Risk management

Overview

Risk management is fundamental to Absolut Bank’s business and is an essential element of its operations. The Bank’s risk management and control system addresses the following key banking risks:

• credit risk;
• liquidity risk;
• operational risk; and
• market risk (including foreign exchange risk and interest rate risk, securities portfolio risk).

Absolut Bank’s risk management policies and procedures are designed to identify and analyze those risks, prescribe appropriate risk limitation s and monitor the level and incidence of such risks on an on-going basis.

Organization

Absolut Bank’s risk management is based on its system of management reporting. Absolut Bank’s primary internal documents on risk management are its credit risk, market risk and internal risk policies. These documents are approved by the management board and set out Absolut Bank’s risk management goals and methodologies.

Absolut Bank’s risk management use the principle separation of departments performing risk assignment from departments involved in risk-related operations. The risk management function is carried out on a centralized basis.

The responsibility for risk management activities is divided among the following units: Risks Department, Assets and Liabilities Committee (ALCO), Credit Committees (at the level of each type of credit product), Financial Control and Budgeting Department, Limit Committee, Financial Market Operation’s Department (The Treasury Department) and Internal Audit Service.

Absolut Bank’s risk management organization is divided between those bodies that are responsible for establishing risk management policies and procedures, and those bodies the function of which is to implement those policies and procedures, including monitoring and controlling risks and limits on an ongoing basis. The Bank’s main tools of risk management are the establishment and implementation of procedures in respect of operations involving certain types of risks such as liquidity gap analysis, value-at-risk (‘‘VAR’’) analysis, stress testing, scenario analyses and the existence of various authority limits on certain operations.

The Board of Directors adopted a risk management policy in 2004. In connection with this policy, the Management Board reviews and approves regulations and procedures to implement this policy. These regulations and procedures are revised and updated on a regular basis.

The main stages of the risk management process include the following:

• risk identi?cation;
• qualitative and, if necessary, quantitative assessment of a particular risk;
• determination of an acceptable level of risk both for Absolut Bank in general and in respect of various types of instruments and, if necessary, the placement of limits on such risks;
• acceptance of risk, risk limitation or risk transfer; and
• creation of a system of controls to monitor compliance with established limits and restrictions.

Risks Department

Within the Risks Department are the Credit Risks Department, the Operations Risks Department and the Financial Risks Department.

Credit Risks Department

The Credit Risks Department’s responsibilities include:

• monitoring and control of credit risks;
• preparing internal documents on the Bank’s risk management procedures, including the identification, evaluation and control of market risks;
• analyzing and evaluating all types of risk to which the Bank is exposed on the financial markets;
• monitoring the financial and business situation of the Bank's counterparties (financial institutions, corporate and insurance companies);
• preparing information for ALCO and Limit Committee; and

Operations Risks Department

The Operations Risks Department is responsible for monitoring and control of operation risks.

Financial Risks Department

The Financial Risks Department is responsible for:

• monitoring and management of financial risks including on-line monitoring and assessment of the Bank’s liquidity, interests and currency risks; and
• preparing internal documents on the Bank’s risk management procedures, including the identification, evaluation and control of liquidity, interests and currency risks; and
• preparing information for ALCO.

The composition of the Risks Department was approved by the Chairman of the Management Board of Absolut Bank. As at 31 December 2006 the Risks Department is staffed by eight persons and is headed by the Head of Department Mr. Alexander Lapko.

ALCO (Assets and Liabilities Management Committee)

The ALCO is composed as per Articles of ALCO approved by the Board of Directors and the serves Chairman of the Management Board as the Chairman of the ALCO, the Director of the Financial Market Operation’s Department (Treasury) Department, the Director of the Risk Department, the Financial Director, the Head of Financial Risks Department, the Director of International Department, the Director of Corporates Client Department and the Director of Retail Business Department.

The ALCO is responsible for the implementation of Absolut Bank’s risk management policy, including:

• managing the structure of assets and liabilities;
• approving interest rate policy;
• setting limits for the balance sheet structure and for interest rates on deposits and loans;
• approving internal documents on risk identification, evaluation and management; and
• approving the policy on the management of middle-term and long-term liquidity.

