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ANNUAL REPORT 2014

Management Discussion And Analysis

6.0. Risk Management

6.1. The Main Theme for 2014

Strong risk management continued to be a top strategic priority at Bank Audi in 2014. Over the past two years, we have accompanied the business growth of our Turkish subsidiary, Odea Bank, to ensure that we maintain the same high standards of risk management. With close monitoring of the loan portfolio, as well as the constant enhancement of its risk management framework and its alignment with that of the Group, we thrived in making the rapid expansion in Turkey a safe and successful one.

We also took the necessary precautions to protect our assets in our entities operating in unstable political and economic environments, notably in Syria where our exposure has become immaterial. With enough provisions taken into account for any possible loss, we were able to confidently face any challenge while being safe and sustainable.

In addition, we maintained good asset quality in the Egyptian market while expanding the Bank’s franchise.

As for the Lebanese operations, we maintained our strong internal controls while persistently looking for ways to enhance our risk management practice. We focused on expanding our retail portfolio and on preserving our good corporate and SME asset quality by reinforcing our existing relationships, while ensuring optimal risk-reward balance.

6.2. Making Bank Audi Safer

Bank Audi has continuously aimed at putting the customer at the heart of all that it does and continuously thrives to bring about the most current risk management best practices. The Bank constantly searches for ways to make Bank Audi safer through:

Protecting Stakeholders and Customers’ Interest

In line with its commitment to constantly protect the interest of its stakeholders and customers and to maintain a high quality of service with minimum disruption, Bank Audi has implemented several initiatives to enhance its cyber security posture and completed the establishment of a world-class business continuity site, along with a disaster recovery site that was awarded the Tier 4 - Fault Tolerant Certification of Design Documents and Constructed Facility.

A Strong Business Continuity Plan

The Bank has developed and implemented a business continuity plan based on international standards to anticipate a variety of probable disaster scenarios. Several business continuity plan testings were conducted over the past year. These tests were concluded successfully by a full operational test that included all branches and critical head office departments. The objective of these tests was to ensure that critical business operations are resumed within a tolerable timeframe based on business requirements. In addition, necessary provisions were taken by the Bank to keep this plan abreast of changes pertaining to people, processes and technology. To ensure the safety of its personnel, the Bank has designated and trained fire marshals, established evacuation procedures, and conducted fire drills for its headquarters facilities.

A Strong Security Posture
The Bank is constantly reinforcing the security of its information systems to address evolving threats and vulnerabilities. Accordingly, advanced security solutions were acquired and implemented during the past year. In addition, security awareness trainings are conducted to all staff on a continuous basis in order to reduce the risk of human errors, theft, fraud or misuse of information resources.

Setting the Risk Appetite and Limits

The risk appetite, which is set on an annual basis, is meant to provide the boundaries within which business lines operate. The setting of the risk appetite at Bank Audi is a result of a formal dialogue between Group Risk, business lines, Senior Management and the Board Group Risk Committee. The risk appetite, which is approved by the Board of Directors, is expressed in both qualitative and quantitative statements. The latter include a set of metrics covering risk appetite or targets, tolerances and limits.

The Bank maintains constant communication of the risk appetite to business lines and monitors the risk profile to ensure that it always remains within the Board of Directors’ approved limits.

The general principles of the Bank’s risk appetite and limits are the following:
  • The Bank does not engage in banking transactions and activities it does not have a full understanding of, specifically in terms of the risk that such transactions or activities are likely to generate.
  • Risk monitoring and control is a key component of our risk management framework. Therefore, the Bank does not engage in risk-generating activities and products that it cannot fully monitor and control.
  • The Bank places great importance and priority on maintaining a robust liquidity profile. As part of this strategy, the Bank endeavours to ensure that its funding base is mainly sourced from a stable and well diversified deposit base. Therefore, in general, the Bank does not normally solicit wholesale market funding for its ordinary banking activities. However, in the event that this situation changes in future, a proper policy framework will be put in place to ensure that the impact of such strategy is well understood and monitored through adequate limits and controls.
  • Senior Management will carefully assess and weigh the risk versus rewards for all business proposals that potentially create significant risk concentration (be it in products, sectors, markets or countries). Final approval for such proposals will only be granted for reasons deemed to be of franchise building for the Bank. When doing so, Senior Management will ensure that such concentration risk is adequately mitigated and controlled.
  • The Bank upholds the highest standards of ethics and professional competence when providing banking services to its clients and engaging with counterparts. Therefore, no products or services or other types of banking transactions will be contracted if deemed unsuitable to the clients or can potentially raise financial or reputational risk for the Bank.
  • The Bank gives the highest importance to the full and complete implementation of all laws and regulations governing its activities. To achieve this, the Bank will conduct regular due diligence exercises and establish adequate controls to ensure that strict adherence to laws and regulations is maintained at all time.
  • The Bank has a very low risk appetite for name lending.
  • The Bank has a low risk appetite for holding for its own account volatile financial instruments that can generate undesirable earnings fluctuations.

