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 of 31 December,2019. The risk developments in the first half year of 2020 are disclosed below.

The COVID-19 outbreak and the subsequent lockdown in the Netherlands and countries where FMO operates, affected FMO’s processes and its clients. In response to these developments, FMO has adapted its governance in order to support business continuity and to enhance risk monitoring. Combined ALCO/IRC meetings were convened initially on a daily basis, continuing on a weekly basis, to monitor the impact of the COVID-19 pandemic on FMO’s business as well as funding markets and to enable quick decision- making. ALCO/IRC is supported by two newly created tasks forces:

• Liquidity and Financial Task Force (LFTF) which monitors the impact of the COVID-19 pandemic on the liquidity and capital situation of FMO

• Corona Business Task Force (CBTF) which monitors the impact on FMO’s operations, markets and clients.

During the first half of 2020, no additional liquidity or market risks materialized due to the COVID-19 pandemic.

3.1 Capital adequacy

FMO complies with the CRR/CRD requirements and reports its capital ratios to the Dutch Central Bank on a quarterly basis. FMO calculates the capital requirement for its entire portfolio based on the standardized approach. At the end of June 2020, the Total Capital ratio equalled to 22.8%, which is a comparable level as per December 2019 (22.5%).

Due to COVID - 19 pandemic, it was expected that the capital position would be effected due to the expected loan loss provisions and devaluation of the Private Equity portfolio. Although a net loss was indeed recognized and deducted from the Tier 1 Capital, this reduction was compensated by a decrease in risk weighted assets. This was mainly driven by lower credit risk capital requirement, due to the lower valuation of FMO’s portfolio. Moreover, the capital charge for market risk has decreased due to a smaller open position for USD, predominantly caused by the revaluation of the equity portfolio and the increased EUR/USD FX rate, and the recent update of EBA-guidance for closely correlated currencies, in which USD has been included as a closely correlated currency with EUR.

FMO’s capital ratio remains above the combined ratio of the SREP minimum and FMO’s internal buffers.

• 1 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

In 2020, the COVID-19 pandemic and related economic crisis is having a severe impact on emerging markets (EMs). It is also expected to significantly affect FMO’s clients and loan portfolio. Despite the crisis, FMO's NPLs reduced slightly from 9.8% to 9.6% during H1-2020. This reduction is a result of several factors, which includes calling on guarantees received for part of the NPL portfolio. FMO also had to write off a small portion of its NPLs. In view of the negative outlook, it is expected that the crisis will affect the NPL levels going forward.

In response to this outlook, FMO concluded that a country crisis override was justified and should be applied to the entire loan portfolio. Country ratings were considered the best proxy to estimate the increased risk of the individual clients. Risk ratings of a large number of clients were downgraded as FMO temporarily implemented more stringent country caps with respect to client sectors in April 2020. The country caps of clients related to the sectors Energy - construction and Energy - off grid were set as one rating notch lower than the respective country ratings. For the clients in the sector Agribusiness, Food and Water - exporting companies, the country caps were set as one rating notch better than the respective country ratings. For the clients related to other sectors, the country caps were considered equal to the respective country ratings. As a result, significant financial impact of the country overrides was reflected in the March to April ECL movement. This impact was observed in two ways: migration from Stage 1 to 2 due to significant increase in credit risk (namely 3 notch downgrade since origination) and increased Stage 1 and 2 impairments due to higher PDs (while the clients remained in the same stage). During this period, ECL for Stage 2 increased by €39 million due to rating migrations from Stage 1 to 2. Furthermore, stage 1 and stage 2 impairments increased by €26 million due to rating downgrades to clients without stage migration. The total impact of adjusting risk ratings as result of this management overlay amounts to €65 million.

The approach applied before COVID - 19 outbreak for incorporating country caps is as follows: for banks and non - banking financial institutions, the final rating would be capped at a maximum of 3 notches better than the client’s country rating if the country rating were F16 or worse; if the country rating was F15 or better, the country cap would be 2 notches. For Corporates, the final rating was capped at a maximum of 3 notches better than the client’s country rating. For Project Finance, the final rating was capped at maximum of 1 notch better than the client’s country rating in case of a Purchasing Power Agreement/Offtake Agreement with a government-related entity. For all other projects, the cap was two notches. If country ratings change, the impact on impairment charge at a portfolio level is expected to be more substantial under the new country caps for countries with low ratings. Country ratings have been updated based on currently available information from external rating agencies, which means that not all countries were downgraded at this point in time. Due to the overall decline of the global economy however, country ratings are likely to face downward adjustments in the near future.

In the first half of 2020, country crisis adjustment and, to a lesser extent, forbearance measures (due to payment holidays) resulted in an increase in the stage-2 portfolio from €502 million to €983 million, and a stage-2 impairment charge of €84 million (YE 2019: €25 million). The stage-3 impairment charge for H1-2020 amounted to €188 million (YE 2019: €182 million), which reflects that FMO’s clients are, at this moment, still coping relatively well with the COVID-19 crisis. However, it is expected that the negative economic outlook will affect FMO’s portfolio and hence stage-3 impairments over time. FMO is closely monitoring the loan portfolio.

