Financial Risk

Investment risk

Investment risk is defined as the risk that actual investment returns will be lower than expected returns, and includes 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 market 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.

Credit Risk management is very important at FMO, both in the context of project selection and project monitoring. In this process, a set of investment criteria per sector and product is used that reflects minimum standards for the required financial strength of FMO’s clients. This is further supported by credit risk models that are used for risk quantification, calculation expected credit loss allowance, and the determination of economic capital use per transaction. Funding decisions depend on the risk profile of the client and financing instrument. For credit monitoring, FMO’s clients are subject to annual reviews at a minimum. FMO also monitors clients that are identified 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 the analysis, Credit will propose mitigating measures to the IRC. If any of the indicators deteriorate further, Risk will be involved to assess to what extent the trend is threatening FMO’s capital and liquidity ratios.

Developments

In 2020, the COVID-19 pandemic had a severe impact on emerging markets. It was also expected to significantly affect FMO’s clients and loan portfolio. However, despite the crisis, FMO’s Non-Performing Loans (NPLs) reduced from 9.8% to 9.1% during 2020. This reduction is a result of several factors, which includes calling on guarantees received for part of the NPL portfolio. FMO also wrote off some of its NPLs (€64 million in 2020) and new NPLs were limited. Considering the negative or uncertain economic outlook, it can still be expected that the crisis will affect the NPL levels going forward in 2021.

In March 2020, in response to the emerging COVID-19 pandemic, FMO concluded that a crisis override (considered an overlay, please refer to ‘Management overlay’ in Accounting policies section) was required in the rating methodology, to 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 March 2020. As a result, significant financial impact of the country overrides was reflected in the 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). In the second half of 2020, the necessity and level of the override was again evaluated. Due to the remaining uncertainty about the impact of the crisis on FMO’s clients, FMO deemed it justified to maintain a crisis override. However, FMO decided to gradually reduce the level of the crisis override, because a significant part of the COVID-19 impact already should be reflected in country ratings and individual client ratings. In addition, it also transpired that our clients have so far been able to do relatively well despite the crisis. Therefore, in the last quarter of 2020, a revised level of overrides was implemented. In addition, individual clients were assessed by the end of 2020 to assure the revised rating properly reflects the potential COVID impact. There was a total impact of €34 million increase in stage 1 and 2 impairments in 2020 related to the revised level of overrides and reassessment of the individual clients in Q4. Of the €34 million increase in impairments, €31 million was due to the combined impact of rating changes without stage migration (€2 million release in stage 1 and €33 million increase in stage 2 impairments) and €3 million was due to the combined impact of rating changes with stage migration (€3 million release in stage 1 and €6 million increase in stage 2 impairments).

The ordinary country caps before COVID are summarized in the table below^[1].

The COVID-led country caps (initial and revised) are summarized in the table below.

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 regularly updated based on currently available information from external rating agencies and not all countries were downgraded at this point in time.

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 using third-party guarantees, master netting, or collateral agreements. Regarding derivative financial instruments, only the ones with positive market values are presented. The maximum exposure to credit risk decreased during the year to €8.20 billion as of year-end 2020 (2019: €8.78 billion). There was an increase in short term deposits at the Dutch Central Bank accompanied by a decrease in FMO’s credit exposure from loans to the private sector in emerging markets, which moved from €5.37 billion to €5.09 billion.

• 1 The lower the credit rating, the higher the F-rating in FMO’s terminology and the worse the creditworthiness of the clients, and vice versa.
• 2 In this example, the final rating considering the country cap cannot be more than three notches better than the country rating.

In measuring the credit risk of the emerging market portfolio at client level, the main parameters used 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 financial and key performance indicators. FMO has a Customer Risk Rating (CRR) methodology. The model follows the EBA guidelines regarding the appropriate treatment of a Low Default Portfolio and uses an alternative for 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 are different for respective client types. The models for Banks and Non-Banking Financial Institutions (NBFIs) use factors including the financial strength of the client, 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.

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 Loss Given Default is assigned by scoring various dimensions of the product specific risk and incorporating client characteristics. 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 Expected Credit Loss (ECL) calculation methodology.

