Credit risk refers to the risk of a loss being incurred as a consequence of a counterparty’s incapacity to meet its obligations on time. On 31 December 2015, 79 (77) percent of Kommuninvest’s credit risk exposure was towards Swedish municipalities and county councils/regions in the form of loans; 20 (22) percent of the exposure was towards states and other issuers of securities in the form of investments; and 1 (1) percent of the exposure was towards derivatives counterparties. The total credit risk exposure, gross and net, is detailed in Note 3. Credit risk is divided into credit provider risk, issuer risk and counterparty risk.
Risk in credit provision
Credit provider risk refers to the risk that a credit counterparty is unable to meet its obligations. Kommuninvest may only provide credit to members and approved companies over whom one or more members have a decisive influence. Approved companies, foundations and associations are to be covered by a guarantee from one or more members. Members and approved companies are followed up continuously and assessed from a holistic perspective at the corporation level. The municipalities and county councils/regions and the companies they own respectively are analysed when processing membership applications and on an ongoing basis during their membership. To obtain an overall view of a member’s financial situation, a quantitative risk value analysis is performed. The analysis includes the income statement, balance sheet, demographics and risks in municipal operations. Once a quantitative analysis has been made, it is, if necessary, followed by a qualitative analysis. This scrutinises and analyses the local government corporation and its financial conditions in more detail. Lending can be limited on the basis of the combined analysis. Since all loans are made to, or are guaranteed by, municipalities and county councils/regions, the risks in the Group’s lending activities are considered low. The Group has never suffered a credit loss in its lending operations. In 2015, the ten largest borrowers accounted for 20 (22) percent of lending, while thecombined population of these borrowers was equivalent to 12 (12) percent of the totalpopulation of the Society’s members. Characteristic of these borrowers is that they arerelatively large and growing municipalities with sizeable operations in company formats.
Kommuninvest’s liquidity reserve shall consist of securities issued by governments and financial institutions. Issuer risk refers to the risk that an issuer fails to repay its full undertaking on maturity. When investing in securities, risk taking shall be kept to a minimum according to the owners’ basic agreement for the operations. The Group’s Board of Directors sets the maximum gross exposure towards individual issuers. The maturity of securities in the liquidity reserve shall not exceed the period during which the financial capacity of the counterparty can be assessed. The liquidity reserve must at all times (to at least 97 percent) be invested in securities and bank deposits with a credit rating of at least A from Standard & Poor’s or A2 from Moody’s. The maximum maturity for investments is 5.5 years. The Kingdom of Sweden (the Swedish state) is approved as counterparty without further decisions being required. For counterparties outside Sweden, the permitted exposure is subject to a country-based limit.
To limit the market risks that arise when contractual borrowing and lending terms do not match, the Group uses risk management instruments in the form of derivative contracts. This gives rise to counterparty risk, that is, the risk that a counterparty to a financial agreement fails to meet its commitments in accordance with the agreement. The Group limits counterparty risks by a) requiring agreements to be set out in accordance with the financial industry standard (ISDA agreements) and b) by signing collateral agreements with counterparties (CSA agreements), see below. Risk taking is also limited by derivative agreements being required to include the right for the Group to transfer derivative agreements to a new counterparty in the event that a counterparty’s credit rate falls below Baa3 (Moody’s) or BBB- (Standard & Poor’s). The counterparty’s credit rating is also decisive in what the Group is prepared to accept when it comes to the contracts’ maturity period, structure and permitted risk exposure.
Membership of ISDA
The Group is a member of the International Swaps and Derivatives Association (ISDA), and before entering derivative contracts it stipulates the right to early redemption of suchcontracts if the counterparty’s credit rating deteriorates below a pre-determined level. The risk exposure comprises the cost of entering an equivalent contract in the market. Such cost is calculated for each contract and is considered a risk to the contract counterparty. ISDA agreements are to be established with all derivatives counterparties. The Group is also a member of the International Capital Markets Association (ICMA), which is responsible for, among other things, the established market standard for repo agreements.
