To monitor and manage compliance with statutory requirements, the Board of Directors sets limits and monitoring thresholds in the Risk Appetite Statement (RAS) securely above the minima set by the Principles for Capital and Liquidity Management as well as those set out in the Bank’s risk management policies and Capital and Liquidity Recovery Plan.
NIB uses its ICAAP to evaluate the amount of capital and liquidity needed to cover the risks it is or might be exposed to. The ICAAP is conducted on an annual basis.
The Bank maintains a sufficient amount of capital and liquidity to cover all material risks and to ensure that operations can be continued without disruptions even in extremely adverse situations. Moreover, in accordance with Principle 3 of the Principles for Capital and Liquidity Management, NIB has put in place contingency measures and procedures for capital, leverage and liquidity adequacy to safeguard its viability.
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NIB’s Statutes require that the Bank’s paid-in capital and accumulated reserves exceed its internally assessed capital requirement covering the nature and level of the risks to which the Bank is or might be exposed. The Principles for Capital and Liquidity Management further establish a risk-based capital adequacy requirement to ensure that the Bank maintains an appropriate level of capital. This is operationalised via a risk-based capital ratio minimum requirement of 100%.
NIB uses an internal economic capital approach to estimate and set the risk-based capital requirements for credit risk, market risk, operational risk, and other business risks. The amount of economic capital reserved to cover these risks, also calibrated to preserve the highest possible (AAA/Aaa) credit rating, is defined as the minimum economic capital requirement. Potential diversification benefits across the main risk categories (credit, market, liquidity, and operational) are not applied. In addition to the minimum economic capital requirement, the Bank maintains macroprudential capital buffers and additional management buffers (e.g. stress test buffer) as appropriate. The Bank may release capital buffers under stressed conditions or when otherwise required to fulfil its purpose.
CREDIT RISK
The credit risk economic capital model is an application of the so-called structural model broadly adopted in the industry. In technical terms, the simulation model is based on a multivariate-threshold t-copula approach. The key idea behind the model is that an individual obligor enters into default when the value of its assets crosses a threshold determined by the counterparty’s creditworthiness. The model for asset values is estimated based on historical equity data incorporating geographical, industrial, and firm-size dimensions. The likelihood that a counterparty’s assets drop below the default threshold depends on the probability of default (PD) estimates and rating scale. Finally, the actual size of default loss depends on two elements: the counterparty exposure at default (EAD) and the loss given default (LGD). The actual loss, as a proportion of the current exposures, is assumed to be random and is informed from the internal LGD methodology. The credit risk migration element is also a function of credit transition probabilities, credit spread values for each rating category, and the sensitivity of loans to spread movements. The transition probabilities are sourced from external credit rating agency data and split between corporate and sovereign lending categories. Credit spreads are estimated from internal historical lending experience, while the spread sensitivities are determined by the cash-flow structure of each individual loan.
MARKET RISK
The market risk economic capital model captures the following sub-categories: interest rate risk (covering both the economic value and net interest income risk perspectives), credit spread risk, currency basis risk, and foreign exchange risk. The Bank applies various stress testing approaches for the calculation of market risk economic capital requirements across these market risk sub-categories and recognises diversification benefits between them in the calculation of the overall economic capital requirement for market risk.
OPERATIONAL RISK
Operational risk economic capital requirement is obtained by first calculating the regulatory capital requirement using the standardised approach and then scaling that requirement up to arrive at a conservative estimate.
MACROPRUDENTIAL BUFFERS
The regulatory macroprudential tools have been designed to mitigate potential systemic risks, help counter procyclicality in the financial system, and to reserve additional capital above regulatory minimum requirements so that banks have better tools to react and operate under stressed conditions. Due to its legal status, national banking legislation does not apply to NIB, nor it is subject to direct supervision from any supervisory authority. Similar to other IFIs, NIB does not require a banking licence for its operations. NIB monitors international regulations and standards and adopts those that it identifies to be relevant and represent best practice. Therefore, NIB includes in its ICAAP the relevant macroprudential buffers (namely for capital conservation and countercyclicality) as well as a management (stress test) buffer.
The capital conservation buffer is a fixed percentage (2.5%) of the Bank’s risk-weighted assets (RWA). The countercyclical buffer is calculated as the weighted average of the private sector exposures and respective countercyclical buffer rates in those countries where the relevant risk exposures are located. The stress test buffer is normally derived from macroeconomic stress testing, based on severely adverse scenarios which build in severe yet plausible shocks to the real economy and financial markets. Scenarios are usually benchmarked to those from supervisory macroeconomic stress tests, but also incorporate expert judgment and/or specific elements to better test sensitivities to relevant factors such as the impact of particular shocks (e.g. higher inflation and interest rates, geopolitical risks) on sectors and/or regions.
In line with sound banking principles and practices, NIB recognises and manages the risk of excessive leverage. The leverage ratio calculation follows the regulatory approach, considering full exposures (both on- and off-balance sheet) and thereby provides the Bank with an all-inclusive metric to measure and monitor the volume of its activities in relation to its loss-absorbing capacity.
The Principles for Capital and Liquidity Management set two specific leverage ratio requirements. The first is that the Bank’s leverage ratio must exceed 7%. The second is that the leverage ratio when including callable capital (in the numerator) must exceed 20%. A key reflection of owner support and an important element of the Bank’s capital management, callable capital is authorised capital that is not paid in.
The exposure amount of an on-balance sheet asset is its accounting value remaining after specific credit risk adjustments. The exposure amount for off-balance sheet items, arising for instance from credit and liquidity commitments, is determined by multiplying the notional amount of an item by an appropriate credit conversion factor. The exposure amount of derivatives transactions is calculated as the sum of the replacement cost and an add-on for counterparty credit risk representing the potential future exposure of the transactions. Cash collateral may be recognised in the calculation as a reduction of exposure.
The leverage ratio is calculated as NIB’s adjusted common equity divided by the total exposure measure. The leverage ratio with callable capital is calculated as adjusted common equity, including callable capital, divided by the total exposure measure. The adjusted common equity is derived from the accounting equity by deducting specific set of items (e.g. intangible assets, dividends) to arrive a prudential equity figure for the purposes of Bank’s capital and liquidity management.
NIB’s business model gives rise to liquidity risk mainly through maturity mismatches between financial assets (loans and treasury investments) and liabilities (borrowing and equity). The Statutes require that NIB maintain a liquidity reserve necessary for continuing its operations for a period of at least six months under a severe stress scenario. The Principles for Capital and Liquidity Management further establish a minimum liquidity requirement to safeguard that the Bank can meet its payment obligations without interruption and continue its operations even under adverse market conditions.
This requirement is operationalised via a minimum survival horizon requirement, which measures the time span during which the Bank is able to fulfil its payment obligations (stemming from ongoing business operations) under a severe stress scenario. The stress scenario considers the Bank continuing to disburse loans, the funding market becoming inaccessible, the credit risk of the loan portfolio, the market risk and liquidity risk of the liquidity reserve, and additional collateral requirements for derivative transactions.
To manage liquidity risk, NIB has integrated an Internal Liquidity Adequacy Assessment Process (ILAAP) into its ICAAP, thereby following the same operational and decision-making procedures as for its capital adequacy assessment.
The liquidity position is also calibrated to preserve the highest possible (AAA/Aaa) credit rating and to fulfil the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) requirements.