Risk management of VP Bank Group

Effective risk, liquidity 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 liquidity and 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. 

Guaranteeing liquidity within VP Bank Group continues to be accorded the highest priority. Giro clearing facilities were further expanded. In addition, the constitution of a base of first-class investments with high liquidity (so-called high-quality liquid assets) was accelerated in view of Basel III and the requirements associated therewith. Even under Basel III, VP Bank will possess a comfortable basis of liquidity. The required liquidity coverage ratio (LCR) is already met.

The reform of the Basel III regulatory framework heightens the capital-adequacy requirements for banks. As a system-relevant bank in Liechtenstein, VP Bank must support its risk-weighted assets with 13 per cent equity as from 1 February 2015 (previously 8 per cent). With a tier 1 ratio of 20.5 per cent, VP Bank possesses a capital base which far exceeds the requirements under Basel III, thus continuing to reflect a high measure of financial stability and security.

The management and monitoring of credit risks continues to assume a central role in view of the significance of credit-granting activities (CHF 4.3 billion as of 31.12.2014). The volume of exposures in the interbank market was reduced by CHF 1.2 billion to CHF 3.3 billion in comparison with the position at the end of 2013. Secured reverse repo positions were entered into in order to limit credit risk. Since the onset of the crisis in financial markets, economic progress has been achieved in certain of the countries impacted by the debt crisis. In these countries, limits which had been completely or partially suspended were in part reactivated.

In 2014, the margin of fluctuation in interest rates, currencies and equity shares, in particular in the core markets of VP Bank Group, remained in a relatively narrow range. As a result of the abolition of the minimum parity to the euro and the shift in the target rate for the three-month LIBOR by the SNB in January 2015, major distortions arose on financial markets. VP Bank believes that the uncertainties will persist in 2015. 

The events in January 2015 do not impact the 2014 financial statements. Because of its robust liquidity and capital base, the risk tolerance of VP Bank remains intact even after the SNB decision. The monitoring and management of market risks remains a central focus point in 2015.

The systematic management of operational risks was further developed at VP Bank in 2014. The centre of the efforts in this respect was the performance of risk assessments in the parent bank and in Group subsidiaries as well as the further consolidation and optimisation of the existing internal control system (ICS).

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 base.

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. While complying 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 unbalanced relationship of risk to return as well as large risks and extreme 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 required qualitative and quantitative disclosures on capital adequacy, on the strategy and processes for risk management as well as on the risk situation of VP Bank are made in this chapter and in the commentary on the consolidated financial statements. 

For each risk category, Basel II, which is in force until the balance-sheet date, provides for 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 2014, the business activities of VP Bank Group required shareholders’ equity of CHF 336.3 million (31 December 2013: CHF 330.2 million). Adjusted eligible equity totalled CHF 860.5 million (31 December 2013: CHF 840.8 million). Year on year, the excess of equity showed an increase of 2.7 per cent to CHF 524.2 million (31 December 2013: CHF 510.6 million), which together with a tier 1 ratio of 20.5 per cent (31 December 2013: 20.4 per cent) continues to reflect the robust equity base of VP Bank. 

The table overleaf shows the equity situation of the Group as of 31 December 2014. 

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 Group can be described as robust.

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, for operational risks and for unsettled transaction positions, converted into equivalent units by multiplying by 12.5.

The implementation of Basel III in Liechtenstein will take effect as of 1 February 2015 and introduces stricter capital-adequacy and liquidity requirements for credit institutions. As a system-relevant bank in Liechtenstein, VP Bank will have to fulfil the requirement of an additional capital buffer. Increased regulatory capital-adequacy requirements enhance the stability of the financial system and improve the protection of creditors. VP Bank possesses a tier 1 ratio of 20.5 per cent as of 31 December 2014. We assume that this value will reach a similar level under the Liechtenstein provisions which take effect as from 1 February 2015 and that the required level of 13.0 per cent will be significantly exceeded.

While 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 and sensitivities. 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 Group Treasury unit 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 Group Risk Control unit monitors observance of the limits throughout the Group. 

Market risks arise as a result of positions being entered into in debt securities, equity shares 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 for market risks 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 value-at-risk indicator is computed on a Group-wide basis with the aid 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 will not be exceeded with a probability of 99 per cent. In order to compute the value-at-risk 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 value-at-risk of VP Bank Group at 31 December 2014 amounted to CHF 22.3 million (31 December 2013: CHF 37.4 million). This equates to a decrease of 40.4 per cent, which derives primarily from interest rate risk. Equity price risk and commodity risk remained approximately constant year on year, whereas the currency value-at-risk decreased in the reporting period. 

The following table shows the value-at-risk (on a monthly basis) analysed by types of risk and the market value-at-risk 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 not 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 market 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, slump in equity share prices). 

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 curves in each maturity band and per currency are increased by one 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. 

