading to more knowledge about the FMOs human rights approach. As a member of the Dutch Banking Sector Agreement, FMO was subject to potential negative press coverage when some NGOs accused banks of not taking sufficient measures to protect human rights. FMO delivered input for a formal response of NVB to the NGOs. Through intense stakeholder engagement, the NGOs refrained from publication. FMO has set up an agenda with engagement activities to keeps close ties with the NGOs involved in monitoring banks' practices.