Annual report 2008
Binck Bank
- Report of the Management Board
- Risk management under Basel II and Pillar III disclosure
- In-control statement
- Personnel and organisation
- Corporate social responsibility
Risk management under Basel II and Pillar III disclosure
Provisions for securities-backed lending Management of operational risk Management of interest-rate risk
Management of liquidity risk Liquidity position as at year-end 2008 Liquidity risk policy and relevant control measures
5. Relevant risks, models and control measures
The risks which are relevant to BinckBank are discussed briefly below. The identification, analysis and assessment of risks, the design and implementation of related control measures and stress testing form a continuous process within BinckBank.
Credit risk is the risk of a counterparty and/or issuing institution involved in trading in or issuing a financial instrument defaulting on an obligation and thus harming BinckBank financially. Credit risk relates to items included in the balance sheet in banks, financial assets (including securities-backed lending) and other assets. With these balance sheet items, the most important consideration is the creditworthiness of the counterparty (except securities-backed lending, because these items are fully covered by securities as collateral). |
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BinckBank lends to central governments, lower-tier public authorities if guaranteed by central government, central banks and other banks and credit institutions with a credit rating equal to or better than AA- (Fitch or equivalent). These are short-term loans with terms ranging from one day to a maximum of one month. BinckBank is exposed to counterparty risk (the risk of default by a counterparty to whom credit has been extended). BinckBank extends credit to counterparties within a system of limits for each counterparty, which are set in advance by the Treasury Committee. Lending to counterparties by the Treasury department is governed by strict rules, in accordance with treasury policy, and internally set limits on both the amount and term of loans to approved counterparties. The resultant credit risk is monitored via regular credit reviews.
The purpose of BinckBank's investment portfolio is to invest the surplus liquidity on the market in order to optimise the interest margin between the funding cost and the investment return, consistent with the company's risk appetite and the constraints of risk management/policy. The risk appetite is reflected in the policy of investing only in safe and liquid instruments that can be offered as collateral to the European Central Bank, within the limits of the following liquidity allocation model:
As at 31 December 2008, the maturity calendar for BinckBank's lending was as follows:
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Under certain conditions, BinckBank will accept bank guarantees on behalf of its clients. Bank guarantees are only accepted from credit institutions with an investment-grade rating according to Fitch standards.
Via the client agreement, BinckBank offers clients securities-backed credit facilities. Advances can be used to cover the margin requirement, purchase securities or furnish bank guarantees against the securities account. In all these cases, BinckBank is exposed to credit risk with respect to the client. Given the nature of the loans and the collateral provided, however, the credit risk is limited. In the case of lending against the collateral of financial instruments, the amount of credit advanced depends partly on the liquidity and price of the security in question. Credit monitoring is performed by the Risk Management department, which carries out automated checks on the basis of real-time prices. The credit risk therefore resides in movements in value of the collateral received. The Risk Management department watches in particular for undesirable concentration within client portfolios. Concentration risk arises when there is an excessive concentration of loans to one client or group of related clients and/or an investment portfolio that is one-sided. The Risk Management department monitors such concentrations daily and takes action where necessary to moderate them. BinckBank maintains a provision of € 2.4 million for this risk.
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For all products, lending against collateral of securities complies with the guidelines drawn up by the Risk Committee in accordance with the limits set by Section 152 of the Decree on the Conduct of Business Supervision of Financial Undertakings (Besluit gedragstoezicht financiële ondernemingen). BinckBank applies an upper limit on advances of 70% on shares and 80% on bonds, which is conservative compared with the standard approach adopted by regulators (maximum of 89.4% at 5 days) to determining credit risk under Basel II. BinckBank has reserved the right vis-à-vis its clients to adjust the limit on advances at any time without prior notice. The permitted limits are translated into maximum spending limits, expressed as a cover ratio. The minimum cover ratio is 1 and the extent to which the client's cover ratio exceeds 1 is a measure of the surplus relative to the minimum requirement. The cover ratio can be raised by furnishing bank guarantees, lodging collateral in the form of securities or increasing liquidity. If the cover ratio falls below 1, the client enters the deficit procedure. If the cover ratio is zero, the client proceeds from the deficit procedure to the recovery procedure.
As at 31 December 2008, receivables from 5,286 clients amounting to € 1.0 million were covered by the recovery procedure and loans to clients amounting to € 15.8 million (and representing 1.1% of the total lending book) were covered by the deficit procedure.
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Permitted limits are defined for each client and enforced by the trading system. For primary limit monitoring, the system does not permit new transactions which exceed a given limit (all based on real-time prices). Risk Management monitors securities-backed lending on a daily basis via the deficit procedure. This procedure is a statutory requirement under Sections 85 and 86 of the Decree on the Conduct of Business Supervision of Financial Undertakings. If BinckBank identifies a shortfall in a client's cover ratio, the client is in principle obliged to redeem the deficit within five trading days. If the client does not take steps to redeem the deficit, BinckBank will proceed to close positions to redeem the deficit on day 5 at the latest.