The following table sets out the effects of a negative movement in the principal currencies on consolidated net income and shareholders’ equity. Responsible for the under­lying fluctuation of the Swiss franc against the euro and the US dollar is the implicit volatility as of 31 December 2014 and 31 December 2013, respectively. 

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. 

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.

In order to hedge interest rate risks, VP Bank principally deploys interest rate swaps. From an economic point of view, the opposing revaluation effects from the underlying security and the hedging instrument offset each other. As VP Bank does not apply hedge accounting in accordance with IFRS, and the derivatives held for the purpose of hedging the interest rate risk are revalued at fair value, there results an asymmetric recording in the profit and loss account of the positive and negative changes in value from the underlying position and the hedging instrument. 

VP Bank also employs foreign-exchange transactions to hedge the Bank’s own financial investment against foreign-exchange rate fluctuations for the principal currencies. Foreign-exchange risks arising from client activities in principle should not arise; residual unsettled foreign-currency positions are closed out on the spot market. Group Treasury & Execution is responsible for the management of foreign-currency risks.

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. 

While complying with the relevant legal liquidity requirements and the provisions regarding risk concentrations among 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 2014. The surplus in the minimum reserves and in the area of short-term liquidity amounted to an annual average of 3,145 per cent and 138 per cent, respectively, of the required values. 

The ratio of liquid assets to short-term liabilities constitutes an important indicator in liquidity management. The following table illustrates the relevant ratios for 2013 and 2014 as of 31 December, as well as the average, the highest and the lowest amounts.

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 will be progressively increased to reach 100 per cent in 2019. Thus, short-term liabilities flow into the LCR on a weighted basis (rate of outflow for stable client assets 3 per cent and 5 per cent, respectively), 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 2014 and 2013, the cash flows (non-discounted capital and interest payments) are made up as follows:

VP Bank can rapidly procure liquidity on a secured basis over its access to the Eurex repo market in case of need. The risk of an extraordinary, but nevertheless plausible event, which will take place with a very small probability, can be measured with the aid of stress tests. In this manner, VP Bank can take all applicable remedial action on a timely basis and, where necessary, set limits. 

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 VP 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 2014, total credit exposures amounted to CHF 9.0 billion (31 December 2013: CHF 9.5 billion). The following table shows the composition thereof by on- and off-balance-sheet positions.

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.

1. In contrast to the remaining tables in the section on credit risks, the tables regarding credit exposures by risk-weighting classes include other assets, not, however, trading portfolios.

Within the scope of the client loan business, credit is granted on a regional and international basis to private and commercial clients, whereby the focus is on the private client business with CHF 2.9 billion of mortgage credits (31 De­cember 2013: CHF 2.7 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 19 per cent of total credit exposures (31 December 2013: 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 granting as well as the framework conditions for the conclusion of all types of credit business; they also designate 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. Deviations from credit-granting principles (exceptions to policy) are dealt with appropriately as part of the credit-risk management process. 

VP Bank enters into both secured and unsecured positions in the interbank business. Unsecured positions result from money-market activities (including bank guarantees, correspondent and metal accounts), secured positions arising from the reverse repo business, securities lending and borrowing 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 entered into 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.

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. 

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

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) Ltd.

As regards the country risk of Russia and Ukraine, VP Bank has no noteworthy risk-domicile exposures in these countries. As in the prior year, no exposures in the GIIPS countries (Greece, Ireland, Italy, Portugal and Spain) exist in financial instruments as of the end of 2014.

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 events and their impact in order to limit them with suitable preventive measures. 

The management of operational risks is understood at VP Bank to be an integral cross-divisional function which is to be implemented on a uniform Group-wide basis over all business units and processes. 

Each person in a management position is responsible for the identification and evaluation of operational risks as well as for the definition and performance of key controls and measures to contain risks. This responsibility may not be delegated. Each person in a management position shall make a critical assessment of whether the key controls have ongoing val­­idity and whether key controls are missing. Each manage­ment member in levels 1 and 2 shall undertake an annual self-assessment of the part of the internal control system for which he or she is responsible. The results of this self-analysis are communicated annually to the central unit Group Risk Control.

Within the scope of its powers of authority, the central unit Group Risk Control makes available on a Group-wide basis the instruments for a systematic management of operational risks and ensures their ongoing development. These include the conduct of risk assessments (scenario analyses) as a part of risk identification and evaluation, the performance of key controls, the maintenance of a database of incidents as well as the deployment of early warning indicators.

As a result of intense cooperation among specialist departments to further develop the 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 incidents 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 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 ISO standard 22301-2012. The basis thereof is the BCM strategy, which is successively 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 materialise. The organisation necessary for crisis management is established and its members are routinely trained and instructed. 

Business risks are the object of a qualitative management process within VP Bank. Within the scope of the ordinary strategy process, business risks are identified by Group Executive Management and taken account of in an appro­priate manner. In view of the complexity of the effects which can impact 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.