The majority of our gross loan portfolio (82%) remains in the F11 to F16 ratings categories. Overall, the credit quality of FMO’s loan portfolio deteriorated in 2020, for the portion of the portfolio rated F17 or worse rising from 11% to 16%, and the portion of the portfolio rated F13 or better decreasing from 54% to 35%. This was a result of worsening economic environment caused by the COVID-19 pandemic, implying both client/country rating deteriorations and crisis overrides. These ultimately affected the allocation of client ratings more to deteriorated ratings.

Credit quality analysis

As of 31 December 2020, the overall impact of country crisis adjustments, individual client ratings and to a minimum extent, forbearance measures (e.g. due to payment holidays) resulted in an increase in the stage-2 portfolio to €768 million (2019: €502 million), and a stage-2 impairment charge of €46 million (2019: €25 million). The stage-3 impairment charge for YE 2020 amounted to €147 million (2019: €182 million), which reflects that FMO’s clients were, as of year-end 2020, still coping relatively well with the COVID-19 crisis. However, it can still be expected that the negative economic outlook will affect FMO’s portfolio and hence stage-3 impairments over time. FMO will closely monitor the loan portfolio.

Apart from 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 when any of the following occur: 

• • When FMO judges that the client is "unlikely to pay" its credit obligation to FMO and IRC decides on a specific impairment on a loan (Stage 3);

  • Loans with interest, principal or fee payments that are past due for more than 90 days (Stage 3);

  • Forborne exposures which are economically performing but are still in probation (curing) period due to Regulatory Standards (Stage 2). Probation period before returning to performing status is one year;

  • Additional forbearance measures are applied for forborne performing loans which have exited the NPL probation (Stage 2);

  • Performing forborne loans which have exited the NPL probation period have past due amounts for more than 30 days (Stage 2);

  • One of the loans is classified as non-performing due to criteria mentioned above, all loans of the client will be identified as non-performing (Stage 2).

As of 31 December 2020, FMO’s NPLs amounted to €464 million (2019: €524 million). FMO’s NPL ratio decreased from 9.8% to 9.1% as a result of the calling of guarantees, a higher amount of write-offs and limited new NPLs.

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

New NPLs in 2020 were highest in the Energy Sector, followed by the Financial Institutions Sector. Overall, NPLs in absolute terms are now highest in the Energy Sector (€164 million), followed by the Industry, Manufacturing and Services (IMS) sector (€158 million). Activities in the IMS sector were terminated during 2017 following a strategic reorientation. The amount of FMO’s NPLs in the Agri Sector and Financial Institutions Sectors amounted to respectively €101 million and €40 million. Overall, the NPL ratio for current focus sectors (i.e. excluding IMS) increased to 6.7% (2019: 6.2%). Geographically, NPLs remained concentrated in India, with a share in total NPLs of 18% (2019: 21%). The second largest country is Argentina, which makes up 17% (2019: 19%) of total NPLs. NPL levels in FMO’s portfolio partially reflect long recovery periods, which are inherent in markets where FMO operates.

Among the NPLs, the loans with interest and/or principal payments that are past due more than 90 days amount to 5.8% (2019: 6.6%) 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.

The table below presents the distribution of Stage 3 loans according to regions and sectors. Impairments are highest in the Agribusiness sector. Geographically there is reduced level of impairments in all regions more considerably in Africa due to the write-off of an Energy client.

Modified financial assets

Changes in terms and conditions usually include extending the maturity, changing the interest margin and changing the timing of interest payments. When the terms and conditions are modified due to financial difficulties, these loans are qualified as forborne. Refer to paragraph related to 'Modification of financial assets' in Accounting Policies section.

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 2020, FMO’s write-offs equaled to €64 million due to 4 loans (2019: 3).

The following table provides a summary of FMO’s forborne assets, both classified as performing and non-performing, as of December 31, 2020.

The following table shows the movement of gross outstanding amount and ECL impact of Stage 2 and Stage 3 loans which were modified during 2020. 

For the forborne loans restored and transferred to Stage 1, ECL decreased from €0.55 million to €0.52 million. There were no loans restored from forborne status which entered into Stage 2/3.

The table below includes Stage 2 and Stage 3 assets for which terms and conditions were modified with the related net modification profit. 

