Risk management

The continuing economic crisis characterized 2010, and was much more evident in the banking sector than the previous year. The crisis exposed weaknesses in the area of credit risk management which, due to the Group’s business model, represents the most significant risk and accounts for the highest proportion of capital requirements.

Problems brought to light include the excessive concentration of the portfolio in high-risk sectors of the economy (e.g. construction and financial holdings), the financing of the companies with high financial leverage and insufficient emphasis on obtaining quality collateral, which must provide an efficient secondary means of payments in the event of default.

The Bank responded to these deficiencies by adapting internal risk management processes and by lowering the target risk profile, and defined this as one of its key strategic priorities in the future.

The strategy identified two key elements in the upgrading of the risk management system.

The Bank redefined its risk profile to reflect its reduced appetite for taking up risks. To that end, the Bank was especially prudent in assessing internal capital adequacy and ensuring sufficient own funds to cover all significant risks within the NLB Group. The internal capital adequacy assessment process (ICAAP) and methodology have been amended accordingly.

Credit risk management

The Bank’s activities in 2010 were primarily focused on monitoring and managing the credit risks that were most significant and most sensitive to the crisis. In the context of the loss of markets, the poor collection of receivables, negative trends on the real estate and capital markets and general payment indiscipline, debtors faced increasing difficulties in settling their liabilities.

Individual and portfolio approach to credit risk management

The NLB Group manages credit risk at two levels: at the transactional and portfolio levels.

At the transactional level (i.e. individual customer or project), appropriate processes must be developed during the various phases of the relationship with the customer (i.e. prior to, during and after entering into an agreement).

In the first phase, information regarding the customer, which facilitates the objective assessment of the customer’s operations and financial position (i.e. information regarding "soft" factors that could affect the customer’s operations and information regarding a customer’s past cooperation with the bank), is critical. The aforementioned serves as the basis for rating a customer, for assessing its creditworthiness and later for rating the customer’s claims.

In the second phase, it is essential to draw up an appropriate agreement, stipulating collateral and obligations.

The third phase comprises various forms of customer monitoring, in particular with regard to the generation of sufficient cash flows for the regular settlement of liabilities and other relevant data that could affect the customer’s solvency (or associated credit risk), and thus the need to create and/or amend the amount of impairments on claims against the customer or provisions for commitments.

The Bank’s Credit Committee prudently and regularly monitors those customers that are under significant pressure from trends in operations and the environment.

The risk of individual investments is also assessed in terms of the credit portfolio. The credit portfolio is regularly monitored by segments (e.g. credit rating, country, type and size of customer, activity, collateral, bad/overdue claims, currency exposure, etc.). Monitoring comprises analyzing changes and identifying trends in movements, risks and concentration of the credit portfolio on the basis of time factors.

Internal rating system and authorizations

The Bank of Slovenia’s Regulation on the Assessment of Credit Risk Losses of Banks and Savings Banks serves as the legal basis for rating each customer and the associated claims, and for creating impairments. The aforementioned regulation prescribes five rating categories (from "A" to "E") for customers and claims, where "A" represents the highest or best credit rating and "E" represents the lowest. The regulation also prescribes the impairment of claims and the creation of provisions for commitments in accordance with the International Financial Reporting Standards, with respect to the risk of a specific transaction and existence of evidence of impairment. The amount of impairment loss is also affected by the collateral received, if it represents an effective secondary means of repayment in the event of a customer’s inability to settle its debts.

Authorizations, procedures and the detailed rating methodology, as well as the setting of a maximum borrowing limit and the impairment of claims, are formalized in the NLB Group’s internal acts. A standard customer rating methodology, with the prescribed set and quality of input data and elements of a rating analysis, applies to all Group companies. Here it should be noted that decisions regarding materially significant customers of the NLB Group is solely the responsibility of the NLB Credit Committee.

Control mechanisms

NLB regularly reviews the business practices and credit portfolios of Group companies to ensure that they are operating in accordance with the minimum risk management standards of the NLB Group. This ensures appropriate standard processes for managing and reporting credit risks at the consolidated level.