The ALCO so reviews proposals to be considered by the Management Board and prepares materials for the Management Board on such matters as the implementation of the Absolut Bank’s limits policy, the adoption of internal procedures for regulating ?nancial risk management, the approval of the terms on which new funding is provided to the Absolut Bank and the use of such funding. The ALCO also performs other functions, including setting limits for branches, within the scope of its responsibilities delegated by the Management Board.

ALCO holds meetings on a weekly basis.

Credit Risk Committees

The primary focus of the credit committees of the Bank is the management of credit risk. Absolut Bank has established the following credit committees, which operate according to various specific factors: Main Credit Committee, Operative Credit Committee and Product sub-committee (which is divided into several committees in accordance with credit products of the Bank: MSE, Mortgage, Car Loans and Credit Cards), Limit Committee (which is so divided in accordance with type of products: Securities, Bonds, Market Counterparties). The Bank aims to employ credit assessment processes that are both efficient from the client’s perspective while providing the Bank with a high quality loan portfolio. To achieve this goal, the Bank:

• determines and approves the terms of credit products;
• determines categories of credit risks;
• implements a sound policy of collateral assessment;
• regularly reviews risk management procedures; and
• forms loan loss reserves.

The composition of credit committees includes senior managers whose activities involve risk assessment and client relations. The composition of credit committees is considered by the Management Board upon the recommendation of the head of the respective department and is subject to final approval by the Chairman of the Management Board. For further details please see “Lending Policies and Procedures section”.

In addition to these Credit Committee, Absolut Bank has credit committees at the regional branch level which approve the terms of individual credit transactions for regional branches and additional offices, respectively. Credit committees of regional branches also approve credit transactions of additional offices in excess of their established credit limits.

Financial Control and Budgeting Department

The Financial Control and Budgeting Department is responsible for the preparation and execution of administrative and capital budgets, review of Absolut Bank’s financial policies and the preparation of Absolut Bank’s financial statements. Financial Control and Budgeting Department is headed by the Deputy Chairman of the Management Board Mr. Sergey Ratz. The Financial Control and Budgeting Department effects its activity on day-by-day basis.

Limit Committee

Primary task of the Limit Committee is to establish limits for the Bank’s activities with credit risk on the financial markets including: counterparty risk, exposure risk for each issuer of debt securities and corporate shares and REPO transactions with counterparties; and establish of total exposure and exposure for each type of financial instruments; and establish of ‘stop-loss’ limits

Financial Market Operation’s Department (The Treasury Department)

Financial Market Operation’s Department is primarily responsible for managing Absolut Bank’s short-term and current liquidity and open currency position within the applicable requirements and limits. Twenty five people work in the Financial Market Operation’s Department which is headed by the Deputy Chairman of the Management Board Mr. Dmitry Invlushin.

Financial Market Operation’s Department is also responsible for the analysis and ongoing monitoring of counterparty credit risk arising in Absolut Bank’s dealings with other ?nancial institutions. In carrying out this role, the Financial Market Operation’s Department makes recommendations to the Limit Committee with respect to credit limit levels for ?nancial institution counterparties.

The Internal Audit Service

The Internal Audit Service reports to the Board of Directors, which appoints the head of the Internal Audit Service (currently, Mrs. Elena Bukina). The Internal Audit Service is responsible for Absolut Bank’s compliance with all applicable legislation and internal regulations and resolutions at all levels of the Bank’s management. This monitoring is performed on a daily basis. The Internal Audit Service is staffed by nine persons, who are not permitted to hold any other positions in Absolut Bank. The activities of the Internal Audit Service are governed by Absolut Bank’s charter and relevant internal regulations. The Internal Control Service also reports to the Supervisory Board on a semi-annual basis and makes recommendations with respect to the efficiency of risk management procedures. The Internal Control Service operates both at the head office level and the regional branch level.

