Risk management

Organization of risk management

For FMO, acting in its role as Fund Manager (hereafter ‘FMO’) to be able to carry out the Fund’s strategy, it is essential to have an adequate risk management system in place to identify, measure, monitor and mitigate financial risks. AEF (hereafter ‘the Fund’) has a pre-defined risk appetite translated into limits for group, client, country, region and currencies exposures. Limit usages are monitored on a monthly basis and for each proposed transaction.

The AEF Portfolio Manager reviews each transaction and provides consent to eligible proposals. The Investment Committee, comprising of senior representatives of several departments, reviews financing proposals for new transactions. Each financing proposal is assessed in terms of specific counterparty, product risk as well as country risk and ESG risk. All financing proposals are accompanied by the advice of the Credit department. This department is responsible for credit risk assessment of both new transactions and the existing portfolio. For small exposures, Credit department has the authority to review new transactions.

In addition, clients are subject to a periodic client review, which are in general executed annually. Exposures requiring specific attention are reviewed by the Investment Review Committee (IRC). The large and higher risk exposures are accompanied by the advice of the Credit department. If the Investment Review Committee concludes that a client has difficulty in meeting its payment obligations, the client is transferred to the Special Operations department – responsible for the management of distressed assets – where it is intensely monitored.

Risk Taxonomy Framework FMO

Risk profile & appetite

The Fund actively seeks to take risk stemming from debt and equity investments in private institutions in developing countries. This risk profile is supported by maintaining prudent levels of capital and liquidity and strong diversification of the portfolio across regions and sectors.

Capital management

The Fund aims to optimize development impact. This can only be achieved with a sound financial framework in place, combining a healthy long-term revolvability of ≥75% and sound capital adequacy. The Fund’s is based on a 100% contribution from the Dutch government. Total contribution to AEF from the Dutch government is EUR 111 million at 31 December 2019 (31 December 2018: EUR 111 million). Total fund capital – which is the sum of the contribution by the government, undistributed results from previous years, results from the current year, grants, and evaluations costs – increased to EUR 131 million in 2019 (2018: EUR 127 million).

Reputational risk

Reputation risk is inevitable given the nature of the fund's operations in developing and emerging markets. FMO has a moderate appetite for reputation risk, accepting that reputational impact of activities may incidentally lead to negative press coverage, NGO attention, undesirable client feedback, or isolated cases of financial losses, as long as these activities clearly contribute to FMO’s mission. FMO has a limited appetite for additional reputation risk that, in extreme cases, may prompt key stakeholders to intervene in the decision-making or running of FMO’s daily business. FMO actively mitigates the risk as much as possible through strict and clear policies, thorough upfront assessments, consultations with stakeholders, and when necessary, through legal agreements with clients. FMO has a Sustainability Policy in place and statements on human rights, land rights, and gender positions.

Financial risk

Investment risk

Credit risk

Credit risk is defined as the risk that the Fund will suffer economic loss because a counterparty cannot fulfill its financial or other contractual obligations arising from a financial contract. Credit risk is the main risk within the Fund and occurs in two areas of its operations: (i) credit risk in investments in emerging markets and off-balance instruments such as loan commitments; and (ii) credit risk in the treasury portfolio, only consisting of bank accounts and money market instruments.

Management of credit risk is FMO’s core business, both in the context of project selection and project monitoring. In this process, a set of investment criteria per sector is used that reflects benchmarks for the required financial strength of FMO’s clients. This is further supported by internal scorecards that are used for risk classification and the determination of economic capital use per transaction. As to project monitoring, the Fund’s clients are subject to periodic reviews. Credit policies and guidelines are reviewed regularly and approved by the IRC.

Credit risk in the emerging markets loan portfolio

The Fund offers loans in emerging market countries. Diversification within the Fund’s portfolio is ensured through limits on individual counterparties (single client limit of 10% of the Fund’s capital), sectors and maximum tenor 20 years in debt transactions.

Internal credit approval process

Credit risk from loans arises from a combination of counterparty risk, country risk and product specific risks. These types of risk are assessed during the credit approval and credit review process and administrated via internal scorecards. The lending process is based on formalized and strict procedures. Decisions on authorizations depend on both the amount of economic capital and the risk profile of the financing instrument. For distressed assets, the Special Operations department applies an advanced workout and restructuring approach.

