B Risk management

IFRS consolidated financial statements, notes to risk management

The principles, role and responsibilities of risk management

Finnvera’s strategy and the objectives set for its implementation when financing the growth, internationalisation and exports of enterprises form the foundation for risk management. Finnvera supplements the financial market and takes greater credit risks than financiers operating on commercial grounds. The credit risk is the principal risk segment for the Finnvera Group, other important segments being financial risks and operational risks associated with activities.

The task of risk management is to identify risks and to help Finnvera’s management to manage risks that could jeopardise the attainment of the company’s objectives. Risk management is of central importance for maintaining the Finnvera Group’s ability to take risks and for attaining the company’s long-term economic objectives. Finnvera’s Board of Directors and executive management are responsible for arranging and organising internal control and risk management. The Board of Directors approves the principles of risk management, risk appetite, credit policy and decision-making powers.

Working independently of Finnvera's business areas, Risk Control is responsible for the development of the methods and guidelines of risk management and for the monitoring of the Group's risk position. Together with the business units, Risk Control is responsible for the development and maintenance of risk classification systems and for monitoring the functioning of these systems. Risk Control reports to the Chief Executive Officer. The practical measures regarding risk management are part of the day-to-day management and are handled by the entire Finnvera organisation and the Group companies.

Risk appetite and risk policies

Finnvera has defined risk appetites for all major risk types. The risk appetite of credit risk has been determined so that the company meets the ownership and industrial policy objectives in the medium term in relation to risk buffers and earnings power. The main indicators are the level of capital adequacy, the internal capital requirement and the expected loss of the credit portfolio. As for liquidity risk, Finnvera secures liquidity for a period defined in advance so that the financing of export credits and lending to domestic SMEs can be managed. Regarding market risks, Finnvera does not take visionary interest rate or currency exchange risks and strives to keep the risk within defined limits. The risk appetite for operational risks has been derived from the ISO 9001 quality standard used by the company and from compliance with the generally applied good practices and requirements in the financing sector, taking into account the cost-quality ratio.

The State compensates Finnvera for some of the losses incurred in SME financing. Apart from the buffer of accumulated equity, the State Guarantee Fund and the State of Finland secure the foreign country, bank and enterprise risks associated with export credit guarantee operations. In the long term, profits from operations must cover the expenses and guarantee losses arising from operations. Finnvera’s goal is to take credit risks in a controlled manner in line with its operating principles, and to hedge against other risks or to minimise them. Some of the investments in subsidiaries consist of capital invested by the State through the parent company, while some is capital invested directly by the parent company.

Finnvera’s risk-taking is based on targets set by the owner for effectiveness and profitability. Risk-taking pertaining to financing is steered by means of the credit, guarantee and country policies ratified by the Board of Directors. Instruments such as reinsurance or credit derivatives may be used to hedge some credit risks in export credit guarantee operations.

In line with their strategic policies, the subsidiaries engaged in venture capital investment focus their risk-taking on start-ups and growth enterprises. The subsidiaries are controlled by the parent company and fall within the scope of risk management and internal auditing practised in the Group.

Credit and guarantee risks and risk classification systems

The risk of a credit loss arises when a debtor or another counterparty does not meet its obligations. In SME financing, the reason for credit losses is usually the insolvency of a corporate client. In the case of export credit guarantees, a guarantee loss may stem from the inability or unwillingness of a country, bank or corporate client to meet their payments.

Management of credit risks in SME financing is based on the assessment of each enterprise. Finnvera applies a risk rating system of eight categories, which is based on long-term observation of insolvency events for each risk category. The scale in use has seven categories for operating enterprises and one for insolvent enterprises. When a decision on financing is made, the account manager is responsible for assessing the credit risk, for giving the client the risk rating and for drafting the financing proposal. The Credit Decision Unit participates in the assessment of risk rating in conjunction with decision-making. The risk rating of Finnvera's client enterprises is updated at least every second year. The value of any available collateral is also assessed and updated in a similar way.

