Effective risk and capital management is a fundamental prerequisite to the success and stability of a bank. VP Bank understands this term to mean the systematic processes to identify, evaluate, manage and monitor the relevant risks as well as the steering of the capital necessary to assume risks and guarantee risk tolerance. The risk policy constitutes the mandatory operating framework in this respect. It contains an overarching framework as well as a risk strategy for each individual risk group (financial risks, operational risks, business risks). Described and regulated therein are the specific goals and principles, organisational structures and processes, methods and instruments as well as target measures and limits.

The reforms of the Basel III regulatory framework heighten the capital adequacy and liquidity requirements for banks. With a ratio of 21.5 per cent, VP Bank possesses a tier 1 ratio which far exceeds that which will be required in future and which continues to reflect a high measure of stability and security.

Following the onset of the crisis in financial markets, exposures in countries affected by the debt crisis were reduced or the related limits were in part completely suspended. Secured reverse repo investments were also deployed in order to limit credit risk. 

In view of the continuing macroeconomic uncertainties in Europe and the USA, the hedging strategy for currency risks was revised. 

Assuring liquidity continues to have foremost priority, for which reason the holdings of securities which are eligible for repo transactions as well as giro clearing positions were increased. 

Systematic management of operational risks was further stepped up. The standard achieved in the parent bank was improved and implemented throughout the Group companies.

Risk and capital management is predicated on the following principles:

Risk appetite is reflected in the risk capital and indicates the maximum loss which the bank is prepared to bear arising from crystallising risks without thereby jeopardising the Bank’s ability to continue as a going concern. As a strategic success factor, risk tolerance is to be maintained and enhanced by employing a suitable process to ensure an appropriate capital basis. 

Risk appetite is rendered operational with the aid of a comprehensive system of limits and implemented in an effective manner together with a clear set of guidelines governing the tasks, limits of authority and responsibility of all functions, organisational units and bodies participating in risk- and capital-management processes. The risk coverage potential, the risk capital and limits are reviewed annually as and when required, but at a minimum once a year and are adjusted whenever necessary. 

Strategic and operational decisions are taken on the basis of risk/return calculations and aligned with the interests of the stakeholders. Assuming compliance with legal and regulatory provisions and the principles underlying business and ethical policies, VP Bank takes on risks consciously so long as the extent of these are known and the technical prerequisites to apprehend them are at hand and that the bank is adequately rewarded. It avoids transactions with an inadequate relationship of risks to returns as well as large risks and risk concentrations which could jeopardise risk tolerance and thus the ability of the bank to continue as a going concern.

Risk control and risk reporting are assured by functions which are independent of those involved in the management of risks. 

The underlying principle of risk monitoring is a comprehensive, objective, timely and transparent disclosure of risks to Group Executive Management and the Board of Directors. 

The risks to which VP Bank is exposed in its ordinary course of business are allocated to three risk groups – financial risks, operational risks and business risks (including strategic risks). Whilst financial risks are consciously entered into in order to generate revenues, operational risks are to be avoided through appropriate controls and measures or, if that is not possible, to be reduced to a level laid down by the Bank. 

Other than business risks, financial and operational risks are the result of a bottom-up process in the risk management process of the bank. Measures designed to contain them are elaborated by the responsible functions, organisational units or committees and approved by the Board of Directors or Group Executive Management. Business risks, on the other hand, are analysed by the Board of Directors and Group Executive Management after considering the banking environment and the internal situation of the company. Company management derives the top risk scenarios from the analysis and designs related measures, the implementation of which is delegated to the competent function or organisational unit (top-down process). 

Market risk expresses the danger that possible economic losses in value in the banking and trading books will arise from adverse changes in market prices (interest rates, currency rates, equity share prices and commodity quotations) or other price-influencing parameters such as volatility. 