In measuring the credit risk of the portfolio at counterparty level, the main parameters are the credit quality of counterparties and the expected recovery ratio in case of defaults. Counterparty credit quality is measured by scoring counterparties on various dimensions of financial strength. Based on these scores, FMO assigns ratings to each counterparty on an internal scale from F1 (lowest risk) to F20 (default), equivalent to a scale from AAA to C ratings.

Credit quality analysis

In addition to on balance loans, irrevocable facilities (off-balance) represent commitments to extend finance to clients and consist of contracts signed but not disbursed yet which are usually not immediately and fully drawn.

The following tables provide insights in the credit risk allocation of loan portfolio and loan commitments according to internal ratings.

• 1 Other loan commitments include off balance items for which no ECL allowance is calculated.

Loans past due

Non-Performing Loans (NPL) are defined as loans with a counterparty-specific impairment and/or loans with interest and/or principal payments that are past due 90 days or more. The NPL percentage increased slightly to 0.3% as per 2019 as there are hardly any non - performing loans in AEF’s loan portfolio. As a result, a small increase of ECL is observed for Stage 3 loans.

• 1 Gross outstanding + accrual

Modified financial assets

Changes in terms and conditions usually include extending the maturity, changing the interest margin and changing the timing of interest payments. When the terms and conditions are modified due to financial difficulties, these loans are qualified as forborne. Refer to paragraph related to 'Modification of financial assets' in the Accounting Policies chapter.

The watch-list process and the Credit department review modified loans periodically. When a loan is deemed no longer collectible, it is written off against the related loss allowance. The write-offs amounted to €1.4 mln in 2019 (2018:€0).

The following table provides a summary of the Fund's forborne assets, both classified as performing and non - performing.

Equity risk

Equity risk is the risk that the fair value of an equity investment decreases. It also includes exit risk, which is the risk that the Fund’s stake cannot be sold for a reasonable price and in a sufficiently liquid market.

The Fund has a long-term view on its equity portfolio, usually selling its equity stake within a period of five to ten years. The Fund can accommodate an increase in the average holding period of its equity investments and so wait for markets to improve again to realize exits. There are no deadlines regarding the exit date of our equity investments. Equity investments are assessed by the Investment Committee in terms of specific obligor as well as country risk. The Investment Review Committee assesses the valuation of the majority of equity investments quarterly. The performance of the equity investments in the portfolio is periodically analyzed during the fair value process. Based on this performance and the market circumstances, exits are pursued in close cooperation with our co-investing partners. The total outstanding equity portfolio including associates at December 31, 2019, amounts to EUR 69 million (2018: EUR 45 million) of which EUR 15 million is invested in investment funds (2018: EUR 9 million).

Concentration risk

Country risk

Country risk arises from country-specific events that adversely impact the Fund’s exposure in a specific country. Within FMO, country risk is broadly defined. It includes all relevant factors that have a common impact on the Fund’s portfolio in a country such as economic, banking and currency crises, sovereign default and political risk events. The assessment of the country rating is based on a benchmark of external rating agencies and other external information.

The level of the country limits depends on the sovereign rating. FMO recognizes that the impact of country risk differs across the financial products it offers. In 2019, FMO has reviewed its country risk framework, based on a peer analysis and discussions with external parties. It was found that FMO was overly conservative regarding assigning country ratings, hence a less conservative approach is now applied. Consequently, the ratings of various countries were upgraded. Kenya, Ghana, Rwanda, Ukraine were upgraded by one notch.

The following tables present how the Fund’s loan portfolio is concentrated according to country ratings. The comparison with FMO demonstrates that loan portfolio of the Fund is concentrated in countries with higher ratings and is relatively prone to higher credit risk.

Single and group risk exposures

In the fund risk appetite, the maximum customer exposure for AEF is set at 10 mln. EUR.

Counterparty credit risk

Counterparty credit risk in the treasury portfolio stems from bank account holdings and placements in money market funds to manage the liquidity in the Fund. The Risk department approves each obligor to which the Fund is exposed through its treasury activities and sets a maximum limit to the credit exposure of that obligor. Depending on the obligor’s short and long-term rating, limits are set for the total and long-term exposure. The Fund pursues a conservative investment policy.