The Broadening of the Stress Testing Scope

Stress testing is used by Bank Audi to measure the Bank’s vulnerability to exceptional but plausible events. Bank Audi has formalised stress testing within a Board of Director-approved document and conducts regular stress testing for material risks to which it is exposed and resulting from both on and off‑balance sheet transactions.

The selection of stress testing scenarios is the result of the discussion between Group Risk, Group Finance and business lines, in consultation with the Group Research department. The results are reported to the Group Executive Committee, Board Group Risk Committee, and Board of Directors depending on the materiality and relevance of the stress test at hand.

The Bank has undergone stress tests outside the framework of regulatory requirements to include all relevant risk disciplines, as well as stress testing at the portfolio, transaction and individual level, enabling the Bank to move towards more complex models and more structured approaches to stress testing.

Close Risk Monitoring

We strive to make sure all material and relevant risks are closely monitored through the enhancement of our MIS capabilities, portfolio reviews, risk assessments, as well as regular reporting from entities supported by regular entity visits.

The Promotion of a Strong Risk Culture

The Group Risk Principles

Bank Audi has defined the following key guiding principles that underpin its approach to risk management, which include:
  • The risk function aims to preserve the Bank’s financial strength by ensuring that risks and rewards are properly balanced and by minimising the impact of undesirable events on capital and profits.
  • Bank Audi’s risk management responsibilities follow a three‑line of defence structure: the first being the business lines, the second being Risk and Compliance, and the third line of defence being Internal Audit and External Auditors.
  • Risks are properly disclosed to various internal and external stakeholders in a transparent, systematic, structured, timely and accurate manner, in order to allow various stakeholders to make prompt and informed decisions.
  • The Risk function is independent from business lines and decision makers, yet supports them in making informed choices and distinguishing among alternative courses of action.

The Risk Training Program

Following the establishment of the Risk Training Academy in 2013, the Bank has continued in the implementation of the program in 2014. Core risk courses were developed and delivered both in-house and through trainings delivered by subject matter experts. Courses are open to attendees from all departments within the Bank in order to promote a strong risk culture across the functions.

Enhancing the Risk-rating System for Corporate and Commercial

In 2014, Bank Audi deployed its new Facility Risk-Rating (FRR) Model and Related-Entity Support Model, accompanied by trainings to relevant stakeholders from various entities. The purpose of the FRR model is to rate facilities taking into account the obligor’s creditworthiness, but also the type of facility and any credit risk mitigant. The Related-Entity Support model provides an objective measurement of degree of support through a substitution of the obligor’s rating, when an explicit or implicit support is available. These models complement the existing credit internal rating models such as the Corporate Model, SME, with and without financial statements and Project Finance.

By continuously enhancing our risk-rating system, the Bank aims to have more accurate measurement of credit risk and expected losses estimates, and consequently be better prepared for the adoption of the final version of the IFRS 9 standards.

Continuously Enhancing Our Methodologies

Bank Audi has taken a strategic decision to move toward advanced approaches in risk management, which require both competent quantitative skills and adequate analytical tools. The Bank has made several efforts to strengthen the framework around model validation by adopting best practices for the development, calibration, validation and maintenance of various risk-related models. Such models will not only allow a better quantification of risk, but also support the business in its decision-making process.

The Development of Risk-adjusted Return on Capital (RAROC) by Business Line

A revised approach to risk-adjusted performance measurement has been implemented in line with international best practice, taking into account a full assessment of the RAROC by business line to ensure proper risk-reward balance.

Submission of the Internal Capital Adequacy Assessment Process (ICAAP) at Entity Level

During 2014, the major entities of the Group have conducted their own Internal Capital Adequacy Assessment Process. The ICAAP exercise has been conducted on a consolidated, but also on an entity level, which included Odea Bank, Bank Audi Egypt, Bank Audi Jordan and Audi Capital. The decisions to undergo the exercise in line with best practices were part of both an internal initiative and a regulatory requirement.

