In this report, biodiversity loss ranks as the fourth most pressing concern after climate change adaptation, mitigation failure, and natural disasters. For financial institutions (FIs), it is therefore a relevant risk that should be taken into account. So, how should FIs implement biodiversity risk in their risk management framework?

Despite an increasing awareness of the importance of biodiversity, human activities continue to significantly alter the ecosystems we depend on. The present rate of species going extinct is 10 to 100 times higher than the average observed over the past 10 million years, according to Partnership for Biodiversity Accounting Financials[i]. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) reports that 75% of ecosystems have been modified by human actions, with 20% of terrestrial biomass lost, 25% under threat, and a projection of 1 million species facing extinction unless immediate action is taken. Resilience theory and planetary boundaries state that once a certain critical threshold is surpassed, the rate of change enters an exponential trajectory, leading to irreversible changes, and, as noted in a report by the Nederlandsche Bank (DNB), we are already close to that threshold[ii].

We will now explain biodiversity as a concept, why it is a significant risk for financial institutions (FIs), and how to start thinking about implementing biodiversity risk in a financial institutions’ risk management framework.

What is biodiversity?

The Convention on Biological Diversity (CBD) defines biodiversity as “the variability among living organisms from all sources including, i.a., terrestrial, marine and other aquatic ecosystems and the ecological complexes of which they are part.”[iii] Humans rely on ecosystems directly and indirectly as they provide us with resources, protection and services such as cleaning our air and water.

Biodiversity both affects and is affected by climate change. For example, ecosystems such as tropical forests and peatlands consist of a diverse wildlife and act as carbon sinks that reduce the pace of climate change. At the same time, ecosystems are threatened by the accelerating change caused by human-induced global warming. The IPBES and Intergovernmental Panel on Climate Change (IPCC), in their first-ever collaboration, state that “biodiversity loss and climate change are both driven by human economic activities and mutually reinforce each other. Neither will be successfully resolved unless both are tackled together.”[iv]

Why is it relevant for financial institutions?

While financial institutions’ own operations do not materially impact biodiversity, they do have impact on biodiversity through their financing. ASN Bank, for instance, calculated that the net biodiversity impact of its financed exposure is equivalent to around 516 square kilometres of lost biodiversity – which is roughly equal to the size of the isle of Ibiza in Spain[v]. The FIs’ impact on biodiversity also leads to opportunities. The Institute Financing Nature (IFN) report estimates that the financing gap for biodiversity is close to $700 billion annually[vi]. This emphasizes the importance of directing substantial financial resources towards biodiversity-positive initiatives.

At the same time, biodiversity loss also poses risks to financial institutions.

The global economy highly depends on biodiversity as a result of the increasedglobalization and interconnectedness of the financial system. Due to these factors, the effects of biodiversity losses are magnified and exacerbated through the financial system, which can result in significant financial losses. For example, approximately USD 44 trillion of the global GDP is highly or moderately dependent on nature (World Economic Forum, 2020). Specifically for financial institutions, the DNB estimated that Dutch FIs alone have EUR 510 billionof exposure to companies that are highly or very highly dependent on one or more ecosystems services[vii]. Furthermore, in the 2010 World Economic Forum report worldwide economic damage from biodiversity loss is estimated to be around USD 2 to 4.5 trillion annually. This is remarkably high when compared to the negative global financial damage of USD 1.7 trillion per year from greenhouse gas emissions (based on 2008 data), which demonstrates that institutions should not focus their attention solely on the effects of climate change when assessing climate & environmental risks[viii].

Examples of financial impact

Similarly to climate risk, biodiversity risk is expected to materialize through the traditional risk types a financial institution faces. To illustrate how biodiversity loss can affect individual financial institutions, we provide an example of the potential impact of physical biodiversity risk on, respectively, the credit risk and market risk of an institution:

Credit risk:

Failing ecosystem services can lead to disruptions of production, reducing the profits of counterparties. As a result, there is an increase in credit risk of these counterparties. For example, these disruptions can materialize in the following ways:

• A total of 75% of the global food crop rely on animals for their pollination. For the agricultural sector, deterioration or loss of pollinating species may result in significant crop yield reduction.
• Marine ecosystems are a natural defence against natural hazards. Wetlands prevented USD 650 million worth of damages during the 2012 Superstorm Sandy [OECD, 2019), while the material damage of hurricane Katrina would have been USD 150 billion less if the wetlands had not been lost.