Credit risk mitigation

As per December 31, 2020, the total carrying value of the FMO’s loan portfolio is €4.7 billion; of which €642 million 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.

The total carrying value of defaulted (stage 3) loans in FMO’s loan portfolio is €155 million; of which €47 million 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.

The majority of amounts of guarantees received and carrying amounts of guaranteed loans are related to stage 1 or performing loans in both 2019 and 2020.

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 materialize exits. The equity investment portfolio consists of direct investments, largely in the financial institutions and energy sectors, co-investments with aligned partners (mainly in cooperation with funds) and indirect investments in private equity funds. The three types of investments require different type of risk assessments and selection criteria. Equity investments are approved by the Investment Committee. In close cooperation with the Credit and Finance departments, the Private Equity department assesses the valuation of equity investments on a periodic basis which are approved by the IRC. Diversification across geographical area, sector and equity type across the total portfolio is evaluated before new investments are made. Based on this performance and the market circumstances, direct exits are pursued by involving intermediaries. For co-investments our fund managers do initiate the exit process as they are in the lead. Exits are limited by available liquidity and the absence of well-developed stock markets.

The risk of building an equity portfolio is driven by two factors:

• 1. Negative value adjustments due to currency effects (EUR/USD and USD/Local FX), negative economic developments in emerging markets (EM) and specific investee related issues. This would negatively affect the profitability of FMO.

• 2. Liquidity of the portfolio – in case FMO is not able to liquidate (part) of its maturing equity portfolio by creating sufficient exits for its direct and co- investment portfolio. This is also reflected in the fund portfolio where some fund managers have to hold longer to their portfolio due to the lack of good exit opportunities.

Developments

In 2020 the market was largely affected by COVID-19, the US–China trade war and devaluation of the USD versus the EUR. Especially the effects of COVID-19 created uncertainty related to the valuation of our investments. Especially the financial sector investments were impacted, leading to a sharp reduction of valuations. In addition, our African fund portfolio also suffered by weakening of local currencies and by COVID-19. Liquidity flows to emerging markets reduced significantly as a first reaction to COVID-19, however with the huge abundance of liquidity in developed markets, liquidity started to return during the last two months of 2020 to emerging markets mainly to frontier Asia. In Africa commercial funding is still limited and almost fully dominated by local liquidity and international financial institutions (IFI’s). The depreciation of the USD in the second half of 2020 (from USD/EUR 1.12 to 1.22) further had a negative impact on the valuations of our equity portfolio.

In 2020 our committed equity portfolio reduced in value to €2.6 billion (2019: €2.8 billion) due to decrease of valuation by €84 million and reduction of €116 million due to the direct impact of the USD/EUR change. We paid-in more capital than we got distributed by funds and through direct exits. In line with our ambition, the percentage of direct investments versus fund investments grew from 44% to 45%. Overall, the return of our portfolio was negative -8.6%. However the level of dividend income was relatively stable and amounted to €32.9 million (2019: €29.5 million)

Exposures

The total outstanding equity portfolio at December 31, 2020, amounts to €2.0 billion (2019: €2.1 billion) of which €900 million (2019: €988 million) is invested in investment funds.

The equity portfolio is left unhedged for FX risk. For more information please refer to the sections on Currency risk and Structural Hedge.

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 trigger material change in 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, 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

Without exceptions, all geographies important to FMO are impacted by the 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 2.4% in 2020, with a recovery to 6.3% in 2021, is now projected (IMF WEO January 2021). The occurrence of the pandemic has a large impact on global economy as well as on performance of FMO’s customers.

FMO has intensively monitored its portfolio throughout 2020 since the surging volatility in commodity and FX markets increased the uncertainty on each focus sector of FMO. On the other hand, the impact of COVID-19 on FMO’s portfolio is different per sector and geography since countries took different measures in response, which reduced and postponed the negative consequences of the pandemic.

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.

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 shareholders equity, 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 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 in 2020. This ensures business continuity and mitigates the reputational risk that would emerge if transactions would need to be cancelled at a very late stage. The fixation of country limits will be re-assessed in the first quarter of 2021.

