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 Company’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 Company 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 Company’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 company’s credit spread will increase the value of the company’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. The Company’s credit market risk on 31 December 2014 entails that an upward parallel shift of one (1) basis point in the market’s basis and credit market spreads, would change the Company’s income, reported according to IFRS, by SEK -1.1 (-2.2) 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 Company’s assets and liabilities. The Company 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 Company incurs increased costs to enter a replacement transaction. The Company’s process for managing counterparty risks (see “Counterparty risk” above) also includes management of liquidation risks. The Company 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 Company’s liquidity risk management is pervaded by a highly restrictive attitude towards liquidity risk. The Company has diversified funding, with access to several different capital markets. This ensures that funding activities provides the necessary conditions to cover new lending, renewals and maturing borrowings even under worsening market conditions. Strategic funding is conducted within the Company’s Swedish Benchmark Programme, benchmark funding in USD within the EMTN (Euro Medium Term Note) programme, the ECP (Euro Commercial Paper) programme, as well as in funding in the Japanese market. The Company maintains a continuous market presence in strategic funding programs. Over the year, Kommuninvest has had good access to liquidity, in both long-term and short-term borrowing. Kommuninvest has completed several issues within the Swedish Benchmark Programme, as well as two major benchmark transactions in USD. The Company continuously monitors the effect on the amount of collateral the company would have to pledge in relation to CSA agreements, were its credit rating to deteriorate three notches. At the end of the year, this amounted to SEK 928 (1,896) million. The Company’s structural liquidity situation is stable with longer maturities on liabilities than on assets. Short-term liquidity risk are capped through limits on the amount of negative net outflows the Company may be permitted in certain time buckets. Short-term liquidity risk is further limited by the Company being a full member of the Riksbank’s (Swedish central bank) RIX payment system, through which the Company 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 20 percent or more than 40 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 good credit and liquidity quality and that largely qualify as collateral at central banks. As of 31 December 2014, the Company’s liquidity reserve consisted to 69 (82) percent of assets eligible as collateral with the Riksbank or the ECB. The favourable quality of the Company’s liquidity reserve is reflected by the fact that the liquidity coverage ratio (LCR) exceeds by a good margin the statutory requirement of a quota of one (1), imposed in Sweden since 1 January 2013. On 31 December 2014, the Company’s total LCR was 3.21 (5.11), and 26.03 (468.67) in EUR and 7.81 (15.44) in USD. Liquidity risks are monitored and analysed continuously to ensure that excessive liquidity outflows do not arise. The Company also reviews liquidity by continuously calculating a “survival period”. This denotes the period during which the Company can manage without access to new financing. On 31 December 2014, the estimated period during which the company could survive, maintaining normal operations but without access to new financing, was 8.7 (9.7) months. During the year, the Company conducted stress tests on both the short and long-term liquidity to assess the size and composition of the liquidity reserve. The results also form the basis for any revisions of the Company’s strategies, guidelines and positions. The results of the stress tests were satisfactory by a good margin. The Company’s liquidity exposure with regard to remaining durations on assets and liabilities is shown in Note 3. The cash flow analysis also illustrates the Company’s liquidity situation.
Events in 2014
As in previous years, the Company’s liquidity situation was very good in 2014. Among other measures, the Company has carried out several issues within the framework of the Swedish Benchmark Programme, as well as two major benchmark transactions in USD. Over the year, the Company evaluated the effects of EU-wide liquidity coverage ratio requirements as of 2015 and prepared to adapt to these. Preparations were also made for the introduction of the new regulations on long-term liquidity, the Net Stable Funding Ratio, to be introduced as of 2018 and with reporting requirements effective from 2014.
Kommuninvest’s balance sheet structure 31 Dec. 2014
A. Kommuninvest’s liquidity reserve includes a large proportion of assets which can be converted into cash rapidly. At year-end, the liquidity reserve exceeded cancellable and short-term funding by SEK 31.7 billion.
B. Kommuninvest’s long-term funding exceeded long-term lending by SEK 64.7 billion at the end of 2014.
Operational risk refers to the risk of losses resulting from inadequate or failed internal processes 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 Company’s operations, as well as in connection with important events that affect the Company 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 Company 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 with checkpoints that are 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 singlehandedly manage a transaction throughout the administration chain and by ensuring that the 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 IT industry standards (Information Technology Infrastructure Library, ITIL), a well-functioning back-up environment and internal regulations.
This risk arises as a consequence of external events. External risk is mitigated by Compliance 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 Company to prevent 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 Company due to negative publicity or rumours about the Company 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 Company due to negative publicity or rumours about the Company or the local government sector in general. The Company works preventively with media monitoring and has employees with in-depth knowledge in the area to pre-empt and counter possible rumours about the Company.
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 Company 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 Company has an established procedure for processing strategic targets 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 Company prove to be less effective than expected. The Company deliberately applies relatively simple methods and techniques for measuring risk, capital requirements and risk appetite to reduce the risk of error. The Company conducts both forward-looking and historical analyses of all risk types. The internal capital adequacy assessment process, ICAAP (see below), addresses negative scenarios to ensure that the impact on the Company is not greater than expected.