For granting export credit guarantees, Finnvera classifies countries into eight categories. The classification is based on methods used by export credit agencies. Various factors affect the determination of the country category: assessment of the country's ability to manage its external liabilities; expectations of the future trend of the country's economy; and political stability and the legislative framework. The granting of export credit guarantees is based on country policy. Each country for which Finnvera can grant export credit guarantees is assigned one country policy out of four policy categories (A–D). Finnvera keeps a close eye on the economic and political situations of countries and makes adjustments to its country policy depending on the changes that have occurred. The category of each country is checked at least once a year.

The taking of bank risks is based on an assessment of each country's banking system and on the risk analyses and risk ratings of individual banks. On the basis of both qualitative and quantitative factors, a risk-taking outline is determined for each individual bank, depending on the risk category. The risk rating of banks is updated whenever needed and always when new projects are introduced.

The taking of enterprise risks is based on an analysis of the enterprise's management, business and finances. The analysis may be concise in the case of small and short-term guarantees. The enterprise analysis is conducted by the account manager and an analysis team independent of business operations. The analysis results in internal risk classification of eight categories, which corresponds in part to the risk classification method used by international rating agencies. The rating is updated when new projects are introduced or otherwise at least once a year.

The credit rating of enterprises is based on the Probability of Default (PD), the Loss Given Default (LGD) and the exposure at default. Finnvera’s financial products are mainly loans and guarantees. Owing to the nature of the products, it is justified to assume that the exposure has been disbursed in full at the time of default. In the model for SME financing, the Loss Given Default is the exposure minus the value of collateral pledged, whereas in the model used for export credit guarantees, losses are estimated empirically. In the model for SME financing, the Probability of Default is based on Finnvera’s own historical data, accumulated for over 20 years, on the probabilities of default in various risk categories. There are considerably fewer loss events in export credit guarantee operations, so the probabilities of default have been derived from the data of rating agencies. Risk Control monitors the functioning of the risk classification models regularly, and amendments improving them are made whenever necessary.

The credit risk models are utilised, for instance, for the following:

• assessment and pricing of credit risks when credits are granted;
• definition of credit policies;
• determination of the authority to make financing decisions;
• setting and monitoring qualitative objectives for the credit portfolio;
• risk reporting on the credit portfolio;
• internal assessment of capital adequacy and calculation of the expected loss.

In connection with the proposal for financing, the account manager or the credit risk analyst conducts risk classification using a rating tool suited for assessing the qualitative and quantitative factors of the risk object. The risk category determined when a proposal for financing is made is confirmed in connection with the financing decision. Whenever necessary, Risk Control gives its opinion on the risk ratings of the largest exposures. Risk categories are updated regularly.

Financing decisions are made by the Board of Directors and according to the authorisations delegated by the Board so that the amount of exposure and risk have an impact on the decision-making level. Finnvera’s Credit Committee makes decisions under its own authority, discusses proposals submitted to the Board of Directors for decision-making, and handles issues requiring a specific policy. The Credit Committee is chaired by the CEO. The Head of the Credit Decision Unit serves as the Vice Chair.

Monitoring of credit risks

Client monitoring takes place through annual analysis of the client enterprise’s financial statements, regular contacts with the client and through monitoring of the client’s payment behaviour and operations. In its monitoring, Finnvera utilises data from its own control systems, from beneficiaries of domestic guarantees and export credit guarantees, and from public registers on payment defaults. Elevated client risks are taken under special monitoring and a report on the special monitoring is drawn up every six months. The probability of credit losses and any needs for write-downs are assessed at the same time.

The concentration of risks in counterparties, sectors and countries is monitored regularly. Owing to the purpose of the company’s operations, it is challenging to set precise limits for these risks. In SME financing, credit policy defines the maximum exposure of an individual counterparty. Decisions greater than this maximum must be justified separately to the company’s Board of Directors and, whenever necessary, to the guiding ministry. In export financing, instruments such as reinsurance agreements are used to hedge against risks associated with individual counterparties and concentrations.