As market conditions change, the advance percentage may not provide adequate cover for possible price movements in the future. Risk Management monitors this on a daily basis and if necessary will adjust the advance percentage immediately in line with the advance policy.
Provisions for securities-backed lending Provisions for non-recoverable debts in respect of securities-backed lending are determined on a case-to-case basis and there are no collective provisions. The amount of the provisions depends on the repayment terms agreed with the client. The total provision as at year-end 2008 was € 0.5 million and equated to 46% of the total outstanding debt. Where Risk Management is unable to recover the debt, the matter is placed in the hands of a collection agency.
The only market risk to which BinckBank is exposed is currency risk. Currency risk is the risk presented by movements in the value of items denominated in foreign currencies due to movements in exchange rates. It is BinckBank's policy not to take active foreign-exchange trading positions. Foreign-exchange positions arising out of operating activities must be hedged the same day they become known. Because of the current system configuration within BinckBank, foreign-exchange positions arising out of client transactions are not visible until one trading day later. The currency risk on these positions during this one trading day's delay is regarded as an accepted risk. It is BinckBank's policy not to hedge the translation risk on equity investments in financial institutions. No stress tests are performed for currency risk. No material gains or losses on foreign-exchange positions were recognised in the 2008 financial year.
Management of operational risk Many unexpected events may occur in BinckBank's operational processes which result in losses or prevent the achievement of targets. Processes, systems and people may fail to perform as intended, employees may commit fraud, incidents may occur and day-to-day processes may be disturbed by accidents or system faults (IT risk). The risks arising out of such events are classed as operational risks. Losses due to operational risks are unavoidable. BinckBank is insured with third parties against many forms of foreseeable loss and, as required by law, maintains a capital buffer against uninsured (unforeseen) losses due to operational risks.
Operational risk is generally the result of deficiencies in the daily processing and settlement of transactions with clients or other parties or in the procedures and actions designed to ensure prompt detection of defects, quantitative or qualitative deficiencies or limitations in human resources, deficient decision-making due to inadequate management information and incorrect non-compliance with internal control procedures.
The capital requirements are calculated using the basic indicator approach, which sets the capital requirement for operational risk at 15% of total revenues, as prescribed by the regulator. The calculation is normally performed on the average of the revenues for the past three reporting years. In the light of its rapid growth, however, BinckBank computes the capital requirement at 15% of the revenues for the previous reporting year. For 2008, the figure is 15% of € 149.0 million, or € 22.4 million.
The internal target is for annual losses on normal activities due to operational risks not to exceed 1% of revenues. 'Losses due to operational risks' here means:
Losses due to operational risk in 2008 amounted to 0.86% of total revenues and thus remained within the internal limit.
Operational risk management is built into the structure of the organisation, which embodies a number of the internal control measures and principles that BinckBank uses to manage operational risk. The main elements are:
IT risk is the current and future risk to BinckBank's financial position and results posed by deficiencies in the technology employed. BinckBank is heavily dependent on IT in general and deficiencies in this area pose a significant threat to BinckBank's financial position and results. The IT organisation is designed to manage that risk and incorporates a series of internal monitoring procedures covering IT policy, security policy, incident management, change management and availability and performance management. BinckBank also has a fallback facility which it can use in emergencies. Each year, BinckBank commissions external agencies to audit and report on specific areas of its IT operations.
As an internet bank, BinckBank is by definition exposed to a significant inherent risk of external fraud by online criminals. BinckBank is fully aware of this risk and operates a highly active security policy which is constantly evaluated. An important element of this policy is the annual 'legal hack' exercise, in which BinckBank invites a third party to attempt to break into its systems.
Risks relating to outsourcing of business processes are current and future risks to the company's financial position and results posed by third-party provision on a structural basis of services which are part of BinckBank's business processes. BinckBank has outsourced the following processes: Belgian payroll processing, French payroll processing, French office administration, management of the BinckBank NV investment portfolio, external custody of securities and some order execution. Service level agreements have been entered into for all outsourced activities and are reviewed regularly.
BinckBank is exposed to settlement risk on its institutional brokerage activities. This relates to a very small number of clients which occasionally have orders executed via BinckBank, mainly in connection with cross-border settlements. The maximum limit on the total amount to be settled is fixed contractually for each wholesale client, based on the client's creditworthiness as assessed independently by Risk Management. Compliance with these limits is monitored by Risk Management, which warns the counterparty if it approaches the set limit. BinckBank's Risk Committee has resolved to hold capital of € 1.0 million against this risk. No stress testing is performed on settlement risk.
Various factors, including loss of clients or slower growth in the client base, lower trading volumes, lower average order values, pressure exerted on prices by competitors etc., may result in lower revenues or losses for BinckBank. The bank operates in a highly competitive environment in which its competitors, often very large financial institutions, have well established brands and ample financial resources. BinckBank also operates in a turbulent economic environment: the international economic (cyclical) conditions and the credit crunch influence financial markets worldwide and thus indirectly affect BinckBank's financial position and results. Its financial position and results can also be adversely affected by misjudged business decisions, poor execution of business decisions or inadequate response to changes in the business climate in general. On the basis of a statistical financial forecasting model using actual data for the past two years and taking account of the possibility of an impairment loss on the Alex acquisition, BinckBank has decided not to hold extra capital against this risk. The Planning & Control department prepares financial forecasts and performs stress tests on various scenarios on a quarterly basis to assess capital adequacy.