Market risk:

The market value of investments of a financial institution can suffer from the interconnectedness of the global economy and concentration of production when a climate event happens. For example:

• A 2011 flood in Thailand impacted an area where most of the world's hard drives are manufactured. This led to a 20%-40% rise in global prices of the product[ix]. The impact of the local ecosystems for these type of products expose the dependency for investors as well as society as a whole.

Core part of the European Green Deal

The examples above are physical biodiversity risk examples. In addition to physical risk, biodiversity loss can also lead to transition risk – changes in the regulatory environment could imply less viable business models and an increase in costs, which will potentially affect the profitability and risk profile of financial institutions. While physical risk can be argued to materialize in a more distant future, transition risk is a more pressing concern as new measures have been released, for example by the European Commission, to transition to more sustainable and biodiversity friendly practices. These measures are included in the EU biodiversity strategy for 2030 and the EU’s Nature restoration law.

The EU’s biodiversity strategy for 2030 is a core part of European Green Deal. It is a comprehensive, ambitious, and long-term plan that focuses on protecting valuable or vulnerable ecosystems, restoring damaged ecosystems, financing transformation projects, and introducing accountability for nature-damaging activities. The strategy aims to put Europe's biodiversity on a path to recovery by 2030, and contains specific actions and commitments. The EU biodiversity strategy covers various aspects such as:

• Legal protection of an additional 4% of land area (up to a total of 7%) and 19% of sea area (up to a total of 30%)
• Strict protection of 9% of sea and 7% of land area (up to a total of 10% for both)
• Reduction of fertilizer use by at least 20%
• Setting measures for sustainable harvesting of marine resources

A major step forwards towards enforcement of the strategy is the approval of the Nature restoration law by the EU in July 2023, which will become the first continent-wide comprehensive law on biodiversity and ecosystems. The law is likely to impact the agricultural sector, as the bill allows for 30% of all former peatlands that are currently exploited for agriculture to be restored or partially shifted to other uses by 2030. By 2050, this should be at least 70%. These regulatory actions are expected to have a positive impact on biodiversity in the EU. However, a swift implementation may increase transition risk for companies that are affected by the regulation.

The ECB Guide on climate-related and environmental risks explicitly states that biodiversity loss is one of the risk drivers for financial institutions[x]. Furthermore, the ECB Guide requires financial institutions to asses both physical and transition risks stemming from biodiversity loss. In addition, the EBA Report on the Management and Supervision of ESG Risk for Credit Institutions and Investment Firms repeatedly refers to biodiversity when discussing physical and transition risks[xi].

Moreover, the topic ‘biodiversity and ecosystems’ is also covered by the Corporate Sustainability Reporting Directive (CSRD), which requires companies within its scope to disclose on several sustainability related matters using a double materiality perspective.[1] Biodiversity and ecosystems is one of five environmental sustainability matters covered by CSRD. At a minimum, financial institutions in scope of CSRD must perform a materiality assessment of impacts, risks and opportunities stemming from biodiversity and ecosystems. Furthermore, when biodiversity is assessed to be material, either from financial or impact materiality perspective, the institution is subject to granular biodiversity-related disclosure requirements covering, among others, topics such as business strategy, policies, actions, targets, and metrics.

Where to start?

In line with regulatory requirements, financial institutions should already be integrating biodiversity into their risk management practices. Zanders recognizes the challenges associated with biodiversity-related risk management, such as data availability and multidimensionality. Therefore, Zanders suggests to initiate this process by starting with the following two steps. The complexity of the methodologies can increase over time as the institution’s, the regulator’s and the market’s knowledge on biodiversity-related risks becomes more mature.  

1. Perform materiality assessment using the double materiality concept. This means that financial institutions should measure and analyze biodiversity-related financial materiality through the identification of risks and opportunities. Institutions should also assess their impacts on biodiversity, for example, through calculation of their biodiversity footprint. This can start with classifying exposures’ impact and dependency on biodiversity based on a sector-level analysis.
2. Integrate biodiversity-related risks considerations into their business strategy and risk management frameworks. From a business perspective, if material, financial institutions are expected to integrate biodiversity in their business strategy, and set policies and targets to manage the risks. Such actions could be engagement with clients to promote their sustainability practices, allocation of financing to ‘biodiversity-friendly’ projects, and/or development of biodiversity specific products. Moreover, institutions are expected to adjust their risk appetites to account for biodiversity-related risks and opportunities, establish KRIs along with limits and thresholds. Embedding material ESG risks in the risk appetite frameworks should include a description on how risk indicators and limits are allocated within the banking group, business lines and branches.

