Risk Management
Management of Key Risks
The Group is committed to developing its risk management techniques and methodologies, both to maintain high standards of risk management practice and to fulfil the requirements of UK and international regulators.
(The information set out below up to and including the section entitled ‘General Insurance’ on page 102 forms an integral part of the audited financial statements as described in the Accounting Policies section of the Financial Statements on
page 160.)
Credit Risk
Credit Risk is the risk of financial loss from counterparty’s failure to settle financial obligations as they fall due.
The Group Credit Risk Committee, one of the Executive Risk Committees, is chaired by the Group Risk Director and comprises senior executives from across the business Divisions and Group Risk and Group Finance functions. It meets monthly and reviews the Group’s lending portfolio, approves material credit models and Group credit standards, limits and divisional credit risk policies. The Group Credit Risk Policy Statement is approved by the Board on an annual basis. The Group Credit Risk Committee also assists the Board in formulating the Group’s credit risk appetite in respect of key products and sectors.
Group Credit, a specialist support function within Group Risk, provides centralised expertise in the area of credit risk measurement and management techniques. In addition to reporting on the performance of each divisional portfolio to the Group Credit Risk Committee, Group Credit exercises independent oversight over the effectiveness of credit risk management arrangements and adherence to approved policies, standards and limits.
Day-to-day management of credit risk is undertaken by specialist credit teams working within each Division in compliance with policies approved by the Board. Typically functions undertaken by these teams include credit sanctioning, portfolio management and management of high risk and defaulted accounts and credit risk model build and governance.
To mitigate credit risk, a wide range of policies and techniques are used across the Group:
-
for retail portfolios use is made of credit scoring software for new applications. In addition, behavioural scoring is used to provide an assessment of the conduct of a customer’s accounts in granting extensions to, and setting limits for, existing facilities. Affordability is a vitally important measure and is reviewed in combination with either application and/or behavioural scores. Small business customers may be rated using scorecards in a similar manner to retail customers.
-
for corporate portfolios a full independent credit assessment of the financial strength of each potential transaction and/or customer is undertaken, awarding an internal risk rating which is reviewed regularly. The same approach is also used for larger SME (small to medium enterprise) customers; and
- within Treasury Division (Treasury), which handles the Group’s banking and sovereign related exposures, as well as the Group’s structured credit bond (ABS) portfolio held for liquidity and proprietary purposes, focused credit risk policies are established and reviewed by Group Wholesale Credit Committee (‘GWCC’), a sub-committee of the Group Credit Risk Committee. Basel II Advanced IRB compliant models are used to rate banking and sovereign counterparties. Structured credit bonds are reviewed individually by an independent credit function prior to purchase and an internal rating is applied to all exposures. The rating assessment is commensurate with, and often more stringent than, those of the external credit rating agencies. Additional thresholds and limits are applied by rating and asset class and, as part of an ongoing portfolio review process, thorough surveillance is performed covering each bond holding, supplemented by stress analyses conducted on a periodic basis.
An additional measure within the credit risk framework is the establishment of product, industrial sector and country limits to avoid excessive concentrations of risk. Material portfolios, such as mortgages, have approved sub-sector limits to ensure that they remain within plan and tolerance for risk. All such limits are set and monitored by the Group Credit Risk Committee. Standards have been established across the Group for the management of credit risk. All Divisions are committed to continuously improving credit risk management. There continues to be investment in the development of credit risk rating tools, including enhancements to the portfolio risk measurement systems and in governance arrangements to support operations within the terms of the Basel II Accord. These include principles for development, validation and performance monitoring of credit risk models. The approval process for credit models is dependant upon materiality, with all models impacting the regulatory capital calculation requiring approval by the Group Credit Risk Committee and those deemed material to the Group being approved by the Group Capital Committee.
Internal reporting has developed further in response to the introduction of improved rating tools. Senior Management across the Group are now capable of assessing the risk profile in terms of Probability of Default and Expected Loss and will do so under the Basel II environment going forward.
Financial instruments subject to credit risk
The table below sets out the Group’s exposure to credit risk relating to financial instruments before taking account of collateral and other security. Policyholder assets are excluded from the analysis in the table as the underlying credit risks are for the account of the policyholders and have no direct impact on the Group’s results, as described further on pages 99 to 102. A full reconciliation between the Group’s consolidated balance sheet and financial instruments subject to credit risk is set out in Note 43 to the Financial Statements on page 217.
| Financial instruments subject to credit risk As at 31.12.2007 £m |
Financial instruments subject to credit risk As at 31.12.2006 £m |
|
| Loans and advances to customers | 430,007 | 376,808 |
| Financial assets held for trading | 54,681 | 49,139 |
| Debt securities | 56,839 | 49,901 |
| Other financial assets | 24,215 | 22,290 |
| 565,742 | 498,138 | |
| Contingent liabilities and commitments | 106,718 | 90,944 |
| Total | 672,460 | 589,082 |
Loans and advances to customers
Loans and advances to customers are managed on a divisional basis. Information about the credit quality of loans and advances to customers is set out on pages 21-22, 29-30, 47, 49, 53 and 56 in the Business Review and in Note 43 to the Financial Statements on page 217.
Financial assets held for trading
Management of credit risk within Treasury portfolios relies on obtaining detailed knowledge and understanding of the assets and issuers it deals with. As described above, a full credit analysis is undertaken and, based upon that, an internal rating is derived which helps to establish a credit appetite for the issuer or asset intended to be acquired.
As Treasury manages the liquidity of the HBOS Group, its mandate is to maintain a high quality credit portfolio and, in addition to the credit process mentioned above, it also actively uses portfolio techniques to manage and monitor the quality of its portfolios, and to avoid concentration risk.
This includes the use of rating based thresholds, established portfolio level thresholds, asset class limits and sub-limits. There are also rules governing the types of assets that can be held within Treasury’s Liquidity portfolios, Trading and Banking books and for individual (ABS) tranche sizes. There are also limits controlling the maximum weighted average life of assets.
Financial assets held for trading are almost exclusively investment grade investments with 99.6% (2006 99.5%) of inter-bank and structured investment portfolios rated ‘A’ or above based on an internal credit ratings scale that is, in general, aligned with the ratings scales of the major credit ratings agencies (Moody’s, S&P and Fitch).
| As at 31.12.2007 % |
As at 31.12.2006 % |
|
| AAA | 51.5 | 51.9 |
| AA | 34.4 | 30.6 |
| A | 13.7 | 17.0 |
| Below A | 0.4 | 0.5 |
Debt securities
Debt securities are primarily held within the Treasury or Insurance & Investment Divisions and are almost exclusively invested in investment grade counterparties with 96.5% (2006 94.0%) of debt securities rated ‘A’ or above, again based on our internal rating scale.
| As at 31.12.2007 % |
As at 31.12.2006 % |
|
| AAA | 57.8 | 67.6 |
| AA | 25.8 | 18.2 |
| A | 12.9 | 8.2 |
| Below A | 3.5 | 6.0 |
The AAA proportion of the portfolio fell during 2007 due to two factors: (i) a reduction in Sovereign assets and (ii) an increase in the size of the portfolio comprising mainly AA and A assets, thereby reducing the AAA proportion.
Other financial assets
Other financial assets include cash and balances at central banks, items in the course of collection, derivative assets,
loans and advances to banks and sundry financial assets.