NLB GROUP AND NLB RISK MANAGEMENT

The goal of the Group's Risk management is to sustain and continue stable performance and to maintain the highest asset quality. The Group achieves these goals by uniformed and constant ex ante and ex post assessment and monitoring of clients and by using the standard Group risk management tools (migration matrices, diversification, Value at Risk, Marking to Future). The use of these tools improves asset quality, structural liquidity, and performance ratios, enables early warning signals and minimises exposure of the Group to all types of risks.

The Bank and subsidiaries respect all Bank of Slovenia requirements, but subsidiaries must also comply with standards of internal credit risk system of NLB as defined in the contracts, which are already executed. The Bank has therefore centralised the role in controlling the assumptions of different risks, regarding the data structure, methodologies adopted and reporting. The Bank, in cooperation with subsidiaries, also prepares credit and market risks policies, sets strategies and places limits within the decision making process.

CREDIT RISKS MANAGEMENT

The Group reviews credit risks from three aspects: specific counter-party risk, portfolio risk and country risk. Credit risk management includes constantly analysing the loan portfolio and providing credit analysis by considering adverse selection and moral hazard problems regarding client behaviour before and after signing of the contract.

In 2002 the Bank strengthened its control of banking and financial subsidiaries abroad by reviewing the quality of their portfolio on a quarterly basis to insure uniform and standard practices in grading and provisioning. In case of differences, mainly due to different country regulations and practices, these are adjusted to Bank of Slovenia regulations.

The credit portfolio includes loans to corporate, retail, and the public sector, exposures to other banks and financial institutions, corporate bonds and other credit risk bank products, such as guarantees, derivative instruments etc. Part of the portfolio (capital investments, investments in securities etc.) is evaluated under fair value, while the quality of the portfolio is analysed by classifying clients and assets into five credit grades (A to E), A being the highest quality credit risk. The "performing" part of the total Group portfolio (A and B) represents 93.5 per cent of the banking group and 95.6 per cent in NLB. The credit portfolio of the Group amounted to 1.642 billion tolars of which 1.218 billion tolars is the portfolio of the NLB.

Table 15: Credit rating migration matrix weighted with exposure for year 2002

The tables show a variant of migration matrix weighted with exposure, which also reflects the size of migrating exposure. The computation of average rating is enabled by means of assigning numerical codes to credit rating grades (A=5, B=4, C=3, D=2, E=1). The average rating indicates the credit quality of the Bank's clients with a particular rating grade after one year. The conclusions from table 15 are as followed:

• Rating A shows large stability without migrations,
• Rating B is migrating in a substantial part to rating A.
• The same procedure goes for ratings C and D, which account for relatively small share in the structure of the portfolio.
• Rating E is traditionally stable in the negative sense.

By comparing year 2002 with weighted averages, we can drive the following conclusion:

• Clients have a much smaller chance of staying stable in the same rating group compared to the weighted average for several years.
• There are more migrations from worse to better rating groups (ex. from C to A and B) compared to weighted averages.
• NLB is exposed the most towards best-rated clients (A and B). Exposure towards worse rating groups (C, D and E) is relatively small; in the last year it was twice as low relatively from the weighted average for several years.

Table 16: Average credit rating migration matrix weighted with exposure (1995 - 2002)

NLB and the Group comply with all regulatory requirements, and all Group members must also comply with the internal NLB credit risk system that is oriented towards future creditworthiness of our clients. Migration matrices for the past 32 quarters from 1994 to 2001 for NLB, show that the Bank has relative strong stability in the quality of assets.

Banks of the Group apply the same criteria regarding client's credit grading, client and country limits, quality of collateral, minimum level of provisions and data structure. The cover ratio of specific provisions to doubtful and non performing assets is higher than 85 per cent in NLB and above the minimum required by the Bank of Slovenia in all subsidiary banks. Foreign subsidiaries also follow this policy. The cover of specific provisions to doubtful and non-performing loans and other credit risk exposures of clients rated as C, D and E credit grade stood at 97 per cent percent and 103.6 percent in NLB.

Country risk is managed by using maximum risk levels for exposures to different countries, including an emerging markets limit. Assessment of the risk level of a given country is performed through a review of that country's major macroeconomic data, its political situation and the rating attributed by international specialised rating agencies.