Considering the potential impact of biodiversity loss on financial institutions, it is crucial for them to extend their focus beyond climate change and also start assessing and managing biodiversity risks. Zanders can support financial institutions in measuring biodiversity-related risks and taking first steps in integrating these risks into risk frameworks. Curious to hear more on this? Please reach out to Marije Wiersma, Iryna Fedenko, or Jaap Gerrits.

[1] CSRD applies to large EU companies, including banks and insurance firms. The first companies subject to CSRD must disclose according to the requirements in the European Sustainability Reporting Standards (ESRS) from 2025 (over financial year 2024), and by the reporting year 2029, the majority of European companies will be subject to publishing the CSRD reports. The sustainability report should be a publicly available statement with information on the sustainability-matters that the company considers material. This statement needs to be audited with limited assurance.

[i] PBAF. (2023). Dependencies - Pertnership for Biodiversity Acccounting Financials (PBAF)

[ii] De Nederlandche Bank. (2020). Indepted to nature - Exploring biodiversity risks for the Dutch Financial Sector.

[iii] CBD. (2005). Handbook of the convention on biological diversity

[iv] IPBES. (2021). Tackling Biodiversity & Climate Crises Together & Their Combined Social Impacts

[v] ASN Bank (2022). ASN Bank Biodiversity Footprint

[vi] Paulson Institute. (2021). Financing nature: Closing the Global Biodiversity

[vii] De Nederlandche Bank. (2020). Indepted to nature - Exploring biodiversity risks for the Dutch Financial Sector

[viii] PwC for World Economic Forum. (2010). Biodiversity and business risk

[ix] All the examples related to credit and market risk are presented in the report by De Nederlandsche Bank. (2020). Biodiversity Opportunities and Risks for the Financial Sector

[x] ECB. (2020). Guide on climate-related and environmental risks.

[xi] EBA. (2021). EBA Report on Management and Supervision of ESG Risk for Credit Institutions and Investment Firms

Early October, the Basel Committee on Banking Supervision (BCBS) published a report[1] on the 2023 banking turmoil that involved the failure of several US banks as well as Credit Suisse. The report draws lessons for banking regulation and supervision which may ultimately lead to changes in banking regulation as well as supervisory practices. In this article we summarize the main findings of the report[2]. Based on the report’s assessment, the most material consequences for banks, in our view, could be in the following areas:

• Reparameterization of the LCR calculation and/or introduction of additional liquidity metrics
• Inclusion of assets accounted for at amortized cost at their fair value in the determination of regulatory capital
• Implementation of extended disclosure requirements for a bank's interest rate exposure and liquidity position
• More intensive supervision of smaller banks, especially those experiencing fast growth and concentration in specific client segments
• Application of the full Basel III Accord and the Basel IRRBB framework to a larger group of banks

Bank failures and underlying causes

The BCBS report first describes in some detail the events that led to the failure of each of the following banks in the spring of 2023:

• Silicon Valley Bank (SVB)
• Signature Bank of New York (SBNY)
• First Republic Bank (FRB)
• Credit Suisse (CS)

While each failure involved various bank-specific factors, the BCBS report highlights common features (with the relevant banks indicated in brackets).

• Long-term unsustainable business models (all), in part due to remuneration incentives for short-term profits
• Governance and risk management did not keep up with fast growth in recent years (SVB, SBNY, FRC)
• Ineffective oversight of risks by the board and management (all)
• Overreliance on uninsured customer deposits, which are more likely to be withdrawn in a stress situation (SVB, SBNY, FRC)
• Unprecedented speed of deposit withdrawals through online banking (all)
• Investment of short-term deposits in long-term assets without adequate interest-rate hedges (SVB, FRC)
• Failure to assess whether designated assets qualified as eligible collateral for borrowing at the central bank (SVB, SBNY)
• Client concentration risk in specific sectors and on both asset and liability side of the balance sheet (SVB, SBNY, FRC)
• Too much leniency by supervisors to address supervisory findings (SVB, SBNY, CS)
• Incomplete implementation of the Basel Framework: SVB, SBNY and FRB were not subject to the liquidity coverage ratio (LCR) of the Basel III Accord and the BCBS standard on interest rate risk in the banking book (IRRBB)

Of the four failed banks, only Credit Suisse was subject to the LCR requirements of the Basel III Accord, in relation to which the BCBS report includes the following observations:

• A substantial part of the available high quality liquid assets (HQLA) at CS was needed for purposes other than covering deposit outflows under stress, in contrast to the assumptions made in the LCR calculation
• The bank hesitated to make use of the LCR buffer and to access emergency liquidity so as to avoid negative signalling to the market

Although not part of the BCBS report, these observations could lead to modifications to the LCR regulation in the future.