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 2020 were India, Turkey and Argentina, together 20% of the total loan exposure. Throughout 2020, the internal rating of Argentina was downgraded from F19 to F20 but has recovered to F19 at the end of the year. The ratings of India and Turkey did not change. Noteworthy changes in country ratings are downgrades of Armenia to F14 (2019: F13), Costa Rica to F15 (2019: F14), Ecuador to F17 (2019: F16) and South Africa to F13 (2019: F11), Ukraine upgraded to F15 (2019: F16).

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

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 the CRR norm of 25% of eligible regulatory 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 fulfill 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 does not have its own trading book and does not actively take 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 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 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

FMO has followed developments since 2019 for the Brexit Action Plan and in addition, FMO advanced the companywide project starting in early 2019 that captures the full impact of changes and discontinuation of Benchmark interest rates, such as Libor and Eonia. For more details please refer to the section 'Legal Risk'. Furthermore, there has been an increased frequency of rating downgrades of FMO’s treasury counterparties within 2020 compared to 2019 mostly owing to the aftermath of the COVID-19 pandemic. However, the latter has not led to a limit breach or urgent mitigating actions by FMO.

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 31 December.

Supra-nationals are international organizations or unions in which member states delegate part of their national powers to a collective decision-making body.

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 fulfill 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 fulfill 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 the 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 to ensure a minimum buffer above the 7-months minimum survival period under stress, a liquidity coverage ratio (LCR) to exceed 135%, a Net Stable Funding Ratio (NSFR) to exceed 110%, 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 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.

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

During 2020, FMO’s liquidity position remained comfortably above the regulatory requirements and the internal managerial limits, with an LCR never falling below 435%. In addition, FMO accessed the capital markets also at the peak of crisis, confirmed by the successful issuance of €500 million sustainability bond on April 4, 2020. An internal Task Force was also established to report on liquidity and financial positions to senior management during full year 2020, providing different scenarios based on market developments.

In addition, over the past few years, FMO has established a key role in local currency frontier markets and is keen to continue issuances in 2021, fostering capital markets development in line with its mandate. In total, FMO issued approximately US$ 136 million of equivalent funding in local currency transactions during 2020. In these transactions a total of US$ 50 million was issued in Uzbekistani Soum, which can be considered a significant amount in frontier market funding.

Liquidity position

Throughout the course of 2020, FMO's liquidity position has been compliant with 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 a specific Liquidity Coverage Ratio (LCR) requirement of 100%. 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 2020. Per reporting date, FMO has a survival period exceeding 8 years (2019: 48 months), an LCR of 1116% (2019: 252%) and a NSFR of 127% (2019: 120%).

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 debentures and notes, either through public or private issuances, hold these instruments till maturity. A final important factor to note about FMO funding, except for our Tier II issuance, is that it is plain vanilla and generally senior unsecured funding. The liquidity profile of our funding notes is therefore very straightforward.

Thematic bonds are an important part of FMO’s funding strategy, that accounted for about 62% of the total capital market issuances in 2020. The FMO Sustainability Bonds Framework was updated in December 2018 in order to issue Green Bonds, Social Bonds or Sustainability Bonds to support FMO’s Strategy. In 2020, FMO has issued another €500 million sustainability bond and a €135 million green bond.

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, this includes 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 defined limits. 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 less 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. 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  

Following extensive preparations for the (L)IBOR transition to new benchmark rates, the first two transitions for cleared derivatives (interest rate swaps) progressed according to plan: in July 2020 LCH transitioned from EONIA to ESTR discounting, in October 2020 LCH transitioned from FedFunds to SOFR discounting. On both occasions, FMO’s interest rate position was not significantly affected. The Benchmark rates reform and discontinuation of LIBOR is continuing to be closely monitored by FMO’s BMR&IBOR ending project.

Exposures

The limits with respect to interest rate risk were not breached in 2020. 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 on a daily basis. Additionally, FMO maintains a deliberately unhedged foreign currency position for the purpose of structural hedge which is reported to the ALCO monthly. Please refer to the structural hedge sub-section for further details.

Developments

No material developments occurred in 2020.

Exposures

Individual and total open currency positions were within risk appetite in 2020. The table below illustrates that the currency risk sensitivity gap per December 2020 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 equity investments valued at fair value through other comprehensive income.

Structural Hedge

FMO maintains a deliberately unhedged foreign currency position for purpose of managing the volatility of the capital ratio. 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.