FMO: prepared for expectations and estimates

Since 1970, FMO has been investing in the private sector of developing countries and upcoming markets. It does this in sectors in which it believes the long-term impact will be the greatest: financial institutions, energy and agricultural sector. With regard to lending, FMO applies a number of criteria. Is the initiative bankable? Does it contribute to a better world? Is it dependent on FMO or can another bank do it as well?

IFRS 9 concerns a number of new accounting requirements for financial instruments and contains three pillars: classification and measurement of financial instruments, provision for possible credit losses on financial assets (impairment) and hedge accounting. The adjustments within the organization fall under the responsibility of the financial division, which is Buijze’s department. “As far as hedge accounting is concerned, the impact is not so relevant for us, but definitely for the other two,” says Buijze. For example, the rules require the bank to look at expected loan losses differently, including taking into account macroeconomic scenarios.

Auditable and executable

During the credit crunch, banks found that the value of assets or liabilities entered on the balance sheet were often too low. In addition, there was also a delay in adjusting the value in response to market developments. The idea that the value of assets or liabilities should reflect the market more closely only seems logical. The question, however, is whether this regulation will achieve this. “It probably will,” thinks Buijze. “But since it arose from a political discussion, it makes it that much more complex. In order to get a grasp on this complexity, we have appointed an external manager to this project. It affects every part of our organization and is a lot of work to not only process it through all the procedures, systems and reports, but also to make sure it is preserved.”

In 2015, FMO began to prepare at a relatively early stage. “That’s why we were able to take all the necessary steps in a constructive way,” explains Buijze. “That process started with the question: what exactly is IFRS 9 and what are we actually facing? After that we needed to verify which elements were already in place. The probability of default (PD), or the probability that a company will go bankrupt, was something we already had a good idea about. As well as the loss given default (LGD), which is loss through default. You need to build your entire framework on these basic elements. IFRS 9 requires a calculation of expected loss (EL) in the next 12 months. However, if the client’s creditworthiness deteriorates, you are responsible for the EL over the entire life cycle of that credit. But what does ‘deteriorate’ actually mean? Such things must be clear; it’s important that it’s auditable and executable.” That raises the question of how one determines the creditworthiness of a local bank in Zimbabwe, for example. No ratings exist for such a bank. Buijze says: “We do that with all the specialists here, through a ranking of the entire portfolio based on the estimated risks. So it’s a relative rating which we subsequently ‘map out’ from the well-known rating scores of Moody’s and Standard & Poor’s.”

Portfolio diversity

Compared with the Basel guidelines, IFRS 9 requires more a point in time, according to Martijn de Groot, director at Zanders. “We had to take a number of measures, especially when using the existing PDs as proof for IFRS 9. Nothing too major, but it must be well founded to obtain approval from the auditor and to be able to take part in the process.” Buijze nods in agreement, saying: “You have to thoroughly explain why certain decisions were made. A lot of banks have very specific problems. As a bank, we can’t do a lot of back testing because we have relatively few clients, and luckily we don’t lose many. To show the expected loss with only historical figures is difficult. You must also substantiate your findings theoretically.” FMO’s portfolio is much smaller but more diverse than that of the average bank. The balance sheet total exceeds €8 billion, with loans amounting to over €4 billion. However, this is distributed among approximately 700 clients in 80 countries.

“There are countries with a high-risk rating, where we’ve never lost a cent, although the expected loss is higher than zero,” explains Buijze. FMO’s expansive agriculture sector does have some consequences. De Groot says: “It means that you have to find a solution for everything for IFRS 9. Because the portfolio is so diverse, so are the effects. A life cycle or credit cycle needs to be modeled, but the FMO credit cycle, based on the total balance, is muted, less volatile, due to the diversity.”

Classification

In the world of FMO, modeling quickly results in highly theoretical levels, says Buijze. “There are no trustworthy figures from a lot of the countries in which we do business. How do you determine the credit cycle in Ukraine, for example? In any case, we try to find the balance: while complying with the standards of IFRS 9, we don’t want to fall into something which appears great in theory, but hardly relates to what’s happening in a country.” All financial instruments must be classified according to the IFRS 9 guidelines. On the liabilities side, there is no impact for FMO but there are implications for the bank’s financial assets. Buijze explains: “We have to separately determine the classification for each loan.” This classification means that loans are entered at cost price or at market value on the balance sheet. However, the market value decreases as the repayment capacity decreases. Because there is also an interest component, in addition to a credit component, the market value is more complex. “Luckily we haven’t needed to price that many loans at market value. We work with normal loans, mezzanine loans and private equity. And for the latter, very different rules apply.”

Fluctuations

One of the most miraculous things about IFRS 9, according to Buijze, is that you are obliged to make a choice for private equity investments. “Either everything goes through the balance sheet, so you never see anything in your profit and loss account (P&L), with the exception of paid dividends, even if you sell the investment at a nice profit, or everything goes through the P&L. That leads to some uncertainty, because valuations can fluctuate and are not always as accurate as possible. Consequently, you get huge fluctuations in your income statement. We finance
almost no listed companies, and should therefore, in valuation, mainly look at theoretical values based on what other companies are doing. If we finance a bank and all banks in that region are assessed at a lower value, then we will also asses the bank at a lower value. During the crisis, the large Dutch banks significantly decreased in value, while we were actually doing quite well. If FMO was valuated in the same way as ING at the time… Therefore, it is an approach, but it’s not spot-on. And that’s all because of your P&L.”

De Groot believes there’s something else involved: “The bulk of private equity isn’t in euros, which means that currency volatility also has an effect on the balance sheet value, which in turn is in euros. Previously, that result only went through selling by the P&L, meaning if it were actually realized. Under IFRS 9, it either never goes through the P&L, or every period your unrealized result also goes through the P&L.” In fact, this all means a higher volatility on the P&L.

That will apply to a lot of banks, but with us, it’s even more extreme because we have a relatively large portfolio in private equity.

Paul Buijze of FMO

FMO has chosen to have put everything go through the P&L. “That was a difficult decision, but it involves almost a third of our activity;, so for reasons of transparency, this was too much not to include in the P&L.”

A glance at 2025

Finance is ultimately the most involved department in implementing the new reporting standards. “Zanders had the ‘spider-in-the-web’ job,” says Buijze. “They brought together collaborators within the organization and developed a tool to calculate the credit facilities and market values of loans. This tool also implemented shadow calculations to get a better sense of the choices made for IFRS 9. What does this mean for the periodic numbers? This provides better insight and we can intervene if necessary. We prefer to have the tool in the system itself, but the systems don’t offer this at the moment. In the next three years, the tool must at least have a sufficient level to make our P&L, and be signed off by the auditor. And after that, we hope that our source systems will have the capacity to do this themselves.”

In recent years, FMO has grown both in size and profitability. “Through the years, we’ve had a lot of up-swings,” says Buijze. “Because of the dollar, but fortunately, also because developments in a large part of the world we work in are going so well.”