Lessons for supervision

With respect to supervisory practices, the BCBS report identifies various lessons learned and raises a few questions, divided into four main areas:

1. Bank’s business models

• Importance of forward-looking assessment of a bank’s capital and liquidity adequacy because accounting measures (on which regulatory capital and liquidity measures are based) mostly are not forward-looking in nature
• A focus on a bank’s risk-adjusted profitability
• Proactive engagement with ‘outlier banks’, e.g., banks that experienced fast growth and have concentrated funding sources or exposures
• Consideration of the impact of changes in the external environment, such as market conditions (including interest rates) and regulatory changes (including implementation of Basel III)

2. Bank’s governance and risk management

• Board composition, relevant experience and independent challenge of management
• Independence and empowerment of risk management and internal audit functions
• Establishment of an enterprise-wide risk culture and its embedding in corporate and business processes.
• Senior management remuneration incentives

3.Liquidity supervision

• Do the existing metrics (LCR, NSFR) and supervisory review suffice to identify start of material liquidity outflows?
• Should the monitoring frequency of metrics be increased (e.g., weekly for business as usual and daily or even intra-day in times of stress)?
• Monitoring of concentration risks (clients as well as funding sources)
• Are sources of liquidity transferable within the legal entity structure and freely available in times of stress?
• Testing of contingency funding plans

4. Supervisory judgment

• Supplement rules-based regulation with supervisory judgment in order to intervene pro-actively when identifying risks that could threaten the bank’s safety and soundness. However, the report acknowledges that a supervisor may not be able to enforce (pre-emptive) action as long as an institution satisfies all minimum requirements. This will also depend on local legislative and regulatory frameworks

Lessons for regulation

In addition, the BCBS report identifies various potential enhancement to the design and implementation of bank regulation in four main areas:

1. Liquidity standards

• Consideration of daily operational and intra-day liquidity requirements in the LCR, based on the observation that a material part of the HQLA of CS was used for this purpose but this is not taken into account in the determination of the LCR
• Recalibration of deposit outflows in the calculation of LCR and NSFR, based on the observation that actual outflow rates at the failed banks significantly exceeded assumed outflows in the LCR and NSFR calculations
• Introduction of additional liquidity metrics such as a 5-day forward liquidity position, survival period and/or non-risk based liquidity metrics that do not rely on run-off assumptions (similar to the role of the leverage ratio in the capital framework)

2. IRRBB

• Implementation of the Basel standard on IRRBB, which did not apply to the US banks, could have made the interest rate risk exposures transparent and initiated timely action by management or regulatory intervention.
• More granular disclosure, covering for example positions with and without hedging, contractual maturities of banking book positions and modelling assumptions 

3. Definition of regulatory capital

• Reflect unrealised gains and losses on assets that are accounted for at amortised cost (AC) in regulatory capital, analogous to the treatment of assets that are classified as available-for-sale (AFS). This is supported by the observation that unrealised losses on fixed-income assets held at amortised cost, resulting from to the sharp rise in interest rates, was an important driver of the failure of several US banks when these assets were sold to create liquidity and unrealised losses turned into realised losses. The BCBS report includes the following considerations in this respect:
  • If AC assets can be repo-ed to create liquidity instead of being sold, then there is no negative impact on the financial statement
  • Treating unrealised gains and losses on AC assets in the same way as AFS assets will create additional volatility in earnings and capital
  • The determination of HQLA in the LCR regulation requires that assets are measured at no more than market value. However, this does not prevent the negative capital impact described above
• Reconsideration of the role, definition and transparency of additional Tier-1 (AT1) instruments, considering the discussion following the write-off of AT1 instruments as part of the take-over of CS by UBS

4. Application of the Basel framework

• Broadening the application of the full Basel III framework beyond internationally active banks and/or developing complementary approaches to identify risks at domestic banks that could pose a threat to cross-border financial stability. The events in the spring of this year have demonstrated that distress at relatively small banks that are not subject to the (full) Basel III regulation can trigger broader and cross-border systemic concerns and contagion effects.
• Prudent application of the ‘proportionality’ principle to domestic banks, based on the observation that financial distress at such banks can have cross-border financial stability effects
• Harmonization of approaches that aim to ensure that sufficient capital and liquidity is available at individual legal entity level within banking groups

Conclusion

The BCBS report identifies common shortcomings in bank risk management practices and governance at the four banks that failed during the 2023 banking turmoil and summarizes key take-aways for bank supervision and regulation.