Counterparty risks also arise in connection with asset and liability management operations. Finnvera’s goal is to keep the counterparty risks of asset management low by setting counterparty-specific limits, by concluding netting and security arrangements associated with derivative contracts, and by working with counterparties with high credit ratings.

The risk-taking realised in relation to risk appetite and goals is followed monthly by means of a diverse set of indicators. The main indicators in Finnvera’s risk management are the distribution of the current credit and guarantee exposure and the change in exposure by risk category, payment delays and non-performing receivables. In SME financing, the LGD estimate is largely based on the value of collateral, whereas in export credit guarantees it is based on a separate estimate of recoveries. The level of risk-taking in relation to outstanding exposure, financing granted, and export credit guarantees is described by using the anticipated statistical value of credit losses, the total loss, and the credit losses realised. These are reported quarterly.

Interest rate and currency risk

At Finnvera, interest rate risks arise when interest rates for borrowing and lending are determined at different times and when there are structural interest rate risks associated with equity. The interest rate of domestic lending intended for small and medium-sized enterprises is mainly based on the 6-month Euribor. The interest rate in export financing is based either on the 6-month Euribor or on the 6-month USD-LIBOR. Interest determination dates are distributed fairly evenly over the various banking days throughout the year. Borrowing takes place in larger individual sums, and often with a fixed interest rate. In the event that borrowing is based on a reference rate other than the 6-month Euribor (or USD-LIBOR), the reference rate is converted to the 6-month Euribor (or USD-LIBOR) by using interest rate swaps when the loan is taken. The interest rate risk arising from differences in the timing of interest determination days between borrowing and lending is controlled by striving to distribute the interest determination days for borrowing evenly over different months.

Structural interest rate risks arise when Finnvera’s own funds, classified as being interest-free, are used in lending and export financing as one source of funding. Finnvera monitors the consequent interest rate risk and, if necessary, hedges this risk. The company’s Board of Directors has determined that the target for return on equity is based on the 6-month Euribor, which governs the size of the structural interest rate risk.

The entire loan portfolio of Finnvera’s SME financing is denominated in euros, whereas export financing uses both euros and dollars. Finnvera acquires funds from a number of markets and in a number of currencies. To control the currency risk, the funds acquired are converted into euros or dollars by using currency exchange rate swaps. Cash assets are also invested in the relevant currencies. The remaining currency risk is hedged using currency derivatives, if necessary.

Finnvera’s goal is to keep both the interest rate risk and the currency risk low. Risks are monitored actively, and the company’s management and the Board of Directors receive regular reports on them.

Liquidity risk

Finnvera acquires long-term funding mainly within the EMTN programme. The programme is guaranteed by the State and has the same credit rating as the State of Finland. The company can also make use of a domestic commercial paper programme. These help distribute the acquisition of funds across several markets and investors.

Finnvera’s Board of Directors approves the principles of liquidity management. According to these principles, the liquidity buffer must at any given time cover the payments scheduled for the next 12 months. The principles also determine how much underfunding the company can accept in the longer term. Liquid assets are invested in objects that have a high credit rating. Finnvera’s Asset Management is responsible for practical tasks associated with borrowing and liquidity management. The company’s accumulated own funds are an important element of the acquisition of funds for lending.

The potentially high claims arising from export credit guarantee operations may lead to a sudden need for liquidity that is greater than normally. To prepare for the realisation of such liquidity risks, Finnvera has entered into contractual arrangements, for instance, with the State Guarantee Fund and the State of Finland.

Market risk

Finnvera does not trade in instruments subject to the effect of market prices. However, a small amount of market risk arises in the balance sheet when liquid assets are invested and when measures are taken to hedge against currency and interest rate risks. The aim is to invest liquid assets in instruments where investments can be kept until maturity. Since the investments are classified as available for sale, changes in market prices do not affect Finnvera’s financial performance. Effort is also made to hedge risks so that the net effect of market changes on financial performance would be slight.