Liquidity risk management

Liquidity risk is monitored and managed in the NLB Group in accordance with the relevant policies and strategies, which set out rules and a hierarchy of responsibility. Standard liquidity risk monitoring and management guidelines were implemented at NLB Group companies in accordance with the NLB Group Liquidity Risk Management Strategy. Liquidity risk management is decentralized, with each company ensuring its own liquidity via the necessary sources of funding and their appropriate diversification and maturity, and by managing liquidity reserves and fulfilling the requirements of regulations governing liquidity. A standardized current reporting system functions within the Group, and ensures adequate control over the provision of operational and structural liquidity at all NLB Group companies.

In addition to monitoring credit risk, the NLB Group also places special emphasis on ensuring the appropriate level of long-term or structural liquidity in the current conditions on the financial markets.

Liquidity is managed at three levels in the NLB Group:

Operational level

Structural level

By forecasting net cash flows, the NLB Group is able to identify critical points in the expected liquidity position in a timely manner.

Exceptional circumstances and stress testing

An exceptional liquidity situation typically arises rapidly and unexpectedly (its occurrence has a significant impact on the Bank’s operations, but is highly unlikely). Due to this characteristic, it is difficult to perceive the signs that warn of its occurrence. In some cases, there are no warning signs at all. In this respect, it is very important to clearly define the roles and responsibilities of those involved and the method of communication and reporting, such that the likelihood of surviving in exceptional circumstances are greatly increased.

In addition to the Bank’s document Contingent Liquidity Management Plan, there are liquidity management stress tests that have been drafted in accordance with the recommendation set out in the document Liquidity Buffers and Survival Periods published by the Committee of European Banking Supervisors (CEBS).

The Group has drafted three types of stress tests, broken down into three levels.

The impact on cash flows of all three stress test levels is monitored over a period of one year, broken down by month. The exception in the first month when the impact is monitored weekly and daily.

Market risk management

The NLB Group’s exposure to various market risks (currency risk, interest-rate risk in the banking book, and other market risks in the trading book) is comparatively low. The Group implements a relatively conservative market risk management policy, which is also reflected in appropriate system limits and procedures defined by policies and other documents adopted at the Group level. The NLB Group Assets and Liabilities Committee consistently assesses all types of market risks and individual limits for reporting purposes.

NLB provides services linked to the trading book within the NLB Group. These mainly comprise the provision services for customers ("back to back" transactions) and asset management, while trading on own account is carried out less frequently. Other Group companies mainly monitor currency and interest-rate risks that are primarily the result of structural fluctuations and macroeconomic conditions.

Monitoring and managing exposure to market risks is generally supported by the use of contemporary internal methodologies tailored to comply with the Basel standards. Furthermore, stress tests are performed on a regular basis. The Group implemented a standardized current reporting system that ensures adequate control over the market risks to which all NLB Group companies are are exposed. The methodologies are in line with the requirements of the regulators at the individual and Group level, while current reporting to the regulator follows a standardized approach. In accordance with Bank of Slovenia requirements, the NLB Group ensures sufficient capital to cover potential unexpected losses due to exposure to currency and other market risks.

Operational risk management

For quality operational risk management, the NLB Group established a system to collect data regarding loss events, and to identify and assess operational risks. As the highest authority in the area of operational risk management, NLB named an Operational Risk Committee to serves as the decision-making body of the Bank's Management Board. The relevant committees for (operational) risk were also named at other NLB Group banks. The management board serves in this role at other subsidiaries. The task of the aforementioned bodies is to discuss the most significant operational risks, and to monitor and support the effective management of operational risks at an individual company.

The upper tolerance limit to operational risk, permitted by an individual bank in its operations, has been defined. A net loss exceeding that limit must be treated individually, and additional measures taken, as necessary, to prevent the same or similar loss events. The relevant provisions are created for maximum foreseeable loss events, the material consequences of which are appropriately assessed.

Possible future losses are estimated by assessing identified operational risks. A operational risk profile is drafted once a year on the basis of these assessments. The most significant risks are managed actively.

Know-how and methodologies are transferred within the NLB Group to companies included in consolidation (except for small companies). All companies have adopted relevant documents that are in line with NLB standards. These are updated periodically in line with the development of operational risk management. Thus, NLB’s operational risk management model was implemented throughout the entire NLB Group. The Bank strives to continuously update the aforementioned model, which is also supported by the development of the relevant software support. Capital requirements for operational risk are calculated using the standardized approach at NLB and using the basic indicator approach at the NLB Group level.