Risk management report

Overview

Nedbank Group has undergone a paradigm shift in its risk and capital management over the last two years. During 2005 the group took a quantum leap forward, with its Basel II programme being the main catalyst. Further details are contained in the Basel II update included in the capital management and Basel II report.

‘Worldclass at managing risk’ is one of the group’s aspirations, coinciding not only with the completion of the group’s three-year recovery process in 2007, but also with the implementation of Basel II in South Africa.

To be world-class at managing risk in Nedbank Group means:

Understanding, measuring and managing risk is central to everything we do. We have engrained risk management in our business. We understand that banking is about managing risk, not avoiding it. Our risk management methodologies are world-class.

Nedbank Group’s approach to risk now embraces risk management as a core competency that allows us to optimise risk-taking, is objective and transparent and ensures that the business prices for risk appropriately, linking risk to return.

When Nedbank Group introduced its Enterprise-wide Risk Management Framework (ERMF), it set three broad risk management objectives:

• protect against unforeseen losses;
  
• ensure earnings stability; and
  
• maximise earnings potential and opportunities leading to shareholder value creation.

In this report we seek to demonstrate that meeting these objectives and becoming world-class at managing risk is well on track.

The key achievements in this regard for 2005 include:

• significant progress in the group’s Basel II programme and implementation of many components;
  
• embedding and refining the ERMF;
  
• finalisation and implementation, on a shadow-reporting basis, of economic capital, risk appetite (primarily based on earnings volatility) and risk-adjusted performance measurement (RAPM) methodologies;
  
• integration of risk and capital management into strategy by including risk-based management actions, which are a strategic and tactical response to Basel II, and economic capital and risk-adjusted return on capital (RAROC) targets in the group’s 2006 to 2008 business plan;
  
• substantial completion of the programme to de-risk the balance sheet of its non-core assets and the elimination of material foreign currency translation risk, which plagued the group in prior years;
  
• appointment of a new Chief Executive Officer (CEO), Chief Financial Officer (CFO) and Chief Risk Officer (CRO) at Imperial Bank, further strengthening its risk management framework and commencing its Basel II project, leveraging off the significant efforts of the Nedbank Group;
  
• further strengthening governance, compliance and reputational risk management practices across the group, including considerable efforts to attain Financial Intelligence Centre Act (FICA) and Financial Advisory and Intermediary Services Act (FAIS) compliance (refer to the enterprise governance and compliance report);
  
• commencement of the rollout of similar risk processes and governance structures throughout the group’s smaller subsidiaries, including those outside South Africa;
  
• further enhancements in asset and liability management (ALM) and the group’s Asset and Liability Committee (ALCO) process; and
  
• significant enhancement in the quality of risk management reporting, at group, business unit and subsidiary levels.
  

Our key focus areas in 2006 include:

• substantially completing our Basel II implementation, particularly the related IT systems implementation, and fully operationalising and embedding most of the new risk measurement and management capabilities, processes and practices;
  
• refining, and embedding in the group, our new economic capital, risk appetite and RAPM methodologies and, with ongoing data refinement, extending development and application of this new management science into fully fledged risk-based pricing and client value management (or value-based management);
  
• completing the implementation of risk management frameworks (and Basel II), aligned with the group’s ERMF, in Imperial Bank, all African subsidiaries and the operations in the UK;
  
• enhancing market risk management to support the group’s strategy to grow its trading operations over the next three years (currently market trading risk consumes only 3% of the group’s total economic capital requirements); and
• maintaining the strong risk management culture, governance and environment that have been built up over the past two years.

Economic capital

Economic capital provides a consistent quantification and comparison of risk across business units and risk types. This also enables a focus on both downside risk (risk protection) and upside potential (earnings). It highlights where the group should grow and diversify or where it needs restructuring in its credit and market risk businesses.

Nedbank Group’s Economic Capital Framework now enables various new capabilities and management science at various levels of the organisation.

Nedbank Group, in line with leading international banks, calculates economic capital against four major risk categories and allows for diversification benefits to arrive at the final economic capital requirement of the group. This is compared with available financial resources and used as the basis for capital allocation through the adoption of economic profit as a key financial performance indicator.

Nedbank Group's economic capital model is illustrated below.

Nedbank Group’s ERMF concerns the definition of its risk universe and a comprehensive risk governance framework to manage that universe, rather than a consistent and tightly defined risk quantitative framework, which is what our Economic Capital Framework now additionally provides us.

Managing risk is, however, not all about capital. Capital is critical, but only one component in the management and supervision of a bank. Not all risks can or should be quantified and management controls, governance and risk management are as important as the right amount of capital a bank holds. Liquidity risk provides a case in point.

There are a few risks for which Nedbank Group does not believe it is appropriate to capitalise, the key ones being:

• reputational risk, which is managed via controls and processes and not via capital allocation – by its nature this risk is difficult to quantify and almost impossible to capitalise; and
  
• liquidity risk, which is also difficult to quantify and at a 99,9% or similar confidence level totally impractical to hold capital for – liquidity risk is best managed by a rigorous control framework and ALCO process.
  

Strategic risk is captured within our economic capital allocation for business risk.

Risk appetite

Risk appetite is an articulation of the risk capacity or quantum of risk the Nedbank Group is willing to accept in pursuit of its strategy.

Risk appetite can be expressed in terms of quantitative risk measures such as earnings-at-risk (earnings volatility), economic capital and risk limits, and qualitatively in terms of policies or controls meant to limit risks that may or may not be quantifiable.

Nedbank Group’s risk appetite is defined within five categories:

• group-level risk appetite metrics;
  
• specific risk type limit setting;
  
• stakeholder targets (eg target debt rating and dividend policy);
  
• policies and controls; and
  
• zero-tolerance statements.

The group-level risk appetite metrics quantify the current risk profile of the group and the targets agreed by the board of directors. These targets have been built into the group’s three-year strategic planning process and are to be achieved by the end of 2007 (which is in line with the group’s three-year recovery programme and the implementation of Basel II in South Africa).

Nedbank Group’s group-level risk appetite metrics

The quantitative group measures outlined above are used to set the group risk appetite and report risk exposure at the group and business cluster level. However, the allocation of limits, below the cluster level, to business units within each cluster is primarily driven using economic capital.

A new risk dashboard has been introduced to provide a holistic overview of the group’s risk profile and to enable the board to monitor the alignment of this risk profile with its chosen risk appetite, as well as to lend support for other key decisions.

An integral part of the risk appetite framework is the continuous analysis and presentation of risk-relevant information to decision makers throughout the organisation. Stress and scenario testing form an important part of this. While this is currently being done to some extent, the Nedbank Group has not yet implemented a comprehensive macroeconomic stress-testing/scenario analysis framework. This will be completed in 2006.