To limit the risks arising because of value changes to derivatives and repo transactions, the Group enters collateral agreements with its counterparties – CSA’s (Credit Support Annexes) for derivatives contracts and GMRA’s (Global Master Repurchase Agreements) for repo transactions. These give the Group the right, under certain conditions, to require collateral but also an obligation to providecollateral under certain other conditions. The change in the value of signed contracts in relation to the exposure and counterparty creditworthiness determined in the agreement is what determines when collateral should be pledged and how much collateral there should be. The Group accepts collateral only in the form of government securities, which have zero risk-weighting from a capital adequacy perspective. Collateral agreements are intended to mitigate the credit and counterparty risk associated with receivables.
Counterparty exposure in 2015
For derivative contracts of a market value entailing Kommuninvest having a claim on the counterparty, a counterparty risk is incurred. Netted per counterparty and with collateral deducted, counterparty risk amounted to SEK 1,726 (2,526) million as of 31 December 2015. For further information on netting and collateral, see Notes 3 and 27.
Concentration risk refers to the risk of losses beyond what is justified by an individual customer/issuer/counterparty’s credit rating, due to the correlation of the risk of default among customers/issuers/counterparties. The correlation in the risk of default can be explained by factors such as industrial and geographical affiliation. The Group’s assignment, to provide credit to the local government sector, entails concentrations in the provision of credit. Concentrations in the provision of credit are restricted by limits on lending to individual customers. Concentrations of issuers in the Group’s investment portfolio and counterparties in the Group’s derivatives portfolio are restricted by limits on both individual counterparties and countries.
Market risk is defined as the risk that the net value (combined value) of the Group’s assets and liabilities will decrease due to changes in risk factors in the financial market. The Group’s market risks are divided into interest rate risk, foreign exchange risk, credit market risk, other price risk and liquidation risk. Market risk mainly arises in the funding operations and in the investment of the funds included in the Group’s liquidity reserve. For funding to be stable and efficient, the Group needs to be active in several different funding markets. Consequently, the Group is exposed to foreign exchange, interest rate and other price risks. The Group hedges this exposure to market risks to as great an extent as possible by using derivative contracts. A limited exposure is permitted with the purpose of making the operations more efficient.
Interest rate risk
Interest rate risk refers to the risk that a change in the interest situation will decrease the net value of the Group’s assets and liabilities. Interest rate risk arises as a consequence of the periods for which interest is fixed for assets and liabilities not being in agreement. For the Group’s assignment to be conducted efficiently with regard to the conservative view on risk, risk is managed through portfolio matching. This means that small, temporary differences in interest rateperiods are permitted for assets and liabilities. The interest rate risk appetite applies only to the currencies in which the Company has investments or lending. According to the limit set by the Board of Directors, the risk (exposure) in the portfolio may never exceed SEK 10 million from a one (1) percentage point parallel shift in the yield curve. However, interest rate risk is permitted to correspond to an exposure of at most SEK 15 million over a period of at most three consecutive business days. When calculating the interest rate risk for contracts with no pre-agreed maturity, assumptions are made regarding the expected duration. On 31 December 2015 the risk in the entire portfolio was SEK -10.0 (-8.5) million in a one (1) percentage point parallel shift in the yield curve. The interest rate risk by currency was: SEK -7.1 (1.4) million, EUR 0.0 (0.3) million and USD –2.9 (–10.5) million. A negative exposure (negative value) entails a loss if interest rates rise and a profit if interest rates fall. A positive exposure (positive value) entails a positive effect on earnings if interest rates rise and a negative effect on earnings if interest rates fall.