6.3. Priorities for 2015

The Bank, in its continuous effort to be the leader in risk management, is always looking for ways to improve the way we look at Risk. Our priorities for 2015 are as follows:
  • Ensure optimal capital allocation.
  • Widen the scope of utilisation of the return on capital measures to include more businesses and entities to ensure proper risk‑reward balance.
  • Maintain and strengthen the Group’s risk culture.
  • Continuously improve the quality of our data.
  • Continue to enhance the scope and accuracy of the credit rating system.
  • Continue with training efforts and widen the scope of participants to include entities.
  • Strengthen our risk and finance infrastructure.
  • Reinforce constantly our security posture, increase the efficiency of our business continuity plan, and keep it abreast of upcoming changes.

6.4. Credit Risk

Corporate Credit Risk

In our Group Risk charter, “Credit Risk entails negative consequences associated with the default or deterioration in credit quality of counterparty in lending operations...”.

The challenging operating conditions persisted throughout 2014, along with the political tensions in the MENA, thus impeding any potential economic breakthrough in the region. Moreover, the concomitant spill over effect of the Syrian conflict maintains the intense pressure on the competitive Lebanese market.

However, within the permanent Management supervisory culture and a sound risk framework, the Group is always keen to boost its financial performance and to build a durable diversified revenue franchise capitalising on its customer base and market knowledge.

Indeed, the performing consolidated corporate loan portfolio maintained its double digit growth of circa 14%, with an adequate quality of assets highlighted by 71% coverage of NPL, 0.74% of net NPL to gross loans and 3.8% of Net NPL to consolidated equity, all comprised within our Group risk appetite.
The Group strategy was successfully implemented in 2014. As a matter of fact, the three pillars of growth, namely our Private Banking business line, as well as our Egyptian and Turkish subsidiaries, were the main growth drivers. Indeed, the aforementioned growth in the consolidated corporate loan portfolio was led by Odea Bank (42%), Private Banking (11%) and Egypt (10%).

Thus, the geographical diversification throughout the entities and business lines, as mentioned, did largely offset the decrease in our domestic corporate portfolio, which mirrors the lending activity slowdown of 9% reported in the banking sector throughout the first 11 months of 2014.

Finally, Management’s oversight and the vigilant credit risk culture outline an encouraging growth perspective and a sound liquidity covering all types of risks and maintaining an acceptable profitability level with respect to international standards and best practices.

Retail Credit Risk

The Bank continues to place great emphasis on the enhancement of data capture and analytics production in 2015. Standardisation of key performance metrics and their definition enables more accurate assessment of portfolios and facilitate decision making at group level.

Significant progress has been made in 2014 for scorecards development for various products and entities of the Group. The objectives of these scorecards are to better assess the creditworthiness of applicants in an objective manner, adopt the industry best practices, and comply with regulatory requirements.

Amongst the 2015 objectives is establishing profitability-linked performance benchmarks and early performance indicators to accurately assess portfolio health and risk appetite.

Accomplishing these objectives will support the Bank in carrying out the portfolio reviews which are scheduled to be conducted over the different entities twice a year.

In terms of risk profile, the Bank closed 2014 with solid credit indicators on its retail portfolio. The portfolio is well diversified: 40% on housing loans, 37% on personal loans, 10% on auto loans, 12% on cards, and 1% on other products.

Despite the unstable political and economic conditions in the countries the Bank operates in, the portfolio has demonstrated resilience, as reflected in the stability of the performance indicators. Gross Retail NPL stands at 2.4% with a 70% of provisions coverage on closure of 2014.

6.5. Operational Risk

Operational risk is the risk of loss arising from system failure, human error, fraud or external events. Operational risk exists in all activities and can materialise in various ways such as errors, frauds or business interruptions that can result in direct and indirect lost income, such as reputational damage.

At Bank Audi, the primary responsibility for the management of operational risk resides in the business. To monitor and control operational risk so as to maintain it within Board-approved risk tolerances, operational risks are assessed on a regular basis by evaluating the effectiveness of the control design against risk scenarios mapped to internal risk registries and implementing corrective actions where needed.

These internal risk registries are mapped to seven standardised categories used for reporting to Management and to the Board of Directors: internal and external fraud; employment practices and workplace safety, clients, products and business practices, damage to physical assets, business disruption and system failures, and execution, delivery and process management. In addition, a system of incident reporting and a set of risk indicators together help confront ex-ante risk assessments to reality and improve controls before a situation develops into lost income exceeding tolerances. In recent years, most of Bank Audi’s operational losses have been caused by external fraud.