Liquidity risks comprise liquidity and refinancing risks as well as market liquidity risk. Liquidity and refinancing risks express the danger that current and future payment obligations cannot be met on the due date or to the full extent. Market liquidity risk includes cases where it is not possible, as a result of insufficient market liquidity, to liquidate positions subject to risk on a timely basis, in the desired amount and on acceptable conditions. 

Credit risks comprise both counterparty and country risks. Counterparty risks describe the danger of a financial loss which may arise if a counterparty of the Bank cannot or does not wish to meet its contractual commitments in full or on the due date (default risk) or the creditworthiness of the debtor has deteriorated (credit risk). Country risks, as a further extension of credit risk, arise whenever political or economic conditions specific to a country diminish the value of an exposure abroad. 

Operational risks represent the danger of incurring losses arising from the inappropriateness or failure of internal procedures, people or systems, or as a result of external events.

Business risks, on the one hand, result from unexpected changes in market conditions and circumstances having a negative impact on profitability; on the other, they describe the danger of unexpected losses resulting from manage- ment decisions concerning the business policy orientation of the Group (strategic risks). 

If the above-mentioned risks are not recognised, appropriately controlled, managed and monitored, this may lead – apart from financial losses – to reputation being damaged. VP Bank therefore considers reputational risk not to be a separate risk category but rather the danger of losses resulting from the individual types of risk of the other risk categories. Management of reputational risks is incumbent on the Board of Directors and Group Executive Management.

The following graph gives an overview in diagrammed form of the organisation of risk and capital management of VP Bank Group.

The Board of Directors bears the ultimate responsibility for risk and capital management within the Group. It is its remit to establish and maintain an appropriate structure of business processes and organisation as well as an internal control system (ICS) for an effective and efficient management of risk and capital, thereby ensure the risk tolerance of the bank on a sustainable basis. The Board of Directors is responsible for approving the Risk Policy and monitoring its implementation, laying down the risk appetite on a Group level and stipulating the target measures and limits for risk and capital management. In assuming its duties, the Board of Directors is supported by the Audit & Risk Management Committee and Group Internal Audit. 

The Group Executive Management is responsible for the implementation and observance of the Risk Policy. Amongst its core tasks are the allocation of the target measures and limits laid down by the Board of Directors to the individual Group companies, the Group-wide management of credit, market, operational, business and reputational risks as well as capital management activities. Group Executive Management is supported by the Group Risk Committee. As the supreme body for the day-to-day management of risks and risk monitoring, it is also responsible for the implementation of risk strategies. 

As an independent function for the central identification, evaluation (measurement and assessment) and monitoring (control and reporting) of the risk situation and risk tolerance of the Group, Group Risk Control supports the Board of Directors and Group Executive Management in assuming its respective duties. A further task of Group Risk Control consists of ensuring that existing legal, regulatory and internal bank prescriptions are complied with and new prescriptions implemented. In addition thereto is the regular review and review of the ongoing effectiveness and appropriateness of the methods, performance indicators and systems deployed in risk management. 

Group Risk Management bears the responsibility for the day-to-day management of the target measures and limits laid down by the Board of Directors and Group Executive Management, whilst complying with legal and regulatory prescriptions. Part of its core tasks is balance-sheet-structure management whilst taking account of the profitability, risks and equity situation of VP Bank as well as liquidity management, collateral management, bank capital management and the management of limits for banks and countries. 

All risk-taking functions and organisational units belong to the operating units. 

The required qualitative and quantitative disclosures on capital adequacy, on the strategy and processes for risk management as well as the risk situation of VP Bank, are made in this section and also in the commentary on the consolidated financial statements. 

For each risk category, Basel II foresees various approaches for the computation of required equity. VP Bank applies the standard approach for credit and market risks and the basis indicator approach for operational risks. 

