Risk management

Arion Bank faces various risks arising from its day-to-day operations. Managing risk is therefore a core activity within the Bank. The key to effective risk management is a process of ongoing identification of significant risk, quantification of risk exposure, action to limit risk and constant monitoring of risk.

The Board of Directors is ultimately responsible for the Bank’s risk management framework and ensuring that satisfactory risk policies and governance for controlling the Bank’s risk exposure are in place. The Board allocates risk management of subsidiaries to the relevant subsidiary. For the parent company (the Bank) the Board sets risk appetite, which is translated into exposure limits and targets monitored by the Bank’s Risk Management division.

The CEO is responsible for sustaining an effective risk management framework, processes and controls as well as maintaining a high level of risk awareness among the employees, making risk everyone’s business.

The Bank’s Risk Management division is headed by the Chief Risk Officer. It is independent and centralized and reports directly to the CEO. Further information on Risk Management division.

 
The Bank operates several committees to manage risk. The Board Audit and Risk Committee (BARC) is responsible for supervising the Bank’s risk management framework, risk appetite and internal capital adequacy assessment process (ICAAP). The Asset and Liability Committee (ALCO), chaired by the CEO or his deputy, is responsible for managing the asset-liability mismatch, liquidity risk, market risk and interest rate risk, and capital management. The Underwriting and Investment Committee (UIC) decides on underwriting and investments. The Bank has four credit committees: The Board Credit Committee (BCC) which decides on all major credit risk exposures; the Arion Credit Committee (ACC) which operates within limits specified as a fraction of the Bank’s capital; the Corporate Credit Committee (CCC) and the Retail Branch Committee (RBC) which operate within tighter credit granting limits. There are also five valuation committees whose role is to establish criteria for estimating collateral and also to inspect valuations of securities owned by the Bank.

The most significant risks the Bank is exposed to are credit risk, including concentration risk, liquidity risk, currency risk, interest rate risk, legal risk and operational risk. The Bank’s Pillar 3 Risk Disclosures 2015 report discusses risk factors and risk management in detail.

CAPITAL ADEQUACY

The Bank’s capital is intended to meet the risk of unexpected loss in its operations. The size of the Bank’s capital base should reflect the risk at any given time and any potential adverse future trends. Risk on the Bank’s balance sheet is assessed by calculating risk-weighted assets (RWA). The Bank uses standardized approach for calculating RWA.

The Bank’s capital base was ISK 195.7 billion at the end of 2015. Tier 1 capital accounted for ISK 189 billion of this total. In 2015 the Bank repaid two thirds of a subordinated loan from the Icelandic government, thereby reducing Tier 2 capital by ISK 20 billion. The Bank’s risk-weighted assets amounted to ISK 808 billion at the end of 2015, increasing by ISK 112 billion over the year. This increase can largely be attributed to a valuation increase of the holding in Bakkavor Group Ltd. and the corresponding increase in the foreign exchange imbalance. The effect of these items receded following the sale of the Bank's share in the company in January 2016. The Bank’s capital ratio at the end of 2015 was 24.2%.

Furthermore, the Bank carries out an Internal Capital Adequacy Assessment Process (ICAAP). ICAAP aims to ensure that the Bank has in place sufficient risk management processes and systems to identify, manage and measure the Bank’s total risk exposure. ICAAP is aimed at identifying and measuring the Group’s risk across all risk types, including those which are not provided for in the standardized approach under Pillar 1, and ensure that the Group has sufficient capital in accordance with its risk profile. The Financial Supervisory Authority (FME) supervises the Group, receives the Group’s internal estimation on capital adequacy and sets capital requirements for the Group as a whole following a Supervisory Review and Evaluation Process (SREP). The capital adequacy in respect of the FME's internal evaluation in addition to the mandatory 8% requirement under Pillar 1 is called an additional capital requirement under Pillar 2. The Group’s capital base meets the FME's SREP requirements. The Bank does not disclose the additional capital requirement under Pillar 2 owing to the uncertainty of the treatments of overlap of risk factors within Pillar 2 and capital buffers which come into effect in 2016.