The Bank has rolled out a special purpose operational risk management tool which allows users to log risk assessments, key risk indicators, incidents, action plans, and follow up on their resolution. This tool is designed to ensure a more efficient group-wide implementation of the operational risk policy. As an additional layer of mitigation against operational events, the Bank purchases comprehensive insurance coverage from highly-rated reinsurers. This coverage is purchased wherever economically feasible and includes coverage against certain types of fraud and political violence, strikes, riots and terrorism in some countries that experienced unrest. Notwithstanding its efforts to control operational risks, Bank Audi does incur unexpected operational losses, in particular as the sum of losses incurred below the insurance deductible, losses that are neither insured nor so predictable as to be priced, as well as setbacks to budgeted revenue (lost income). When these happen, they are escalated to the relevant manager or Management committee and followed up for possible recoveries and process improvements. The Bank applies the basic indicator approach for the calculation of its capital charge for operational risk, while complying with the qualifying standards of Basel II’s standardised approach (Paragraph 663 of the Basel II Capital Accord). Finally, the operational risk framework is audited yearly as per regulatory requirements and standard industry practice.

6.6. Liquidity Risk Management

Liquidity risk is the risk that the Group will be unable to meet its payment obligations when they fall due under normal and stress circumstances.

Liquidity risk can manifest in the following two forms:
  • Funding liquidity risk is the risk that the Bank’s financial condition is adversely affected as a result of its inability to meet both expected and unexpected current and future cash flow and collateral needs in a timely and cost efficient manner.
  • Market liquidity risk is the risk that the Bank cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption ultimately leading to loss. The Bank addresses these risks in two distinct environments:
  • Normal conditions where the Bank must satisfy daily liquidity needs (flows) and the liquidity risk associated with those needs (e.g. in conjunction with expanding product or business mix, settlement, deposit/loan growth, etc.).
  • Stressed conditions where the Bank is facing liquidity strains due to idiosyncratic or systemic conditions and may invoke the Contingency Funding Plan (CFP) as a result.

Liquidity Adequacy

Management considers the Bank’s liquidity position to be strong, based on its liquidity metrics as of December 31, 2014, and believes that the Bank’s funding capacity is sufficient to meet its on and off-balance sheet obligations.

The Bank’s funding strategy is intended to ensure sufficient liquidity and diversity of funding sources to meet actual and contingent liabilities through both normal and stress periods.

The Bank continues to source funds by relying on a stable customers’ deposit base constituting 84% of its funding (liabilities + equity), which was USD 35.4 billion at December 31, 2014, rising from USD 30.7 billion at December 31, 2013. Nearly 70% of deposits are Retail/Personal Banking accounts, whereas about 29% are corporate/SME. The large Retail/Personal Banking base emphasises the Bank’s reliance on sources of funding that are considered to be the most stable, evidenced by their treatment under the Basel III Liquidity Standards, as part of the Liquidity Coverage Ratio (LCR) of 60%. Local rules in Lebanon have not been published yet, but the Bank’s internal assessment of the LCR reveals healthy levels above the final target of 100%, to be adhered to starting 2019. The rule has been placed into effect as of January 2015 and includes for Odea Bank, the Bank’s subsidiary in Turkey, whose LCR is above the minimum statutory requirement.

The Bank’s consolidated short-term liquidity ratios (defined as net current accounts and maturing placements with central banks plus banks and financial institutions relative to maturing deposits over one-month and three-month horizons) are at healthy levels. For example, the one-month ratio stands at 21.4%.

The Bank maintains pools of liquid unencumbered securities and short-term placements with highly rated bank counterparts or the Central Bank in the relevant jurisdiction. It also engages in short-term reverse repo agreements whose underlying securities’ risk-weighing is equal or better than the sovereigns where the liquidity risk is being taken. The Bank also actively monitors the availability of funding across various geographic regions and in various currencies. Its ability to generate funding from a range of sources in a variety of geographic locations and in a range of tenors is intended to enhance financial flexibility and limit funding concentration risk. However, the ability to transfer cash/liquid assets between entities is given thorough consideration. As mentioned later under Liquidity Management, the Bank’s liquidity management strategy promotes self-sufficiency of legal entities, most especially across borders.

The Bank monitors its liquidity position in new markets on a daily basis. The Bank’s fund-raising ability in Turkey has been tested and found reliable in several instances during unsettled periods.

Governance

The Bank’s governance process is designed to ensure that its liquidity position remains strong at both entity and parent levels. The Asset-Liability Committee (ALCO) formulates and oversees execution of the Bank’s liquidity policy at the level of each entity (which essentially lays down the Bank’s liquidity management strategy). The liquidity risk policy for identifying, measuring, monitoring and reporting liquidity risk, and the contingency funding plan are recommended by Risk Management, reviewed by ALCO, approved by the Executive Committee, and finally ratified by the Board of Directors. Measurement, monitoring and reporting are performed for the most part by either Treasury or Risk Management, each of which inform and may escalate to ALCO based on key risk indicators and both regulatory and internal limits.