Foreign exchange risk
Foreign exchange risk refers to the risk that a change in exchange rates will affect the net value (combined value) of the Company’s assets and liabilities. Foreign exchange risk arises if assets and liabilities denominated in a specific currency in the balance sheet are mismatched in terms of size. The Group hedges all known future flows by means of derivatives. However, foreign exchange risk arises on an ongoing basis through the net interest income generated on returns on foreign currency investments. This risk is limited by continuously converting such returns into SEK. The Company’s foreign exchange exposure is detailed in Note 3. The exposure means that a 10-percent strengthening of the SEK would cause the Company’s profit to decrease by SEK 0.4 (0.4) million.
Credit market risk
Credit market risk refers to the risk that a change in a basis or credit market spread in the market would reduce the net value (combined value) of the Group’s assets and liabilities. Credit market risk arises primarily as a consequence of imbalances in maturities between assets and liabilities. The business model means that the Group is permitted to have longer maturities on liabilities than on the corresponding assets. Maturity risk as a consequence of an inverse imbalance, that is, maturities on assets being longer than on liabilities, shall not occur. The imbalances that arise in maturities between borrowing and lending shall, to the extent possible, taking other types of risks into account, be offset by maturities on investments. Credit market risk is further divided into credit spread risk on assets, credit spread risk on derivatives, credit spread risk on proprietary debt and basis swap risk. Credit spread risk on assets and derivatives respectively refers to the risk that a change in the counterparty’s credit spread will reduce the value of the Group’s asset or derivative (credit spread risk on derivatives corresponds to the risk sometimes referred to as credit valuation adjustment risk). Credit spread risk on proprietary debt refers to the risk that a change in the Group’s credit spread will increase the value of the Group’s liabilities. Basis swap risk refers to the risk that a change in the basis swap spread between two currencies will affect the market value of currency related derivatives contracts negatively. As per 31 December 2015, the Group’s credit market risk meant that a one (1) basis point parallel shift upwards in basis swap and credit market spreads would have changed the Group’s earnings, reported in accordance with IFRS, by SEK 2.6 (negative 1.1) million.
Other price risks
Other price risks refers to the risk that a change in the pricing situation of underlying assets, such as shares, share indexes or raw materials indexes, will affect the net value (combined value) of the Group’s assets and liabilities. The Group uses derivatives to hedge price risks with regard to underlying assets and indexes. This means that no other price risks remain.
Liquidation risk refers to the risk that a counterparty to a transaction in interest-bearing instruments or foreign currency is unable to meet its obligations and that the Group incurs increased costs to enter a replacement transaction. The Group’s process for managing counterparty risks (see paragraph above) also includes management of liquidation risks. The Group is to work proactively to avoid losses as a consequence of liquidation risks.
Liquidity risk refers to the risk that it will not be possible to meet payment obligations on maturity without the cost of obtaining payment funds increasing considerably. The Group’s liquidity risk management is pervaded by a highly restrictive attitude towards liquidity risk. The Group has diversified funding, with access to several different capital markets. This ensures that funding activities provides the necessary conditions to cover new lending, maturities and renewals even under worsening market conditions. The strategic funding programs are the Group’s Swedish Benchmark Programme, benchmark borrowing in USD within the EMTN (Euro Medium Term Note) programme, the ECP (Euro Commercial Paper) programme, as well as its funding in the Japanese market. The Group maintains a continuous market presence in strategic funding programs. As in previous years, the Group had good access to liquidity, in both long-term and short-term funding, in 2015. Among other measures, the Group has carried out several issues within the framework of the Swedish Benchmark Programme, as well as two major benchmark borrowings in USD. The Group continuously monitors the effects a possible downgrade of the Group’s credit rating would have on the amounts that the Company needs to provide as collateral for CSA agreements. As per 31 December 2015, a downgrading of the credit rating by three steps lead to the collateral requirement increasing by SEK 939 (928) million. The Group’s structural liquidity situation is stable with longer maturities on liabilities than on assets (see