The identified shortcomings in bank risk management include gaps in the management of traditional banking risks (interest rate, liquidity and concentration risks), failure to appreciate the interrelation between individual risks, unsustainable business models driven by short-term incentives at the expense of appropriate risk management, poor risk culture, ineffective senior management and board oversight as well as a failure to adequately respond to supervisory feedback and recommendations.

Key take-aways for effective supervision include enforcing prompt action by banks in response to supervisory findings, actively monitoring and assessing potential implications of structural changes to the banking system, and maintaining effective cross-border supervisory cooperation.

Key lessons for regulatory standards include the importance of full and consistent implementation of Basel standards as well as potential enhancements of the Basel III liquidity standards, the regulatory treatment of interest rate risk in the banking book, the treatment of assets that are accounted for at amortised cost within regulatory capital and the role of additional Tier-1 capital instruments.

The BCBS report is intended as a starting point for discussion among banking regulators and supervisors about possible changes to banking regulation and supervisory practices. For those interested in engaging in discussions related to the insights and recommendations in the BCBS report, please feel free to contact Pieter Klaassen.

[1] Report on the 2023 banking turmoil (bis.org) (accessed on October 19, 2023)

[2] Although recognized as relevant in relation to the banking turmoil, the BCBS report explicitly excludes from its consideration the role and design of deposit guarantee schemes, the effectiveness of resolution arrangements, the use and design of central bank lending facilities and FX swap lines, and public support measures in banking crises.

The MoRM division of ABN AMRO comprises around 45 people. What are the crucial conditions to run the department efficiently?

Habing: “Since the beginning of 2019, we have been divided into teams with clear responsibilities, enabling us to work more efficiently as a model risk management component. Previously, all questions from the ECB or other regulators were taken care of by the experts of credit risk, but now we have a separate team ready to focus on all non-quantitative matters. This reduces the workload on the experts who really need to deal with the mathematical models. The second thing we have done is to make a stronger distinction between the existing models and the new projects that we need to run. Major projects include the Definition of default and the introduction of IFRS 9. In the past, these kinds of projects were carried out by people who actually had to do the credit models. By having separate teams for this, we can scale more easily to the new projects – that works well.”What exactly is the definition of a model within your department? Are they only risk models, or are hedge accounting or pricing models in scope too?

“We aim to identify the widest range of models as possible, both in size and type. From an administrative point of view, we can easily do 600 to 700 models. But with such a number, we can't validate them all in the same degree of depth. We therefore try to get everything in picture, but this varies per model what we look at.”

To what extent does the business determine whether a validation model is presented?

“We want to have all models in view. Then the question is: how do you get a complete overview? How do you know what models there are if you don't see them all? We try to set this up in two ways. On the one hand, we do this by connecting to the change risk assessment process. We have an operational risk department that looks at the entire bank in cycles of approximately three years. We work with operational risk and explain to them what they need to look out for, what ‘a model’ is according to us and what risks it can contain. On the other hand, we take a top-down approach, setting the model owner at the highest possible level. For example, the director of mortgages must confirm for all processes in his business that the models have been well developed, and the documentation is in order and validated. So, we're trying to get a view on that from the top of the organization. We do have the vast majority of all models in the picture.”

Does this ever lead to discussion?

“Yes, that definitely happens. In the bank's policy, we’ve explained that we make the final judgment on whether something is a model. If we believe that a risk is being taken with a model, we indicate that something needs to be changed.”

Some of the models will likely be implemented through vendor systems. How do you deal with that in terms of validation?

“The regulations are clear about this: as a bank, you need to fully understand all your models. We have developed a vast majority of the models internally. In addition, we have market systems for which large platforms have been created by external parties. So, we are certainly also looking at these vendor systems, but they require a different approach. With these models you look at how you parametrize – which test should be done with it exactly? The control capabilities of these systems are very different. We're therefore looking at them, but they have other points of interest. For example, we perform shadow calculations to validate the results.”