As of 31 December 2012, the business activities of VP Bank Group required shareholders’ equity of CHF 313.3 million (31 December 2011: CHF 360.8 million). Adjusted eligible equity totalled CHF 834.0 million (31 December 2011: CHF 801.0 million). Year-on-year, the excess of equity showed a marked increase of 18.3 per cent to CHF 520.6 million (31 December 2011: CHF 440.2 million) but together with a tier 1 ratio of 21.5 per cent (31 December 2011: 18.0 per cent) it continues to reflect the robust equity base of the Bank. 

The following table shows the equity situation of the Group as of 31 December 2012. 

As VP Bank Group has not recognised any hybrid capital in eligible equity and as it does not offset (balance sheet reduction) assets against liabilities in accordance with International Financial Reporting Standards (IFRS), the tier 1 of VP Bank is not “diluted” and can be described as robust.

Capital-adequacy computation

1. Eligible equity (as adjusted) as a percentage of required equity (net).
2. Eligible core capital (tier 1) as a percentage of the risk-weighted positions plus the required equity for market risks, operational risks and for unsettled transaction positions, converted into equivalent units by multiplying by 12.5.
   
   

Whilst complying with the relevant legal and regulatory provisions, the monitoring and daily management of financial risks is based upon internal Bank target measures and limits relating to volumes, sensitivities and losses. In addition, scenario analyses and stress tests demonstrate the effect of events which were not or not sufficiently taken into consideration within the scope of ordinary risk evaluation. 

The unit Group Risk Management with its already mentioned areas of duty is responsible for the centralised management of financial risks within the limits laid down. Group Executive Management distributes the value-at-risk (VaR) limit for financial risks, as set by the Board of Directors, over the individual Group companies and risk categories, within which the individual companies manage the risks under their own responsibility. The unit Group Risk Control monitors observance of the limits throughout the Group. 

Market risks arise as a result of positions being entered into in debt securities, equity paper and other securities under financial investments, foreign currencies, precious metals and in related derivatives, arising both from activities for clients as well as for Group companies whose functional currency is denominated in a foreign currency. 

The Bank employs a comprehensive set of methods and indicators for the monitoring and management of market risks. In this respect, the value-at-risk approach has established itself as the standard method to measure general market risk. The value-at-risk method quantifies the negative deviation, expressed in Swiss francs, from the value of all positions exposed to market risk as of the date of the evaluation. The VaR risk indicator is computed on a Group-wide basis with the help of historical simulation. In this process, the historical movements in market data of the last 260 trading days are read in order to measure all market risk positions. The projected loss is valid for a holding period of 30 days and does not occur with a probability of 99 per cent. In order to compute the VaR for interest-rate-risk, fixed interest-bearing positions are mapped with the interest lock-up period and variable interest positions using an internal replication model. 

The market risk VaR of VP Bank Group at 31 December 2012 amounted to CHF 26.1 million (31 December 2011: CHF 41.8 million). This equates to a reduction of 38 per cent which derives primarily from foreign-currency risk. The foreign- currency value-at-risk gradually declined during the current accounting period as a result of the growth in hedging volumes as well as the discontinuation of negative risk scenarios in the third quarter. 

The following table shows the value-at-risk (on a monthly basis) analysed by types of risk and the market VaR computed over all risk categories. The computation of the average, highest, lowest and aggregate values is based on a separate year-on-year perspective; the total value does therefore equate to the sum of the respective individual values by risk type.

As the maximum losses arising from extreme market situations cannot be determined with the value-at-risk approach, the market risk analysis is supplemented by stress tests. Such tests render possible an estimate of the effects on the net present value of equity of extreme market fluctuations in the risk factors. In this manner, the net present value fluctuations from all balance-sheet positions in the area of interest-rate and currency risks are computed with the aid of sensitivity indicators on the basis of synthetically produced market movements (parallel shift, rotation or inclination changes in interest-rate-curves, exchange rate fluctuations by a multiple of their implicit volatility). 