MARKET RISKS MANAGEMENT

Basic market risks that the Group faces are foreign exchange, interest rate, securities portfolio and liquidity risks. These risks are analysed and managed on three levels. Firstly, business departments are responsible for managing of market risks within their authorities determined by the Management Board. Secondly, on the NLB level these risks are analysed and managed in accordance with internal policies and domestic central bank standards. Thirdly, the Risk Management Centre of the Bank controls market risk exposures of each bank and of the Group as a whole.

Foreign exchange risk

The NLB's foreign exchange risk emanates from both tradingbook and structural positions, while the foreign exchange risk of the Group is concentrated in structural positions.

On a consolidated basis foreign exchange risks are reported to Bank of Slovenia using a standardised approach every halfyear end. We ensure capital adequacy for these exposures.

Internally NLB manages foreign currency risk in line with policy that sets limits on currency positions, dealer limits and VAR calculation. In VAR calculations the Basle Committee amendment criteria for internal approach to measure foreign currency risk capital charge is applied. In September 2002 it was decided to implement a historical simulation method instead of the previously selected parametrical VAR. The approach provides for a daily revaluation of the Bank's foreign exchange portfolio on the basis of the historical trend in market prices and their correlation over the past year. VAR methodology is therefore one of the most important tools in the active management of open foreign currency positions. The model is supplementary to the requirements of the Bank of Slovenia.

The foreign currency risk measurement model has the following characteristics (VAR parameters):
- VAR is calculated daily, based on the previous working day's exposure
  (trading and banking book),
- the holding period of 10 days,
- the period of observation is 250 working days,
- the level of confidence 99 per cent,
- the historical series is updated daily.

Since the implementation of new method, the average daily VAR for the last quarter of 2002 was 290 million tolars, including derivatives.

Interest rate risk

The measurement of interest rate risk exposure means quantifying the potential loss, resulting from an adverse movement in interest rates. In the Bank and Slovene subsidiaries, gap methodology and duration is used, while foreign subsidiaries are using their own models, making different scenarios for interest rate movements.

Liquidity risk

Management of liquidity risk includes effective control processes and fulfilment of Bank of Slovenia regulating requirements on the liquidity area. The Bank regulates operative liquidity on the basis of planned cash flows, on tolar side at least for 30 days ahead and on foreign for 10 days. Adequate information system enables connection between business sectors, administration and treasury, that asures data on liabilities due and new accounts approved, thus enabling a sufficient management system. Liquidity scale with the information on all known cash flows from bank's operations presents the basis for daily reports on liquidity in advance for up to 45 days daily, for up to one year monthly and for more than one year annually.

We balanced the liquidity management between NLB and daughter banks with a contract of cooperation of banks in the area of Treasury. Each bank is thus primary responsible for its daily liquidity in tolars and foreign currency. It ensures required financial assets and manages its surpluses and deficits with the Parent Bank. With the goal of effective liquidity management, rules of internal trading with tolar and foreign currencies were formed, that enable daily operations with deposits in local and foreign currency and repurchase of foreign assets.

Securities portfolio management

Treasury manages an extensive debt securities portfolio for foreign and local issuers. Trading is performed in cooperation with foreign and domestic banks, and investment banking and other customers.

Management of the domestic securities portfolio was affective. Major part of it represent Government bonds of the Republic of Slovenia. The Bank also took over the role of the official maintainer of the treasury bills market and has a leading role in dealing with domestic debt securities.

The majority of foreign investment represent foreign Bank of Slovenia certificates of deposit, prescribed by monetary regulation. The daily liquidity of foreign currency was managed with this portfolio.

PROVISIONING POLICY

Banks of NLB Group form special provisions for potential losses arising from credit, country and other known risks exposures. Regarding the growth and structure of loan portfolio the Group assigned 12.4 billion tolars from net income to provisions. In the same period the Bank formed additional provisions in amount of 0.75 billion tolars. Write-offs amounted to 2.2 billion tolars and 0.9 billion tolars recoveries from assets previously written off were realized.

The average grade of provisions within each rating group of exposures is always above the level required by the Bank of Slovenia. This together with above 100 per cent NPL's provision coverage express prudent performance of provisioning policy.