How do you include the more qualitative elements in the validation of a risk model?

“There are models that include a large component from an expert who makes a certain assessment of his expertise based on one or more assumptions. That input comes from the business itself; we don't have it in the models and we can't control it mathematically. At MoRM, we try to capture which assumptions have been made by which experts. Since there is more risk in this, we are making more demands on the process by which the assumptions are made. In addition, the model outcome is generally input for the bank's decision. So, when the model concludes something, the risk associated with the assumptions will always be considered and assessed in a meeting to decide what we actually do as a bank. But there is still a risk in that.”

How do you ensure that the output from models is applied correctly?

“We try to overcome this by the obligation to include the use of the model in the documentation. For example, we have a model for IFRS 9 where we have to indicate that we also use it for stress testing. We know the internal route of the model in the decision-making of the bank. And that's a dynamic process; there are models that are developed and used for other purposes three years later. Validation is therefore much more than a mathematical exercise to see how the numbers fall apart.”

Typically, the approach is to develop first, then validate. Not every model will get a ‘validation stamp’. This can mean that a model is rejected after a large amount of work has been done. How can you prevent this?

“That is indeed a concrete problem. There are cases where a lot of work has been put into the development of a new model that was rejected at the last minute. That's a shame as a company. On the one hand, as a validation department, you have to remain independent. On the other hand, you have to be able to work efficiently in a chain. These points can be contradictory, so we try to live up to both by looking at the assumptions of modeling at an early stage. In our Model Life Cycle we have described that when developing models, the modeler or owner has to report to the committee that determines whether something can or can’t. They study both the technical and the business side. Validation can therefore play a purer role in determining whether or not something is technically good.”

To be able to better determine the impact of risks, models are becoming increasingly complex. Machine learning seems to be a solution to manage this, to what extent can it?

“As a human being, we can’t judge datasets of a certain size – you then need statistical models and summaries. We talk a lot about machine learning and its regulatory requirements, particularly with our operational risk department. We then also look at situations in which the algorithm decides. The requirements are clearly formulated, but implementation is more difficult – after all, a decision must always be explainable. So, in the end it is people who make the decisions and therefore control the buttons.”

To what extent does the use of machine learning models lead to validation issues?

“Seventy to eighty percent of what we model and validate within the bank is bound by regulation – you can't apply machine learning to that. The kind of machine learning that is emerging now is much more on the business side – how do you find better customers, how do you get cross-selling? You need a framework for that; if you have a new machine learning model, what risks do you see in it and what can you do about it? How do you make sure your model follows the rules? For example, there is a rule that you can't refuse mortgages based on someone's zip code, and in the traditional models that’s well in sight. However, with machine learning, you don't really see what's going on ‘under the hood’. That's a new risk type that we need to include in our frameworks. Another application is that we use our own machine learning models as challenger models for those we get delivered from modeling. This way we can see whether it results in the same or other drivers, or we get more information from the data than the modelers can extract.”

How important is documentation in this?

“Very important. From a validation point of view, it’s always action point number one for all models. It’s part of the checklist, even before a model can be validated by us at all. We have to check on it and be strict about it. But particularly with the bigger models and lending, the usefulness and need for documentation is permeated.”

Finally, what makes it so much fun to work in the field of model risk management?

“The role of data and models in the financial industry is increasing. It's not always rewarding; we need to point out where things go wrong – in that sense we are the dentist of the company. There is a risk that we’re driven too much by statistics and data. That's why we challenge our people to talk to the business and to think strategically. At the same time, many risks are still managed insufficiently – it requires more structure than we have now. For model risk management, I have a clear idea of what we need to do to make it stronger in the future. And that's a great challenge.”

According to Constant Thoolen, global head of financial risk at ING, the Accelerating Think Forward strategy, an updated version of the Think Forward strategy that they just call ATF, comprises several different elements.

"Standardization is a very important one. And from standardization comes scalability and comparability. To facilitate this standardization within the financial risk management team, and thus achieve the required level of efficiency, as a bank we first had to make substantial investments so we could reap greater cost savings further down the road."

And how exactly did ING translate this into financial risk management?

Thoolen: "Obviously, there are different facets to that risk, which permeates through all business lines. The interest rate risk in the banking book, or IRRBB, is a very important part of this. Alongside the interest rate risk in trading activities, the IRRBB represents an important risk for all business lines. Given the importance of this type of risk, and the changing regulatory complexion, we decided to start up an internal IRRBB program."