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 €111 thousand is calculated for the ECL of both asset classes as per June 30, 2020.

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, 2020. An increase is mainly observed in Stage 2 exposures and ECL allowance, driven by changes in the client ratings which were monitored and updated after the start of the COVID - 19 pandemic.

The following table shows the credit quality and the exposure to credit risk of the financial guarantees on June 30, 2020.

The following table shows the credit quality and the exposure to credit risk of the loan commitments to private sector on June 30, 2020. These represents contract signed but not disbursed yet. A similar trend is visible for these exposures as loans to the private sector due to downgrades in client ratings. 

• 1 Total financial guarantees represent €74,777 classified as contingent liabilities and €292,063 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 changes in loans for the period June 30, 2020. 

• 1 Total financial guarantees represent €74,777 classified as contingent liabilities and €292,063 classified as irrevocable facilities, as per Section 6 Commitments and Contingent Liabilities.

The modelling methodologies, assumptions and inputs applied in determining ECL in the current period are consistent with those applied in the financial year ending December 31, 2019, except for the adjustment of the country caps.

The COVID-19 pandemic triggered discussions regarding any potential need for reassessment of the impairment model. Some aspects of the impairment model such as staging criteria were rethought but it was concluded that there was not sufficient justification to make a change in model assumptions and methodology. However, it was decided that any payment deferrals or holidays granted to the COVID-19 affected clients will be treated as forbearance measures and therefore, the clients will be transferred to stage 2. Moreover, the macroeconomic scenarios’ model was updated following the publication of the new COVID-19-incorporated macroeconomic outlook data by the International Monetary Fund (IMF) in April 2020 and in June 2020. The updates of the model caused new point-in-time adjustments to probability of defaults in the impairment model, leading to an increase of €5.54 and  €3.23 million in combined stage-1 and stage-2 impairment charge in April and June 2020, respectively.

FMO has announced it will undertake several restructuring measures to support clients. These include granting payment holidays (temporarily forbearing repayment of notional) to clients with short term liquidity needs. Existing clients can also apply for loans providing additional liquidity. Moreover, FMO is extending grants to a group of clients to enable them to adapt their business models and to support COVID - 19 affected communities to meet current health and socio-economic challenges. During Q2 2020, only a limited number of restructuring measures were requested and approved, having no material impact on the gains/losses due to modifications. As the COVID - 19 pandemic is now accelerating in the countries where FMO operates, more requests related to restructuring of loans are expected over time.

3.3 Equity investment risk

Initially, COVID-19 was limited to China and the only negative impact FMO expected was related to supply chain disruptions. In March 2020, the COVID-19 pandemic accelerated, affecting FMO's equity investments portfolio significantly after Q1 2020. Despite relatively strong dividend income (€20 million), which FMO mainly received in Q1 2020, a loss of €189 million (refer to note 'Results from Equity Investments') was incurred during first half of the year, driven by the reduction in the value of the equity investments portfolio by approximately 12.5%.

The fair value of the equity investments is based on best reasonable estimates, which rely on the latest available financial information. Due to the timing of the publication of the available information (which is mainly based on the March 31^st financial reporting of investees), the effect of COVID-19 was not always fully considered in the information received. Therefore, when applicable (where the COVID-19 was not yet included in the received information), FMO further adjusted the inputs for valuations by using the MSCI (Morgan Stanley Capital International) indexes, specifically Emerging and Frontier markets, to generate a reasonable estimate of the fair value as per June 30, 2020. The adjustment is based on the global/regional indices while also considering the currency exposure (LCY, USD and EUR). 

Although a lot of companies are affected, most losses can be found in the financial sector in Africa and India. Moreover the poor macro-economic situation in Argentina resulted in a lower valuation of FMO's investments in that country. In the Energy sector we also noted a slow-down of new project construction and payment issues of distributors, affecting return. Exit risk did increase in Q1 and Q2 2020 as the market for private equity transactions slowed considerably. In Q1 2020, we did receive return of capital distributions from our fund investments (€33 million); however, most transactions were contracted in 2019, resulting in distributions in 2020. In Q2 2020 this slowed down to €27 million. Exit processes on our direct investments are postponed or awaiting approvals. The expectation is that the exit risk will further increase in second half of 2020.  

3.4 Concentration risk

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 an institution’s health or ability to maintain its core operations or trigger material change in institution’s risk profile. Strong diversification within FMO’s emerging market portfolio is ensured through stringent limits on individual counterparties, sectors, countries and regions. These limits are monitored by FMO's Risk department, regularly reviewed and approved by the IRC. Diversification across countries, sectors and individual counterparties, is a key strategy to safeguard the credit quality of the portfolio.

To ensure diversification within FMO’s emerging market portfolio across regions, a country limit framework is in place to mitigate concentration risk from the perspective of the portfolio as a whole. Country limits range from 8% to 22% of FMO’s shareholders’ equity, depending on the country rating, where FMO sets higher limits in less risky countries. Sector limits are in place, with a limit equal to 50% of the country limit for each sector in any given country. 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.