chart showing Kommuninvest’s balance sheet structure on 31 December 2015 on page 51). At the end of the year, the average maturity on the Group’s outstanding borrowing was 2.8 (3.2) years, on the condition that cancellable loans are maintained to maturity. If the earliest possible cancellation date is applied in the calculation, the average maturity was 2.2 (2.0) years. In connection with cancellable borrowing, the investor has the right, under certain conditions, to request premature repayment of loaned funds. At the end of the year, the average period for which capital was tied up in the Group’s lending portfolio lending portfolio was 2.2 (2.2) years. The average period for which capital is tied up in the Group’s liquidity reserve is 1.9 (1.9) years. Short-term liquidity risk is subject to limits on the scale of negative net outflows the Group may have within certain time intervals. Short-term liquidity risk is further limited by the Group being a full member of the Riksbank’s (Swedish central bank) RIXpayment system, through which the Group can, among other things, raise loans against collateral. In order to meet liquidity needs even during periods when financing opportunities on the capital markets are limited or too costly, the Board of Directors has decided to maintain a liquidity reserve whose nominal value may not be less than 15 percent or more than 35 percent of the total lending volume. In addition, at least 40 percent of the liquidity reserve is to be held in SEK. The liquidity reserve contains securities of high credit and liquidity quality, which are largely eligible as collateral at central banks. The high share of government bonds and other liquid assets in the Group’s liquidity reserve explains why the liquidity coverage ratio (LCR) exceeds the authorities’ requirements by a good margin. The Group currently needs to meet two different LCR measures: the LCR as required by Finansinspektionen (Swedish Financial Regulatory Authority) and the LCR required under the European Commission’s delegated act. The measures are largely similar, although there are certain computational differences. Due to the Group’s minor outflows in EUR, there can be variations in the reported LCR in EUR. As per 31 December 2015, the Group’s LCR according to Finansinspektionen totalled 3.43 (3.21), 7,742 (26.03) in EUR and 6.10 (7.81) in USD. As per 31 December 2015, the Group’s LCR according to the EU Commission’s delegated act totalled 3.22 and 5.51 in USD. Since EUR is not a significant currency for the Group, it does not need to report LCR in EUR according to the delegated act. Liquidity risks are monitored and analysed continuously to ensure that excessive liquidity outflows do not arise. The Group also reviews liquidity by continuously calculating a “survival period”. This denotes the period during which the Group can manage without access to new financing. On 31 December 2015, the estimated period during which the Company could survive without access to new financing, while continuing its normal business activities, was 9.4 (8.7) months. During the year, the Group conducted stress tests examining how the survival period is affected by new regulatory requirements. The results form the basis for any revisions of the Group’s strategies, guidelines and positions. The results of the stress tests were satisfactory. The Group’s liquidity exposure with regard to remaining durations on assets and liabilities is shown in Note 3. The cash flow statement also details the Group’s liquidity situation.
Events in 2015
During the year, the Group adapted to the EU’s community-wide liquidity coverage ratio requirements, which came into effect on 1 October 2015. The Group also adapted to the regulations on long-term liquidity, the so-called net stable funding ratio (NSFR), during the year. The NSFR reporting requirement took effect in 2014 and the requirement for a minimum NSFR ratio is expected to be introduced effective from 2018.
Operational risk refers to the risk of losses resulting from inadequate or failedinternalprocesses or routines, human error,incorrect systems or external events, including legal risks. Operational risks exist in all business operations and can never be avoided. The gross risk is considerable in a financial business that manages large amounts and long-term transactions. Through good governance and control, operational risk is kept to a controlled and acceptable level. Risks are identified continuously over the year in connection with each major change in the Group’s operations, as well as in connection with important events that affect the Group directly or that occur externally. A risk assessment is performed for each risk that is identified. The method also includes planning measures to manage the risks that are identified. Procedures and systems support are in place to enable reporting and follow-up of undesired events. The Group divides operational risks into the risk areas: process risk, personnel risk, IT and systems risk and external risk.