So the challenge facing the bank was how to develop a consistent framework in benchmarking and reporting the interest rate risk?

"The ATF strategy has set requirements for the consistency and standardization of tooling," explains Gilbert van Iersel, head of financial risk analysis. "On the one hand, our in-house QRM program ties in with this. We are currently rolling out a central system for our ALM activities, such as analyses and risk measurements—not only from a risk perspective but from a finance one too. Within the context of the IRRBB program, we also started to apply this level of standardization and consistency throughout the risk-management framework and the policy around it. We’re doing so by tackling standardization in terms of definitions, such as: what do we understand by interest rate risk, and what do benchmarks like earnings-at-risk or NII-at-risk actually mean? It’s all about how we measure and what assumptions we should make."

What role did international regulations play in all this?

Van Iersel: "An important one. The whole thing was strengthened by new IRRBB guidelines published by the EBA in 2015. It reconciled the ATF strategy with external guidelines, which prompted us to start up the IRRBB program."

So regulations served as a catalyst?

Thoolen: "Yes indeed. But in addition to serving as a foothold, the regulations, along with many changes and additional requirements in this area, also posed a challenge. Above all, it remains in a state of flux, thanks to Basel, the EBA, and supervision by the ECB. On the one hand, it’s true that we had expected the changes, because IRRBB discussions had been going on for some time. On the other hand, developments in the regulatory landscape surrounding IRRBB followed one another quite quickly. This is also different from the implementation of Basel II or III, which typically require a preparation and phasing-in period of a few years. That doesn’t apply here because we have to quickly comply with the new guidelines."

Did the European regulations help deliver the standardization that ING sought as an international bank?

Thoolen: "The shift from local to European supervision probably increased our need for standardization and consistency. We had national supervisors in the relevant countries, each supervising in their own way, with their own requirements and methodologies. The ECB checked out all these methodologies and created best practices on what they found. Now we have to deal with regulations that take in all Eurozone countries, which are also countries in which ING is active. Consequently, we are perfectly capable of making comparisons between the implementation of the ALM policy in the different countries. Above all, the associated risks are high on the agenda of policymakers and supervisors."

Van Iersel: "We have also used these standards in setting up a central treasury organization, for example, which is also complementary to the consistency and standardization process."

Thoolen: "But we’d already set the further integration of the various business units in motion, before the new regulations came into force. What’s more, we still have to deal with local legislation in the countries in which we operate outside Europe, such as Australia, Singapore, and the US. Our ideal world would be one in which we have one standard for our calculations everywhere."

What changed in the bank’s risk appetite as a result of this changing environment and the new strategy?

Van Iersel: "Based on newly defined benchmarks, we’ve redefined and shaped our risk appetite as a component part of the strategic program. In the risk appetite process we’ve clarified the difference between how ING wants to manage the IRRBB internally and how the regulator views the type of risk. As a bank, you have to comply with the so-called standard outlier test when it comes to the IRRBB. The benchmark commonly employed for this is the economic value of equity, which is value-based. Within the IRRBB, you can look at the interest rate risk from a value or an income perspective. Both are important, but they occasionally work against one another too. As a bank, we’ve made a choice between them. For us, a constant stream of income was the most important benchmark in defining our interest rate risk strategy, because that’s what is translated to the bottom line of the results that we post. Alongside our internal decision to focus more closely on income and stabilize it, the regulator opted to take a mainly value-based approach. We have explicitly incorporated this distinction in our risk appetite statements. It’s all based on our new strategy; in other words, what we are striving for as a bank and what will be the repercussions for our interest rate risk management. It’s from there that we define the different risk benchmarks."

Which other types of risk does the bank look at and how do they relate to the interest rate risk?

Van Iersel: “From the financial risk perspective, you also have to take into account aspects like credit spreads, changes in the creditworthiness of counterparties, as well as market-related risks in share prices and foreign exchange rates. Given that all these collectively influence our profitability and solvency position, they are also reflected in the Core Tier I ratio. There is a clear link to be seen there between the risk appetite for IRRBB and the overall risk appetite that we as a bank have defined. IRRBB is a component part of the whole, so there’s a certain amount of interaction between them to be considered; in other words, how does the interest rate risk measure up to the credit risk? On top of that, you have to decide where to deploy your valuable capacity. All this has been made clearer in this program.”