The following table exemplifies the results of the key rate duration process. First, the present values of all asset and liability positions as well as derivative financial instruments are determined. Subsequently, the interest rates of the relevant interest-rate curve in each maturity band and per currency are increased by 1 per cent (+100 basis points). The respective movements represent the gain or loss of the present value resulting from the shift in the interest-rate curve. Negative values point to an excess of assets, positive values to an excess of liabilities in the maturity band.

Key rate duration profile per 100 basis points increase

In the following table, the effects of a negative movement in the principal currencies on consolidated net income and shareholders’ equity are set out. Responsible for the underlying fluctuation of the Swiss franc against the US dollar is the implicit volatility as of 31 December 2012 and 31 December 2011, respectively.

Movement in the principal currencies

The impact of a possible downward movement in equity markets of 10, 20 and 30 per cent, respectively, on consolidated net income is illustrated by the following table. 

Variances in the relevant stock markets

For daily risk management purposes, derivative financial instruments are entered into exclusively in the banking book and serve to hedge equity price, interest-rate and currency risks as well as to manage the banking book. The derivatives approved for this purpose are laid down in the Risk Policy.

VP Bank deploys interest-rate swaps principally to hedge interest-rate risk. From an economic point of view, the offsetting revaluation effects from the underlying position and the hedge cancel each other out. As VP Bank does not apply hedge accounting and interest-rate swaps held to hedge interest-rate risk are managed from the trading book, there results an asymmetric reporting of changes in value between the underlying security and the hedge transaction in the income statement. 

During the financial year, VP Bank hedged its own financial investments against currency fluctuations in the main currencies through the conclusion of foreign currency forward contracts. In principle, no currency risks should arise from client activities; remaining unsettled foreign currency positions are closed out over the foreign currency spot market. Group Trading is responsible for the management of foreign currency risks arising from client activities. 

Liquidity risks may arise through contractual mismatches between the in- and outflows of liquidity in the individual maturity bands. Any differences arising demonstrate how much liquidity the Bank must eventually procure in each maturity band should there be an outflow of all volumes at the earliest possible time. Furthermore, concentrations of refinancing may lead to a liquidity risk if they are so important that a massive withdrawal of the related funds could trigger liquidity problems. Also the lack of availability of assets eligible for repo operations at the Swiss National Bank (SNB) could represent a liquidity risk. 

Whilst complying with the relevant legal liquidity requirements and the provisions regarding risk concentrations amongst both assets and liabilities, liquidity risks are monitored and managed through internal guidelines and limits for the interbank business. The minimum reserve requirements of the SNB and the provisions of the Liechtenstein Banking Law on short-term liquidity were complied with at all times during the course of 2012. The surplus in the minimum reserves and in the area of short-term liquidity amounted to an annual average of 1,014 per cent and 159 per cent, respectively, of the required values. 

The ratio of liquid assets to short-term liabilities constitutes an important indication in liquidity management. The following table illustrates the relevant ratios for 2012 and 2011 as of 31 December as well as the average, the highest and the lowest amounts. 

Liquidity

Included in liquid assets are the following positions: balances due from banks, bonds and other assets maturing within one month, liquid assets, assets which the Swiss National Bank authorises for repo operations required under monetary policy and those which in the home country of a foreign branch are eligible for discount, pledging or for repo operations with the central bank as well as bonds of domestic issuers and foreign states. Short-term liabilities reflect all savings and deposit accounts, sight liabilities as well as deposits from banks and clients maturing during the following month. 

In this manner, the above-mentioned ratios differ sharply from those which are planned within the framework of Basel III. This concerns primarily the liquidity coverage ratio (LCR) for which a minimum requirement of 100 per cent will apply. Thus, short-term liabilities flow into the LCR on a weighted basis (for instance, stable client deposits in all probability at 3 per cent), whereas these amounts are reflected in full in the above mentioned ratios. 