This risk arises when internal processes and procedures are faulty or inadequate. Process risk is mitigated by means of internal instructions, process descriptions and steering documents including points that are checked and quality assured on a regular basis.
This risk arises as a consequence of shortcomings attributable to human error. Personnel risk is mitigated by it not being permitted for any individual to single-handedly manage a transaction throughout the administration chain and by ensuring that person assigned to each post has the necessary competence and experience.
IT and systems risk
This risk arises as a consequence of faulty systems. IT and systems risk is mitigated by means of a clear strategy based on sector standards (Information Technology Infrastructure Library, ITIL), a well-functioning reserve environment and internal regulations.
This risk arises as a consequence of external events. External risk is mitigated by the Compliance function following up on adherence to regulations and providing advice on adjustments to new and amended regulations; agreements entered being correctly formulated, and operations including processes and procedures that, among other things, enable the Group to reduce the risk for external crime and detect supplier errors at an early stage.
Reputation risk is the risk that income from potential and existing customers declines if they lose confidence in the Group due to negative publicity or rumours about the Group or the local government sector in general. Reputation risk is also the risk of increased borrowing costs if potential or existing investors lose confidence in the Group due to negative publicity or rumours about the Group or the local government sector in general. The Group works preventively with media monitoring and has employees with in-depth knowledge in the area to pre-empt and counter possible rumours about the Group.
Business risk is the risk of reduced revenues or increased costs as a consequence of factors in the external business environment (including market conditions, customer behaviours and technological developments) having a negative impact on volumes and margins. All departments within the Group work continuously with external monitoring in their respective fields. A process is also in place to conduct in-depth media monitoring each year ahead of strategy discussions.
Strategic risk is the long-term risk of losses due to erroneous or misguided strategic choices and business decisions, incorrect implementation of decisions or inadequate sensitivity to changes in society, regulatory systems or the financial sector and/or local government sector. The Group has an established procedure for developing the strategic targets that are set by the Board of Directors. The risk appetite for strategic risks is limited by strategic decisions being made on the basis of well-founded analyses and decisions of a strategic nature often being made by the Board of Directors.
Residual risk is the risk that established techniques for risk assessment and risk reduction applied by the Group prove to be less effective than expected. The Group deliberately applies relatively simple methods and techniques for measuring risk, capital requirements and risk appetite to reduce the risk of error. The Group conducts both forward-looking and historical analyses of all risk types. The internal capital assessment (see page 36) addresses negative scenarios to ensure that the impact on the Group is not greater than expected.
To provide cost-efficient financing without exceeding the Group’s risk appetite, risk management in operations is to be characterised by preventive measures that serve toprevent and/or limit both risks and theirdamaging effects. The Group’s Risk Manager bears the overall responsibility for the Group’s risk framework. Each department manager is responsible for the management and control of risks within his/her area of operations. Forward-looking and historical analyses are used to ensure that the Group identifies, assesses and measures risks correctly. The Risk and Control department, the Group’s function for risk control, is responsible for continuously checking and implementing ongoing follow-up and analysis of financial risks limit control and reports daily to the President and monthly to the Board of Directors. Risk and Control is headed by the Chief Risk Officer, who reports to the President and is a member of the Executive Management Team. The department consists of nine employees, including a Deputy Chief Risk Officer. Of the nine employees, three work with prospective analyses regarding credit and market risks, etc., three with reporting and data management, two in contact with the local government sector and one with operational risks. Beyond what has been mentioned above, the department is also responsible for following up that risks are reported correctly and in accordance with applicable external and internal regulation, regularly performing stress tests, ensuring that the Group’s business models are appropriate and secure as well as leading and coordinating efforts related to operational risks. The Credit Committee functions as a preparatory body in the assessment of new counterparties, new financial instruments and other credit issues requiring decisions by the President. The Group’s Asset Liability Committee (ALCO) is responsible for preparing matters concerning market risk and liquidity that require a decision by the Board of Directors or the President.
Risk management – Lending