Treasury is responsible for executing the Bank’s liquidity policy, as well as for maintaining the Bank’s liquidity risk profile according to ALCO directives, all within the risk appetite set by the Board of Directors.

The parent bank’s Treasury and Capital Markets division communicates with entity Treasury departments to ensure adequate liquidity conditions at the Group level.

Liquidity Monitoring and Risk Appetite

Monitoring and setting of risk appetite for liquidity occur independently for each entity. Given the Bank’s operating environment, the Bank monitors liquidity adequacy in each currency separately, especially for significant currency positions.

The Bank employs a variety of metrics to monitor and manage liquidity. One set of analyses used by the Bank relates to the timing of liquidity sources versus liquidity uses (e.g. liquidity gap analysis). A second set of analyses focuses on ratios of funding and liquid assets/collateral (e.g. measurements of the Bank’s reliance on short-term unsecured funding as a percentage of total liabilities, as well as analyses of the relationship of short-term unsecured funding to highly-liquid assets, the loans-to-deposits ratio, and other balance sheet measures). The Bank also uses methods such as Basel’s Liquidity Coverage Ratio to measure and monitor liquidity under different conditions, which is not confined to the regulatory weighting, but reflects Management’s own view under different scenarios in the relevant jurisdiction.

The Bank performs liquidity stress tests as part of its liquidity monitoring. The purpose is to ensure sufficient liquidity for the Bank under both idiosyncratic and systemic market stress conditions. They are produced for the parent and major bank subsidiaries.

Liquidity Management

Liquidity management at the parent level takes into account regulatory restrictions that limit the extent to which bank subsidiaries may extend credit to the parent and vice versa and to other non-bank subsidiaries. The Bank’s liquidity management strategy promotes self-sufficiency of legal entities, most especially across borders.

Although considered as a source of available liquidity, the Bank does not view borrowing capacity at central bank discount windows in the jurisdictions it operates in as a primary source of funding, but rather as a secondary one. In addition, the Bank holds high quality, marketable securities available to raise liquidity, such as corporate and sovereign debt securities.

6.7. Market Risk Management

Market risk is defined as the potential loss in both on and off‑balance sheet positions resulting from movements in market risk factors, such as foreign exchange rates, interest rates and equity prices.

The Bank maintains low appetite to market risk stemming from changes in equity prices and foreign exchange rates. However, operations in Turkey open revenue-generating opportunities from trading activities in FX and interest rates which the Bank is willing to make use of.

The Bank’s main exposure to changes in FX rates at year-end 2014 stems mainly from its structural FX positions resulting from its equity investments in banking subsidiaries in currencies that cannot be hedged against, except for the Turkish Lira where derivatives can be used.

IRRBB

Interest rate risk in the banking book arises out of the Bank’s interest-sensitive asset, liability and derivative positions. The mismatch in the re-pricing dates of these positions creates interest rate risk for the Bank which is inherent in its banking activities.

The sensitivity of net interest income for major currencies is listed below at the consolidated group level.

IRRBB

It is important to note that interest rates on assets do not change in tandem with liability rates. The stickiness of customer deposit rates in Lebanon, an observed phenomenon in the Lebanese market, has been incorporated in the above table. It has been quantified for the Lebanese USD customers’ deposits market whereby a relationship between changes in deposit rates has proven statistically reliable and reflects historical behaviour. For LBP, the estimated relationship is based on relatively recent history, which Management believes is more relevant in the current economic environment. The relationship, along with Senior Management’s view of current market dynamics, is incorporated for customers’ deposits in Lebanese entities only, whereas other entities are calculated on purely contractual terms. It is worth noting that the relationship also incorporates the lag in the response of deposit rate changes to changes in market rates. These relationships are reviewed annually to ensure they still hold.

The interest rate risk profile of the Bank is within acceptable bounds. The impact of a fall in USD rates (50 bps), as indicated above, constitutes less than 1% of net interest income for the Group. In LBP, the stated rate (100 bps) increase takes away less than 1% of net interest income as well.

Using the same method above, a shock of +3% on TRY interest rate sensitive positions affects net interest income by nearly -10% of annual NII from a purely contractual perspective. On a separate note, the Turkish regulator imposes a limit for 5% and 2% shocks on TRY and FX interest sensitive balance sheets of banks in Turkey respectively, to assess the change in the economic value of equity relative to capital. The Bank’s end-of-year 2014 position was at 13%, well within the limit of 20%.