Management Reporting Systems

Absolut Bank has implemented a management reporting system that involves the preparation, by those departments responsible for the implementation of Absolut Bank’s risk management system, of the following reports and calculations:

• daily assessment and calculation of Absolut Bank's exposure (liquidity and currency position), reports on compliance with interbank limits, operational liquidity forecast reports and information on intraday cash flows; covenants control and management balance;
• weekly reports on focus products including Absolut Bank's loan portfolio including over-due loans, reports on compliance with CBR requirements, capital adequacy and liquidity reports; ALCO report (liquidity, currency and interest rate risks, stress testing);
• monthly review of principal loan portfolio risk characteristics, early and late collection procedures, clients' account performance, outstanding risks in other banks, pledge of goods; product’s range reports; current control of the budget; administrative expenses analysis by cost and fix assets expenditures; staff costs report;
• quarterly review of financial figures, pledge of equipment and real estate, legal monitoring; budget and business plan reports; financial and non-financial indexes analysis, current organizational procedures; IAS report; and
• annual general credit re-appraisals of its exposures.

Credit Risk

As with any other bank, Absolut Bank is exposed to credit risk, the risk that a borrower or a counterparty will be unable to pay amounts in full when due. Absolut Bank has designed the Bank’s ‘‘know your client’’ procedures and credit risk management system based on CBR requirements, the recommendations of the Basel Committee on Banking Supervision, international auditing standards and the experience of the leading Russian and international ?nancial institutions.

Absolut Bank aims to diversify its credit portfolio in order to avoid credit risk over-concentration. In accordance with Absolut Bank’s Credit Policy, its exposure to a single borrower (or group of related borrowers) does not exceed 25 per cent, of the Bank’s regulatory capital, which is in line with the mandatory requirements of the CBR.

The Bank structures the levels of its credit risk by placing limits on the amount of risk accepted in relation to an individual borrower or groups of borrowers, and economic sectors. Limits on the level of credit risk by borrower (or group of borrowers) and economic sectors are approved by the Bank’s Credit Committee on a regular basis. Risks related to individual borrowers are evaluated on the basis of a scoring method developed by the Bank with the support of international financial institutions such as IFC, EBRD, etc.

Exposure to credit risk is managed through regular analysis of the ability of borrowers and potential borrowers to meet interest and capital repayment obligations and by changing lending limits where appropriate. Exposure to credit risk is also managed, in part, by obtaining collateral and corporate and personal guarantees. Absolut Bank monitors pledges of goods on a weekly basis, pledges of equipment on a quarterly basis and conducts general credit appraisal for all credits on an annual basis.

The Bank’s maximum exposure to credit risk is primarily reflected in the carrying amounts of financial assets on the balance sheet. The impact of possible netting of assets and liabilities to reduce potential credit exposure is not significant.

Credit risk for off-balance sheet financial instruments is defined as the possibility of sustaining a loss as a result of another party to a financial instrument failing to perform in accordance with the terms of the contract. The Bank uses the same procedures and methodologies, as defined by its credit policy, for approving credit related commitments (credit lines, letters of credit and guarantees) as it does for on-balance sheet credit obligations (loans).

Liquidity Risk

As with any other bank, Absolut Bank is exposed to liquidity risk, arising from mismatches between the maturities of its assets and liabilities.

The matching and/or controlled mismatching of the maturities and interest rates of assets and liabilities is fundamental to the management of the Bank. It is unusual for banks to be completely matched since business transacted is often of an uncertain term and of different types. An unmatched position potentially enhances profitability, but can also increase the risk of losses. The maturities of assets and liabilities and the ability to replace, at an acceptable cost, interest-bearing liabilities as they mature, are important factors in assessing the liquidity of the Bank and its exposure to changes in interest and exchange rates. Liquidity risk is managed by ALCO. ALCO monitors Absolut Bank’s liquidity risk position through weekly liquidity reports from the Financial Risks Department and the Financial Market Operation’s Department and takes the necessary actions to match asset and liability positions both on- and off-balance sheet in such a way that Absolut Bank is able to meet its obligations immediately.

Operational Risk

In line with the proposed Basle II banking regulatory reforms, Absolut Bank regards operational risk as the risk of loss resulting from inadequate or ineffective internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk. The Bank’s internal regulations are one of the principal instruments used to manage operational risks. A clear and unambiguous description of each transaction and the decision-making process is one of the crucial factors that reduce the level of operational risk and establish the basis for the timely identi?cation and the ef?cient control of risk.