In the area of short-term maturities, the Bank principally refinances itself with sight deposits from clients. The following table shows the maturity structure of liabilities according to the maturity bands. As of 31 December 2012 and 2011, the cash flows (non-discounted capital and interest payments) are made up as follows:

Cash flows on the liabilities side of the balance sheet

VP Bank can rapidly procure liquidity on a secured basis over its access to the Eurex repo market. In addition, the holdings of securities eligible for repo transactions as well as clearing giro balances, which serve the Bank as a liquidity reserve, were increased during the course of the year. In view of the continuing financial market crisis as well as of Basel III, VP Bank actively pursued its objective of securing sources of long-term refinancing during 2012. 

Credit risks arise from all transactions for which payment obligations of third parties in favour of the Bank exist or can arise. Credit risks accrue to the Bank from client lending activities, the money-market business including bank guarantees, correspondent and metal accounts, the reverse repo business, the Bank’s own investments in securities, securities lending and borrowing, collateral management as well as OTC derivative trades. 

As of 31 December 2012, the credit exposures aggregated CHF 9.4 billion (31 December 2011: CHF 10.1 billion). The following table shows the composition thereof by on- and off-balance-sheet positions.

Credit exposures

Credit exposures by groups of counterparties

Credit exposures by collateral 

In the case of amounts due from banks, money-market paper as well as of interest-bearing securities among its own investments, the valuation is based on external ratings. 

The following tables show the individual on- and off-balance-sheet positions by rating classes, risk-weighting classes and domicile.

Credit exposures by rating classes 

Credit exposures by risk-weighting classes

Credit exposures by domicile

Within the scope of the client loan business, credits are granted on a regional and international basis to private and commercial clients, whereby the focus is in the private client business with CHF 2.6 billion of credits secured by mortgage (31 December 2011: CHF 2.4 billion). From a regional perspective, VP Bank conducts the lion’s share of this business in the Principality of Liechtenstein and in the eastern part of Switzerland. Given the broad diversification of the exposures, there are no risk concentrations by industry or segment. 

The ten largest single exposures to clients encompass 22 per cent of total credit exposures (31 December 2011: 19 per cent). Exposures to banks relate exclusively to institutions with a high credit capacity (minimum rating A) and a registered office in an OECD country (excluding GIIPS countries). 

In addition to the Risk Policy, the Business Rules on Credit constitute the binding framework regulating customer lending activities. Set out therein are not only the general guidelines governing credit (principles) as well as the framework conditions for the conclusion of all types of credit business; they also designate those who can take valid decisions and the corresponding bandwidths within the framework of which credits may be approved (powers of authority). 

With only few exceptions in the area of private and commercial clients, customer lending exposures must be covered by the collateral value of the security (collateral less a deduction for risk). Counterparty risks in the loan business are governed by limits which restrict the amount of exposure depending on creditworthiness, industry segment, collateral and risk domicile of the client. VP Bank employs an internal rating procedure to evaluate creditworthiness. 

VP Bank enters into both secured and unsecured positions in the interbank business. Unsecured positions result from money-market activities (incl. bank guarantees, correspondent and metal accounts), secured positions arising from the reverse repo business, securities & lending activities, collateral management as well as OTC derivative transactions. As repo deposits are fully secured and the collateral received serves as a reliable source of liquidity in a crisis situation, not only counterparty but also liquidity risk could be reduced with the introduction of the business with reverse repo transactions. 

Counterparty risks in the interbank business may only be assumed in approved countries and with approved counterparties. A comprehensive system of limits reduces the level of exposure depending on the duration, rating, risk domicile and collateral of the counterparty. In this connection, VP Bank uses the ratings of the two rating agencies Standard & Poor’s and Moody’s. OTC derivative transactions may only be concluded with counterparties with whom a netting contract has been agreed. 