Operational risks

An operational risk is a risk of loss caused by insufficient or inoperable internal processes, systems, human resources or external events. Operational risks also include legal risks and the risk of damage to reputation.

The management of operational risks has been developed systematically since 2006, and operational risks have been registered since the beginning of 2007. Risk Control is responsible for developing the management of operational risks. In practice, the process teams, units and the Information Security Group are responsible for implementing practical measures. Finnvera has a full-time Information Security Manager. Potential risks are charted and the severity of any consequences they might involve is assessed regularly. In addition, Finnvera has drawn up risk scenarios that, if realised, would have serious consequences for the company’s operations. Responsibility for the implementation of actions to avert the risk scenarios and other severe risks has been divided between the various organisational units in line with their tasks. Safeguards are taken against operational risks, for instance, by introducing internal control mechanisms, by developing processes, information systems and the quality of operations, and by taking out insurance against risks.

The management of operational risks is closely linked to Finnvera’s operating system. Finnvera has an ISO 9001 quality certificate and meets the requirements set by central government for the increased level of information security.

Operational risks realised are registered into the management system of operational risks accessible to the entire personnel. The reasons leading to the events and the measures taken to prevent the recurrence of similar events are described in the application. Finnvera’s management and Board of Directors receive regular reports on operational risks realised.

Venture capital investments

Within the Finnvera Group, venture capital investments are carried out by Veraventure Ltd and ERDF-Seed Fund Ltd. Investments made in these companies fall within the scope of Finnvera’s credit risk monitoring.

Risk management by the subsidiaries engaged in venture capital investment is based on enterprise analysis, limiting the size of investments, sharing the risk with other investors, and on sufficient diversification of the investment portfolio. The principles for liquidity investment are the same as those applied by the parent company.

The companies engaged in venture capital investment comply with the recommendations issued by the European Venture Capital Association (EVCA) on the valuation of portfolio companies and fund investments. Investments are carried at fair value in accordance with the above-mentioned recommendations.

Capital management, capital adequacy and external risk weight

Finnvera calculates its capital adequacy for SME financing according to the principles of the Basel III standard method even though Finnvera is not officially required to apply this method. Owing to the nature of its business, Finnvera must ensure that the amount of equity is sufficient in relation to the credit risks taken. The Ministry of Economic Affairs and Employment has set a goal of 12–20 per cent for Finnvera’s capital adequacy. Finnvera also uses stress tests to assesses credit losses and their impact on capital adequacy.

Economic capital is calculated using a credit risk model that corresponds to the models generally used by banks. The model considers the probability of default for the risk objects and the loss resulting from the exposure should the default be realised. Internally, Finnvera’s aim is to attain as much economic capital as is needed to cover the annual losses arising from credit risks and counterparty risks with a certainty of 99 per cent. In addition, capital is reserved for operational risks. Finnvera has assessed that a certainty of 99 per cent is sufficient for the indicator of economic capital because the State is ultimately responsible for Finnvera’s domestic guarantees and export credit guarantees.

Equity and retained earnings are allocated to the reserve for domestic operations and to the reserve for export credit guarantee and special guarantee operations. The State provides direct support for Finnvera’s domestic financing by paying credit and guarantee loss compensation for some of the credit losses incurred by Finnvera. At present, the compensation for credit and guarantee losses ranges from 35 to 80 per cent, depending on the project. The average is about 55 per cent of the outstanding credit and guarantee exposure. In export credit guarantee operations, the State of Finland is responsible, e.g. through the State Guarantee Fund, for the losses that may arise during the financial period and exceed the assets in the reserve for export credit guarantee and special guarantee operations.

It has been ensured through legislation that, in the capital adequacy calculations of banks, the risk weight of Finnvera’s guarantees is the same as that applied to the liability of the State of Finland.