On 1 March 2016 the FME reached a decision on capital buffers which will apply in 2016. They will total 8.5% when they have been fully implemented on 1 March 2017 for systemically important institutions, which Arion Bank is categorized as. There are four capital buffers, (i) a capital conservation buffer, (ii) a systemic risk buffer (restricted to the domestic part of the RWA), (iii) a systemically important institution buffer, and (iv) a countercyclical capital buffer. The capital buffers are designed to ensure that the Bank maintains a minimum level of capital despite severe shocks. The Bank assesses the impact of such shocks by regularly performing stress tests.

Credit risk

Strong and improving mortgage portfolio

The quality of the mortgage portfolio has been steadily improving with lower average loan-to-value and a reduction in default rates. Higher default rates among loans in the Drómi transaction did, however, raise the average mortgage default rate in 2013. The main reasons for lower default rate in 2015 were the improving economic climate, restructuring and better loan collection rates.

Well diversified loan portfolio

Single name concentration decreasing

Collateral coverage of loans to customers

Mortgages over residential properties and charges over commercial real estates are the most common types of collateral obtained by the Bank, representing 74% of total collateral. Fishing vessels and other fixed and current assets, such as cash and securities, are also used to secure loans. The Bank places emphasis on collateral maintenance, valuation and central storage of collateral information. At the end of 2015 loans to customers (gross value ISK 680,350 million) are secured by collateral valued at ISK 582,774 million, giving a collateral coverage ratio of 86%, but as shown in the following diagram this ratio varies between different sectors.

Loan book quality is steadily improving

Collateral securing problem loans

Operational risk

The primary tools used by the Bank to measure operational risk are:

• Loss Data Collection
• Risk and Control Self-Assessment
• Key Risk Indicators

Loss data is collected, analyzed and recorded by Operational Risk as well as data which could have resulted in a loss. Serious events are analyzed more thoroughly to find a root cause and to devise ways of reducing the likelihood of such events reoccurring. The total amount of loss events in 2015 was ISK 619 million and the number of events was 2,471. The increase in the number of events can be attributed to changes in the way loss data are collected, with more factors being taken into account now. The increase in the amount of the category “Clients, products and business practices” is predominately due to a fine imposed on Arion Bank hf. in conjunction with a December 2014 settlement concerning changes to the way in which interchange fees, which card companies pay to the banks, are decided and the awarding of customer loyalty points.

Market risk

Market risk is the risk that price changes and interest rate changes will affect the value and cash flow from the Bank’s financial instruments. The main types of market risk are interest rate risk, equity price risk and foreign exchange risk.

Interest rate risk is primarily related to the fact that in part of the balance sheet there is a mismatch between interest-bearing assets and liabilities and a gap in interest-fixing periods. Generally the value of the Bank’s fixed-interest assets is higher than the value of liabilities with the same interest-fixing period as the Bank is primarily funded by deposits. An increase in market interest rates would therefore have a negative effect on the Bank’s earnings. The majority of risk stems from the portfolio of CPI-indexed mortgages at fixed interest which were originally issued between 2004 and 2006. The risk is largely hedged because the portfolio is partly funded by structured covered bonds at fixed interest. The Bank has reduced this risk by issuing new covered bonds and by offering its customers loans with variable interest rates. Moreover the loan principal adjustment carried out in 2015 in relation to the Government’s relief program also helped to reduce the risk.

Foreign exchange risk is the risk that movements in the exchange rate of the Icelandic króna could have a negative impact on the Bank's earnings. The Group’s currency imbalance at the end of 2015 was ISK 32.1 billion. This position reflects the Bank’s proceeds from the sale of its holding in Bakkavor, and the imbalance decreased again following the sale at the beginning of 2016. Arion Bank’s currency imbalance has been stable since the early part of 2012. The Bank uses derivatives to hedge against foreign exchange risk.

The net position of the Bank’s indexed assets and liabilities was 95.0 billion at the end of 2015. The indexation imbalance increased in 2013, primarily as a result of the Bank’s takeover of loans in connection with the Drómi bond. The increase in 2014 is largely due to the payment of structured covered bonds, but this is counterbalanced by the regular issue of new indexed covered bonds. The Bank’s inflation loans and borrowings have increased largely at the same rate in 2015 but in other respects derivatives are the main factor behind the increase in the net position during the year.

Liquidity risk