Liquidity risk

Liquidity risk is the risk of not being able to fulfil the financial obligations and meet financial commitments due to insufficient availability of liquid means. The Fund aims to maintain adequate liquidity buffers, enough to support the implementation of the Fund’s development agenda and impact objectives while avoiding putting pressure on Dutch Ministry of Foreign Affairs DGIS subsidy budget allocated to the Fund. To realize this ambition, the Fund benefits from the experience of FMO’s treasury and risk management functions in managing the liquidity risk, which primarily involves periodical forecasting of the Fund’s liquidity position under normal and stress scenarios. During these periodical exercises, the assumptions underlying the liquidity model are reviewed and changes in expected cashflows, stemming from updated portfolio management strategies and changes in the Fund’s operating environment, are reflected on the said assumptions. As a result of the forecasting activity, the predicted liquidity shortfall is avoided through arrangements in investments portfolio, if possible; through the utilisation of the subsidies available from the budget allocated to the Fund by Dutch Ministry of Foreign Affairs DGIS (‘beschikkingsruimte’); and lastly, through the request of a loan from FMO, not exceeding 10% of the Fund’s net committed portfolio. In requesting subsidies that will be made available to the Fund’s utilisation from Dutch Ministry of Foreign Affairs (‘MoFA’), the Fund administrators strictly follow MoFA’s directives.

Market risk

Interest rate risk

Interest rate risk is the risk of potential loss due to adverse movements in interest rates. Changing interest rates mainly have an effect on the fair value of fixed interest balance sheet items. Given the balance sheet and capital structure of the Fund interest rate risks are considered limited.

Currency risk

Currency risk is defined as the risk of having an adverse effect on the value of the Fund’s financial position and future cash flows due to changes in foreign currency exchange rates. The Fund offers debt, equity and guarantee instruments in denominated in USD, EUR and partly in emerging market currencies, while the main source of funding to the Fund, subsidies received from Dutch Ministry of Foreign Affairs is in EUR. The Fund targets to invest in USD as a risk-averse alternative to investing in local currencies when possible; additionally, cash inflows denominated in local currencies are converted to hard currencies when received. Due to its commitment to the implementation of the Fund’s development agenda and impact objectives, the Fund does not exclusively look for investments that counter-balance this currency risk exposure in its portfolio; the Fund also does not use derivatives and other financial instruments to hedge against the currency risk, and avoids bearing the cost of these engineered measures. The Fund does not take active positions in any currency for the purpose of making a profit.

Non financial risk

Environmental, social and governance risk

Environmental & Social (E&S) risk refers to potential adverse impacts of the FMO investments on the environment, the employees, the communities, and other stakeholders. Corporate Governance (G) risks refers primarily to risk to client business. In addition to impacts on the environment, employees and workers, communities and other stakeholders, ESG risks can result in non-compliance with applicable regulation, NGO and press attention, reputation damage and financial loss where such risk adversely affects operational and financial performance. These risks stem from the nature of the Fund’ projects in difficult markets, where regulations on ESG are less institutionalized. FMO has an appetite for managed risk, accepting ESG performance below standards when we first start working with a client. ESG risks are mitigated through environmental and social action plans, monitoring and technical assistance. The risk appetite for deviations from the exclusion list and human rights violations is zero. We furthermore expect the highest standards in professional conduct.

Compliance risk

Compliance Risk is the risk of failure to comply with laws, regulations, rules, related self-regulatory organization, standards and codes of conduct applicable to FMO. Being a regulated bank, the most important applicable laws in relation to products and customers, are the Dutch Financial Supervision Law (WFT); AML (WWFT); Sanctions Law and General Data Protection Regulation.

Fund’s customers follow FMO’s procedures e.g. customer onboarding; assessment of compliance risks, periodic Know Your Customer (KYC) reviews as well Event Driven KYC Reviews. FMO’s standards and policies and good business practices foster acting with integrity. FMO is committed to its employees, clients and counterparties, adhering to high ethical standards. FMO has a Compliance framework which entails identifying risks, designing policies, monitoring, training and providing advices. FMO has policies on topics such as know your customer (KYC) & sanctions, anti-bribery and corruption, receiving and giving gifts-entertainment & hospitality, conflicts of interest, internal fraud, private investments, outside positions, privacy and speak-up. FMO also regularly trains its employees in order to raise awareness by means of e.g. face-to-face trainings and mandatory compliance related e-learnings. Employees are also encouraged to speak up in case of suspected integrity violations conducted by an FMO employee. Management is periodically informed via the Compliance Committee or when required on an ad-hoc basis, on integrity related matters at client or employee level. In 2019 no significant integrity incidents related to FMO employees have been reported and there were no incidents at existing clients’ outside FMO’s risk appetite.