Examples of events that are included under this definition of operational risk are losses from fraud, computer system failures, settlement errors, model errors or natural disasters. An effective monitoring process is essential for adequately managing operational risk. Regular monitoring activities can offer the advantage of quickly detecting and correcting deficiencies in the policies, processes and procedures for managing operational risk. Promptly detecting and addressing these deficiencies can substantially reduce the potential frequency and/or severity of a loss event. Absolut Bank is focused on the implementation of a process to regularly monitor its operational risk profiles and material exposures to operational losses.

Absolut Bank’s systems calling for the regular reporting of information to senior management and the Board of Directors will also support the proactive management of operational risk, which the Basle Committee requires in its “sound practices” paper.

The Legal Department, The Internal Audit Service and the Security Service are also involved in operational risk control.

Market Risk

Absolut Bank is exposed to market risks (including foreign exchange risk and interest rate risk) which arise from losses caused by fluctuations in the market price of financial instruments. To manage market risks, the Bank implements stress-testing, which is carried out at least quarterly. The stress-testing technique is based on a scenario analysis involving a forecast of the Bank's financial performance as affected by various negative factors. One of the stress-testing techniques — the “worst-case scenario” — is based on an analysis of the impact of a combination of the most negative factors. The parameters of the scenario analysis are suggested by the Risks Department. These parameters contain quantitative standards for analysing the ratios generated by the forecast. Depending on the purpose of the stress-testing, up to three scenarios may be analyzed at a time.

Foreign exchange risk

Absolut Bank is subject to foreign exchange rate risk due to adverse movements in the exchange rates of the currencies in which it maintains its assets and liabilities. The Bank is also exposed to foreign currency exchange rate fluctuations on its cash flows primarily through spot market transactions and its foreign currency assets and liabilities. Absolut Bank limits its total on and off- balance sheet foreign currency positions to ten per cent, of total shareholders’ equity. Absolut Bank’s currency risk is monitored by ALCO and the Financial Market Operation’s Department on a daily basis. Absolut Bank’s open currency position limits, with respect to both overnight, and intra-day positions and stop-loss limits are established by ALCO.

Interest rate risk

The Bank is exposed to interest rate risk as a result of lending to clients and other banks at fixed interest rates in amount s and for periods which differ from those of term deposits and other borrowed funds at fixed interest rates. Due to future changes in interest rates, the Bank’s liabilities may have disproportionately high interest rates compared to those of its assets and vice versa. Interest margins on assets and liabilities having different maturities may increase as a result of changes in market interest rates.

The Bank evaluates its interest rate risk based on internal analytical models to measure the sensitivity of financial results to changes in key financial market indicators, stress-testing and scenario analysis, which takes into account possible changes in the structure of the Bank’s assets and liabilities. The results of interest rate risk analysis are used in the preparation of long and short-term business plans and for establishing the Bank’s interest rates and the structure of its assets and liabilities. For the purposes of assessing interest rate risk, assets and liabilities are classified by maturity, currency and by fixed or floating interest rates. The Bank conducts sensitivity tests to consider the impact of interest rate movements on the Bank’s portfolio of assets and liabilities over the course of each year.

In the Bank’s view, the use of interest rate hedging instruments to mitigate interest rate risk are not widely used in Russia and it has a limited set of interest rate management tools at its disposal. The Bank attempts to mitigate interest rate risk by setting medium term criteria with respect to the maturities and types of funds which can be accessed by the Bank, by resetting fixed short-term interest rates on both assets and liabilities (other than retail customer deposits) to reflect current market conditions, by setting limits on the degree of potential interest rate changes in negotiated contracts, and by managing treasury and investment portfolios.

Reputation risk

Absolut Bank takes account of possible reputation risk in its business. In this context, reputation risk is the risk of losses to the Bank’s business due to negative perception regarding the Bank’s creditworthiness, its quality of service and/or regarding the quality of its business in general.

Absolut Bank conducts its evaluation of reputation risk by monitoring information from customers, partners and employees. Also Absolut Bank monitors information and forecasts concerning itself in the media. The Bank would delegate appropriate management resource to review an react to any circumstances that may give rise to reputation risk.

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