During the first half of 2020, country risk has become an even more important risk factor as the shape of the world economy has changed significantly, with the COVID-19 pandemic spreading across the globe. Without exceptions, all geographies important to FMO are impacted by this pandemic. Instead of a predicted growth in developing and emerging markets of around 4-5% in 2020 and 2021 (IMF WEO Jan 2020), forecasts have been drastically revised. A decline of 3% in 2020, with a recovery to 6% in 2021, is now projected (IMF WEO June 2020).

Consequently, a number of countries were downgraded in the first half year of 2020, most notably Argentina, Costa Rica, Ecuador, Lebanon, South Africa, Sri Lanka and Zambia. The downgrades of Costa Rica, Ecuador, South Africa and Sri Lanka also led to a reduced country limit.

Given the high uncertainty regarding developments in the markets, countries have become more prone to being downgraded by rating agencies, possibly resulting in lower country limits. Besides, a decline in shareholders’ equity leads to lower country limits. In order for FMO to remain a reliable partner for its clients in markets especially important to FMO, country limits for a number of countries were temporarily fixed. This ensures business continuity and mitigates the reputational risk that would emerge if transactions would need to be cancelled at a very late stage.

Apart from economic developments in FMO’s regions and their effect on the country limits, FMO closely follows the development of COVID-19 cases and policy responses in its markets. Since June, India is the country with the highest number of confirmed cases among the key markets important for FMO; followed by South Africa and Turkey. New confirmed cases in India and South Africa are still growing daily at an exponential rate. Turkey saw the curve with daily confirmed cases flattening over the course of April. Next to South Africa, various other Sub-Saharan African countries experienced the largest percentual increase in the total number of cases over this last period. Cases of COVID-19 cases continue to increase in many of the key developing countries (i.e. not flattening the curve), indicating that lockdowns are not sustainable or that measures do not have the desired effect.

On a sector level, FMO observed that in the Agribusiness, Food & Water sector some clients suffer from tightening of local liquidity and 10 to 15% of our clients have requested deferral of payments. The Energy portfolio shows different developments in different regions and markets, with an elevated risk profile in East Africa. About 20% of the portfolio is classified as subject to high risk due to the COVID-19 circumstances. Within Financial Institutions, an elevated risk profile is observed for some 20% of FMO’s clients, whereby the impact of the COVID-19 crisis is expected to become visible with a delay.

FMO monitors the developments in its markets on an ongoing basis, whereby the Corona Business Taskforce plays an important role in translating developments in the markets into actions we can take to support our clients where possible.

Overall, FMO keeps a well-diversified portfolio across a wide range of countries, which is assured through its limits framework on countries and sectors, and through close monitoring. Despite the fact that all countries are affected by the COVID-19 pandemic, the impact of the pandemic on our markets differs per country as the government responses vary in timing and stringency. Diversification across countries and sectors remains a key strategy to safeguard the credit quality of the portfolio.

3.5 Compliance risk

Based on a revised Financial Economic Crime (FEC) Enhancement program plan sent to DNB at the end of March 2020, FMO continued to remediate KYC files and execute the plan in 2020. A more comprehensive scope is taken to improve and ensure sound and controlled operations towards “know-your-customer” requirements, thereby transparently managing customer integrity risks that specifically apply to FMOs customer portfolio. Improvements were made related, for example, to hiring new staff in both the first line - enabling FMO to further develop a dedicated KYC team - as well as in the Compliance department. Further preparations for the desired future proof infrastructure and processes aim to go-live in the third quarter of 2020 while work continues on remediating “KYC-files”. A robust training course was rolled out for relevant existing and new staff within the first line and support functions, e.g. on awareness regarding anti-money laundering risks, the latest requirements, and the revised financial economic crime framework. In total more than 300 employees were trained. This will continue in 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 in the Regulatory Risk section of the 2019 Annual Report.

The unprecedented COVID-19 outbreak has forced regulators to put in place a set of supervision measures with the aim to alleviate the operational burden for banks and support lending, while maintaining a sound capital base. To this end, supervisors have temporarily allowed banks to operate below certain capital buffers (CCB and P2G), but it remains uncertain at what pace buffers will be required to be re-built. On 27 March 2020, The Basel Committee also announced deferral of implementation of the final phase of the Basel III standard by one year. This will affect the revisions of Capital Requirements Regulation and market risk framework, which means that a higher risk weight for equity investments and a higher capital charge for market risk will be delayed or possibly revised. Such postponement gives FMO more time to prepare for implementation, but it also increases uncertainty regarding upcoming regulatory actions.

Despite the high priority level of the COVID-19 pandemic, European supervisors remain committed to further advancing the management and disclosure of climate-related and environmental risks. On 20 May 2020, ECB published a draft Guide on climate-related and environmental risks for consultation. The Guide represents a first supervisory standard in this field. The Guide will be effective immediately upon its final publication which is expected later in 2020. In light of the expectations set out in the Guide, FMO will need to adapt its internal practices and include climate-related and environmental risks considerations into business strategy, risk management and governance frameworks, as well as to enhance the climate-related and environmental disclosures.