To provide cost-efficient financing without exceeding the Company’s risk appetite, risk management in operations is to be characterised by preventive measures that serve to prevent and/or limit both risks and their damaging effects. The Company’s Risk Manager bears the overall responsibility for the Company’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 Company identifies, assesses and measures risks correctly. The Risk and Control department, the Company’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 consists of nine employees of whom four work with credit and counterparty risks, three with liquidity and market risks and one with operational risks. The department is headed by the Chief Risk Officer, who reports to the President and is a member of the Executive Management Team. 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 regulations; regularly performing stress tests; ensuring that Kommuninvest’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 Board or the President. The company’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. Representatives from Risk and Control act as secretaries in the above mentioned groups. The diagram above illustrates the Company’s risk management in relation to the credit risks in its lending operations.
Kommuninvest’s capital planning is intended to ensure that the operations are fully capitalised to meet both the risks in the operations, as well as future regulatory requirements. In relation to the risks inherent in its operations, Kommuninvest is well capitalised. The principal priority of capital planning is ensuring that Kommuninvest meets the new leverage ratio requirement planned to be introduced within the EU from 2018 (see also the section New regulations on pages 30–32 in the Kommuninvest i Sverige AB annual report 2014) along with pages 28-30 in the Society’s annual report .
Capital plan and internal capital adequacy assessment process
Within Kommuninvest, a capital plan is developed at least once a year. The plan calculates how capital is intended to be developed over the next three years. The plan is based on assumptions regarding, among other aspects, margins in lending operations, margins in the management of the liquidity reserve, cost trends and forecasts for lending and other balance sheet items. The capital plan is an important building block in the internal capital adequacy assessment process (ICAAP) for the Company and the Group, consisting of the Society, the Company and Kommuninvest Fastighets AB, which owns the property in which the credit market company conducts its operations. In supporting the capital plan, the Society’s owner directives determine the desired risk appetite and sets clear targets with regard to capital structure. Under current regulations, credit institutes are responsible for designing their own ICAAP. The intention is that the institutes shall map their risks and assess their risk management in an integrated and comprehensive way and, on the basis of that, assess their capital requirements, and that they should communicate analyses and conclusions to Finansinspektionen. Within Kommuninvest, the finance department is responsible for the ICAAP. The Risk and Control department performs quality assurance related to the ICAAP, for example by assessing the evaluation methods that are applied. A significant portion of Kommuninvest’s risk-focused capital planning consists of stress tests that illuminate how risk-related capital requirements are affected by unfavourable external trends in various dimensions. Kommuninvest’s capital assessment shows that Kommuninvest meets all known requirements in accordance with both current and future regulations (primarily CRR/CRD IV1 – Capital Requirements Regulation/Capital Requirements Directive IV; and EMIR2 – European Markets Infrastructure Regulation). However, uncertainty prevails regarding the introduction of a leverage ratio requirement in the EU, with levels to be announced in 2016 (see also pages 30–32 in the Kommuninvest i Sverige AB annual report 2014) along with pages 28-30 in the Society annual report.
On 31 December 2014, the Company’s risk exposure amount (REA), calculated in accordance with CRR, amounted to SEK 6,784.9 (4,558.7) million. The core Tier 1 capital amounted to SEK 2,345.7 (1,650.8) million, entailing a core Tier 1 capital ratio of 34.6 (37.0) percent. The requirement, including the capital conservation buffer requirement, was 7.0 percent. Tier 1 capital was also SEK 2,345.7 (1,650.8) million, and the Tier 1 capital ratio was 34.6 (37.0) percent. The requirement, including the buffer requirement, was 8.5 percent. The total capital base was SEK 3,345.7 (2 650.8) million, which gave a total capital ratio of 49.3 (59.5) percent. The requirement, including the buffer requirement, was 10.5 percent. Transitional regulations do not significantly affect the Company’s capital ratio and other measures of capital.
On 31 December 2014, the Group’s risk exposure amount (REA), calculated in accordance with CRR, amounted to SEK 6,788.9 (4,455.0) million. The core Tier 1 capital amounted to SEK 2,345.7 (1,650.8) million, entailing a core Tier 1 capital ratio of 35.6 (37.6) percent. The requirement, including the capital conservation buffer requirement, was 7.0 percent. Tier 1 capital was also SEK 2,416.9 (1,674.3) million, and the Tier 1 capital ratio was 35.6
(37.6) percent. The requirement, including the buffer requirement, was 8.5 percent. The total capital base was SEK 3,216.9 (2,511.4) million, which gave a total capital ratio of 47.4 (56.4) percent. The requirement, including the buffer requirement, was 10.5 percent.
Transitional regulations do not significantly affect the Company’s capital ratio and other measures of capital.
1) Capital Requirements Regulation/Capital Requirements Directive IV, i.e. the European Parliament and the Council’s regulation (EU) No. 575/2013 on supervisory requirements for credit institutes and securities companies and the European Parliament and Council’s directive (EU) No. 2013/36/EU on authorisation to conduct operations in credit institutes and on supervision of credit institutes and securities companies.
2) EMIR (European Markets Infrastructure Regulation). The European Parliament and the Council’s regulation (EU) No. 648/2012 on OTC derivatives, central counterparties and trade repositories.