Credit risks are managed and monitored not only on an individual client level but also on a portfolio level. At the portfolio level, VP Bank uses the expected and unexpected credit loss to monitor and measure credit risk. The expected credit loss calculates – on the basis of historical loss data and estimated default probabilities – the loss per credit portfolio which may be anticipated within a year. In addition, the results of the analysis flow into the calculation of the general valuation allowances in the annual financial statements. The unexpected credit loss values the deviation of the actual loss, expressed as the value-at-risk, from the expected loss assuming a certain probability. In this model-based measurement of credit risk, rating changes of counterparties and changes in credit spreads impact the results. 

During the past financial year, VP Bank has further reduced the volume of credit derivatives in its own portfolio. The following table shows the contract volume of credit derivatives by type of product. 

Credit derivatives (contract volumes)

The following table shows impaired and overdue receivables, as well as specific valuation allowances, by domicile.

Credit exposures vulnerable to default by domicile 

Overdue receivables by remaining term

Country risks arise whenever political or economic conditions specific to a country impinge on the value of an exposure abroad. 

The monitoring and management of country risks is made using volume limits which restrict the respective aggregate exposures per country rating (Standard & Poor’s and Moody’s). All on- and off-balance-sheet receivables are considered in this process; investments in the Principality of Liechtenstein and Switzerland do not fall under this country limit rule. The risk domicile of an exposure is the basis for recognising country risk. In the case of secured exposures, in principle the country in which the collateral is located is considered. 

The following table shows the distribution of credit exposures by country rating. Non-rated positions are mostly exposures from local business activities (receivables secured by mortgage) of VP Bank (BVI) Limited. 

Country exposures by rating

Financial instruments in GIIPS countries

1. As of 31/12/2012, 85 per cent of the total is collateralised by the European Investment Bank (as of 31/12/2011: 38 per cent). 

The causes for operational risks are multiple. People make mistakes, IT systems fail or business processes are inoperative. Therefore it is necessary to detect the events which trigger important risk occurrences and their impact in order to limit them with suitable preventive measures. 

The management of operational risks is understood in VP Bank to be an integral cross-divisional function which is to be implemented on a uniform Group-wide basis over all areas and processes. The second level of management is responsible for the identification and evaluation of operational risks as well as for the definition and conduct of key controls and measures to contain risks. Within the scope of its decision-making authority, the central functional unit Group Risk Control makes available on a Group-wide basis the instruments for a systematic OpRisk management and ensures their ongoing development. These include the conduct of risk assessments as part of risk identification and evaluation, the conduct of key controls, the maintenance of a databank of incidents as well as the employment of early warning indicators. 

As a result of intense co-operation amongst specialist departments to further develop a complete system of management of operational risks, risk consciousness could be reinforced at all levels. In this connection, a catalogue of key controls was further developed and the database of losses was expanded to include specific valuation allowances and provisions raised in addition to losses incurred. Knowledge and experience were exchanged within the Group in order to ensure a coordinated approach. Thanks to a uniform implementation of the project, it is now possible to provide the relevant target groups (Board of Directors, Group Executive Management and Senior Management) with a meaningful quarterly status report on operational risks within VP Bank Group. Business Continuity Management (BCM) as a further important sub-area is systematically pursued by VP Bank with expert and specialised knowledge along the lines of norm 25999-2:2007. The basis thereof is the BCM and IT service continuity strategy which was gradually implemented by Group Executive Management and reviewed on an ongoing basis for compliance and accuracy. Operationally critical processes are reviewed in detail, discussed and, where necessary, documented with a clear course of action whenever risks crystallise. The organisation necessary for crisis management has been established, its members are routinely trained and instructed. 

Business risks are the object of a qualitative management process with VP Bank. Within the scope of the ordinary strategy process, business risks are identified by the Board of Directors and Group Executive Management and taken account of in an appropriate manner. In view of the complexity of the effects which can be impacted by the future development of the business and the profitability of the Bank, potential business risks and their probability of occurrence and effects are discussed on the basis of scenarios and appropriate measures decided upon to contain the risks. The results serve as a basis for the strategic planning process and thus flow into the annual planning and budgeting process.