RBS 2012 Annual Report Download - page 256

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Business review Risk and balance sheet management continued
Country risk continued
Governance, monitoring and management*
The Group’s country risk framework is set by the Executive Risk Forum
(ERF), which has delegated authority to the Group Country Risk
Committee (GCRC) to manage exposures within the framework and deal
with any limit breaches, with escalation where needed to ERF. Under this
framework, exposures to all countries are monitored. Countries with
material exposures are included in the Group’s country risk Watchlist
process to identify emerging issues and facilitate the development of
mitigation strategies. Detailed portfolio reviews are undertaken on a
regular basis to ensure that country portfolio compositions remain aligned
to the Group’s country risk appetite in light of evolving economic and
political developments.
Limits on total exposure are set for individual countries based on a risk
assessment taking into account the country’s economic and political
situation and outlook, as well as the Group’s portfolio composition in that
country. Sub-limits are set on medium-term (greater than one year)
exposure since this exposure can, by nature, not be reduced as rapidly
as short-term exposure in the event of deterioration of a country’s
creditworthiness.
During 2012, in addition to all emerging markets and the vulnerable
eurozone countries, the Group brought nearly all advanced countries
under country limits. The exceptions were the UK (and related European
special territories of Guernsey, Jersey, the Isle of Man and Gibraltar) and
the US, given their home country status.
Also in 2012, an enhanced country risk appetite framework was
introduced. The Group’s risk appetite for a particular country is now
guided by global risk appetite, the country’s internal rating and strategic
importance to the Group, the portfolio composition by tenors and clients,
an assessment of the potential for losses arising from a number of
possible key country risk events, and other country-specific
considerations such as funding profile, risk/return analysis, business
opportunities and reputational risk. The actual country limits continue to
be set by GCRC (or the ERF above certain benchmark levels).
Further enhancements included improved divisional country risk
operating models and the implementation of a new sovereign rating
model.
Eurozone crisis preparedness
A Group executive steering group is driving eurozone crisis
preparedness. Its agenda in 2012 included operational preparations for
possible sovereign defaults and/or eurozone exits. The steering group
also considered initiatives to determine and reduce redenomination risk.
Further actions to mitigate risks and strengthen control in the eurozone
typically included taking guarantees or insurance, updating collateral
agreements, and tightening certain credit pre-approval processes.
Redenomination risk
The overall impact of redenomination risk on the Group is difficult to
determine with certainty, but would be shaped by: the scope and reach of
any new legislation introduced by an exiting country; its applicability to
the facility documentation; and whether there are any appropriate offsets
to the exposures. For the purposes of estimating funding mismatches at
risk of redenomination (detailed below), the Group takes, as its starting
point balance sheet exposure as defined on page 255 and excludes
exposures at low risk of redenomination. The latter are identified through
consideration of the relevant documentation, particularly the currency of
exposure, governing law, court of jurisdiction, precise definition of the
contract currency (for euro facilities), and location of payment. The Group
also deducts offsets for provisions taken and liabilities that would be
expected to redenominate at the same time.
A redenomination event would also be accompanied by increased credit
risk, for two reasons. First, capital controls would likely be introduced in
the affected country, resulting in any non-redenominated assets,
including non-euro assets, potentially becoming harder to service.
Second, a sharp devaluation could imply payment difficulties for
counterparties with large debts denominated in foreign currency and
counterparties that are heavily dependent on imports.
The Group's focus continues to be on reducing its asset exposures and
funding mismatches in the eurozone periphery countries. During 2012,
total asset exposures to these countries decreased by 13% to
£59.1 billion. The estimated funding mismatch at risk of redenomination
was £9.0 billion for Ireland, £4.5 billion for Spain, and £1.0 billion for Italy
at 31 December 2012. These mismatches can fluctuate due to volatility in
trading book positions and changes in bond prices. The net positions for
Greece, Portugal and Cyprus were all minimal.
Refer to pages 256 to 280 for discussion on the Group’s exposure to
banks, financial institutions and other sectors in a number of eurozone
countries.
Credit default swaps
The Group uses credit default swap (CDS) contracts to service customer
activity as well as to manage counterparty and country exposure. The
latter is done to hedge portfolios or specific exposures. This may give rise
to maturity mismatches between the underlying exposure and the CDS
contract, as well as between bought and sold CDS contracts on the same
reference entity. CDS positions are monitored on a daily basis as part of
regular market risk management.
The terms of the Group’s CDS contracts are covered by standard
International Swaps and Derivatives Association (ISDA) documentation,
which determines if a contract is triggered due to a credit event. Such
events may include bankruptcy or restructuring of the reference entity or
a failure of the reference entity to repay its debt or interest. Under the
terms of a CDS contract, one of the regional Credit Derivatives
Determinations Committees of the ISDA is empowered to decide whether
or not a credit event has occurred.
The Group transacts CDS contracts primarily on a collateralised basis
with investment-grade global financial institutions who are active
participants in the CDS market. These transactions are subject to regular
margining, which usually takes the form of cash collateral. For European
peripheral sovereigns, credit protection has been purchased from a
number of major European banks, predominantly outside the country of
the reference entity. In a few cases where protection was bought from
banks in the country of the reference entity, giving rise to wrong-way risk,
this risk is mitigated through specific collateralisation and monitored on a
weekly basis.
*unaudited