Management of interest-rate risk Interest-rate risk is the risk of movements in interest rates which might adversely influence future profitability.
BinckBank has an investment portfolio consisting of fixed-income securities with a range of maturities. The composition of the investment portfolio is determined by the Treasury Committee. The value of the investment portfolio is subject to variation due to movements in interest rates and changes in the creditworthiness of the issuing institutions/guarantors of those bonds.
To measure interest-rate risks on its investment portfolios, BinckBank uses an in-house value-at-risk (VAR) model to calculate with some degree of reliability the maximum loss on the investment portfolio in a given period. The variables can be adjusted to reflect the various scenarios. The historical data for the past ten years are used as source data on which the variance of and correlation between cash flows from the different instruments in the investment portfolio are determined. A separate model is used for stress testing, which involves applying different stress scenarios to interest income and expense. The dataset for 2008 is used as the basis, because there was a large fluctuation in interest rates. Because of the extreme developments on the financial markets in the past period, these data are also used for stress testing the interest-rate risk.
Assuming a holding period of 10 trading days, the maximum loss on the portfolio, at a 99.0% confidence level, is € 6.1 million. A holding period of 10 trading days has been chosen to allow for the reduced liquidity of some instruments in the investment portfolio. BinckBank assumes it will be able to liquidate a large proportion of its investment portfolio within this period at fair market prices. BinckBank therefore holds capital of € 6.1 million against interest-rate risk.
Liquidity risk is the risk of liquid assets and investments not being available in sufficient quantity to enable BinckBank to meet its liabilities in the short term. BinckBank gives high priority to the management of this risk, to ensure that it always holds enough liquid reserves and can always discharge its financial liabilities. The liquidity risk management process is designed to take account of the effects of BinckBank-specific stress factors, such as negative publicity, increased trading activity by clients (net purchases) and variation of competitors' interest rates.
If clients withdrew their assets en masse or client assets were used collectively to invest, there is a risk of BinckBank being unable to meet its liabilities to creditors. BinckBank's liquidity risk policy therefore focuses primarily on managing this aspect of liquidity risk.
BinckBank's assets under administration that are used to fund demand for securities-backed lending cannot be liquidated to make up liquidity shortages. Because the available liquid assets far exceed the demand for securities-backed lending, however, the surplus liquidity can be invested short-term in the money market or in BinckBank's investment portfolio (0-3 years). Liquidity risk is monitored by computing the liquidity position on a daily basis, covering all these items.
Liquidity position as at year-end 2008 If necessary, it is expected that the entire investment portfolio can be liquidated in 10 days (enforced sale could incur losses) - depending on market liquidity. It can thus be concluded that BinckBank is unlikely to encounter liquidity problems.
One measure of liquidity risk is the gap profile, determined by grouping net (assets minus liabilities) face values into 'maturity buckets'. BinckBank's gap profile on the basis of the contractual remaining term is shown in note 44 to the financial statements on page 146.
Liquidity risk policy and relevant control measures BinckBank pursues a prudent liquidity-risk policy designed to manage a liquidity crisis caused by the unexpected withdrawal of client assets. The liquidity risk policy comprises liquidity management based on a going-concern situation, asset liquidity monitoring and procedures in the event of unforeseen events. Liquidity risk management addresses the composition of the investment portfolio and money market deposits in a going-concern environment. Day-to-day cash management to cover BinckBank's operating cash requirement is performed by the Treasury department in accordance with the regulator's guidelines in this area. An important indicator of liquidity risk is the surplus shown by the liquidity test performed by De Nederlandsche Bank (weekly and monthly), which is based on a going-concern situation, assuming normal maturity of existing money market deposits and investments and a given degree of stress on savings and client accounts. The procedures in the event of unforeseen events is defined in the liquidity contingency plan.
The liquidity management process is divided into four stages, which run continuously.
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Integrity risk is the risk of inadequate compliance with codes of conduct imposed by BinckBank standards, social standards and legislation and regulations. Integrity risk may result in direct damage (such as claims and penalties) or consequential damage (such as reputational harm or loss due to fraud). In many cases, these are losses which have been insured against up to a reasonable amount. To control this risk, BinckBank imposes clear internal standards and codes of conduct which are clearly communicated within the organisation. BinckBank has a Compliance Officer, for whom clear reporting lines have been defined and a clear escalation procedure has been implemented. Together with the Legal department, the Compliance Officer is responsible for notifying managers and the Management Board promptly and accurately, in order to ensure that BinckBank's activities comply with the applicable legislation and regulations. BinckBank has procedures in place for whistleblowers and mandatory reporting of suspicious transactions and has a Security Officer and a Privacy Officer.
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