KYC & Sanctions

FMO’s KYC procedure includes screening of clients on compliance with applicable anti-money laundering, terrorist financing and international sanctions laws and regulations. Due diligence is performed on clients, which includes checks, such as verifying the ultimate beneficial owners of the client, identifying politically exposed persons, and screening against mandatory international sanction lists. These checks are also performed regularly during the relationship with existing clients. Following the DNB onsite inspection in 2018, FMO set up a FEC Enhancement Plan (FEC EP). In 2019 FMO started with execution of the FEC EP which consisted of a.o. conducting the Systematic Integrity Risk Assessment (SIRA) and enhancing the know your customer (KYC) policy and procedures. The updated KYC policy and procedures have been implemented. Part of the FEC EP consists of remediation of the customer KYC files and bringing them in line with the updated policy. FMO has not been able to achieve the interim target on number of remediated customer KYC files. However additional actions, based on lessons learnt, are undertaken to further improve the FEC EP. The progress of the FEC EP is closely monitored by the Management Board and reported to DNB.
It cannot always be prevented that a client is involved or alleged to be involved in illicit acts (e.g. corruption). If such an event occurs, FMO will initiate a dialogue with the client to understand the background in order to be able to assess the severity. When FMO is of the opinion that no improvement by the client will be achieved (e.g. awareness, implementing controls) or the risk to FMO’s reputation is unacceptably high, FMO can invoke legal clauses in the contract to terminate the client relationship.

Operational risk

Operational risk is the risk of loss resulting from inadequate or failed processes, people and systems or loss caused by external events. Operational risks are not actively sought and have no direct material upside in terms of return/income generation, yet operational risk events are inherent in operating a business. Operational risk events can result in non-compliance with applicable (internal and external) standards, financial losses or misstatements in the financial reports, and reputational damage.

FMO has in place an operational risk framework that governs the process of identifying, measuring, monitoring, reporting and mitigating operational risks. Operational risks are managed and monitored in accordance with the ‘three lines of defense’ governance principle. Management of the first line of defense is primarily responsible for managing (embedded) risks in the day-to-day business processes. The first line acts within the risk management framework and supporting guidelines defined by specialized risk departments and committees, the second line of defense. Internal Audit in its role of the third line of defense provides independent assurance on the effectiveness of the first and second lines.

Operational risk control self-assessments are conducted annually in order to identify inherent operational risks, controls, and residual operational risks. The strategy and business/strategic objectives are also reviewed annually by the Directors in a risk perspective. Based on these Risk and Control Self Assessments, the Directors sign an internal In Control Statement at the year-end, which sets the foundation for the management declaration in the Annual Report. operational risks resulting from new products or activities are assessed in FMO’s Product Approval and Review Process. No risk events outside FMO’s risk appetite have been reported.

Legal risk

Legal risk is defined as the risk of a counterparty (client, supplier, stakeholder or otherwise) not being liable to meet its obligations under law or FMO being liable at law for obligations not intended or expected, caused by lack of awareness or misunderstanding of, ambiguity in, or indifference to the way law and regulation apply to business, relationships, processes, products and services, leading to financial or reputational loss.

Given the specific nature of legal risks that can occur, no risk appetite metrics are assigned to this risk type. Instead, the most relevant developments on this risk type are included in the risk appetite report on a quarterly basis. FMO’s Legal team is responsible for the review of the legal aspects of Fund’s contracts with its clients and for mitigating legal risks arising from Fund’s businesses and operations. The members of the Legal team are qualified in a variety of jurisdictions and competent to provide expert and professional advice on a wide range of legal areas. Where applicable, the team seeks external expertise, particularly for legal analyses in emerging market jurisdictions, or in the event of particularly complex matters. Members of the team also serve on several cross-departmental committees, enabling them to address legal risks at an early stage and share their knowledge where needed.