Does this mean that every change in the market can be accommodated by adjusting the risk appetite?

Thoolen: “Changing behavior can indeed influence risks and change the risk appetite, although not necessarily. But it can certainly lead to a different use of risk. Moreover, IFRS 9 has changed the accounting standards. Because the Core Tier 1 ratio is based on the accounting standard, these IFRS 9 changes determine the available capital too. If IFRS 9 changes the playing field, it also exerts an influence on certain risk benchmarks.”

In addition to setting up a consistent framework, the standardization of the models used by the different parts of ING was also important. How does ING approach the selection and development of these models?

Thoolen: “With this in mind, we’ve set up a structure with the various business units that we collaborate with from a financial risk perspective. We pay close attention to whether a model is applicable in the environment in which it’s used. In other words, is it a good fit with what’s happening in the market, does it cover all the risks as you see them, and does it have the necessary harmony with the ALM system? In this way, we want to establish optimum modeling for savings or the repayment risk of mortgages, for example.”

But does that also work for an international bank with substantial portfolios in very different countries?

Thoolen: “While there is model standardization, there is no market standardization. Different countries have their own product combinations and, outside the context of IRRBB, have to comply with regulations that differ from other countries. A savings product in the Netherlands will differ from a savings product in Belgium, for example. It’s difficult to define a one-size-fits-all model because the working of one market can be much more specific than another—particularly when it comes to regulations governing retail and wholesale. This sometimes makes standardization more difficult to apply. The challenge lies in the fact that every country and every market is specific, and the differences have to be reconciled in the model.”

Van Iersel: “The model was designed to measure risks as well as possible and to support the business to make good decisions. Having a consistent risk appetite framework can also make certain differences between countries or activities more visible. In Australia, for example, many more floating-rate mortgages are sold than here in the Netherlands, and this alters the sensitivity of the bank’s net interest income when the interest rate changes. Risk appetite statements must facilitate such differences.”

To what extent does the use of machine learning models lead to validation issues?

“Seventy to eighty percent of what we model and validate within the bank is bound by regulation – you can't apply machine learning to that. The kind of machine learning that is emerging now is much more on the business side – how do you find better customers, how do you get cross-selling? You need a framework for that; if you have a new machine learning model, what risks do you see in it and what can you do about it? How do you make sure your model follows the rules? For example, there is a rule that you can't refuse mortgages based on someone's zip code, and in the traditional models that’s well in sight. However, with machine learning, you don't really see what's going on ‘under the hood’. That's a new risk type that we need to include in our frameworks. Another application is that we use our own machine learning models as challenger models for those we get delivered from modeling. This way we can see whether it results in the same or other drivers, or we get more information from the data than the modelers can extract.”

Thoolen: “But opting for a single ALM system imposes this model standardization on you and ensures that, once it’s integrated, it will immediately comply with many conditions. The process is still ongoing, but it’s a good fit with the standardization and consistency that we’re aiming for.”

In conjunction with the changing regulatory environment, the Accelerating Think Forward Strategy formed the backdrop for a major collaboration with Zanders: the IRRBB project. In the context of this project, Zanders researched the extent to which the bank’s interest rate risk framework complied with the changing regulations. The framework also assessed ING’s new interest rate risk benchmarks and best practices. Based on the choices made by the bank, Zanders helped improve and implement the new framework and standardized models in a central risk management system.

Six years ago, in the middle of the challenging days of a new-born financial crisis, Anadolubank Nederland N.V. entered the Dutch market. Looking back, the bank didn’t seem to suffer much from those challenges and managed to grow steadily. However, during that process, it became clear that the bank needed to bring its risk management framework to the next, higher level.

The parent bank, Anadolubank A.S., was established in Turkey in 1996. Nowadays it is a well-known middle-sized bank with 2,100 employees, providing credits for small and medium-sized businesses. On entering the Dutch market in 2008, the bank had a challenging start but its results steadily improved and it expanded from 15 to 35 employees. The growth meant that more and more projects needed to be managed while banking regulations were intensified.
“We didn’t have all the expertise readily available to deal with the latest developments,” says Nuriye Plotkin, managing director with responsibility for risk management at Anadolubank. “Larger banks have invested heavily and therefore have more mature risk management frameworks.” For the implementation of a comprehensive risk management framework, the bank was looking for more advice and support.

Three phases

In late 2012, we invited six different parties to be interviewed about their ideas and to get an impression of their approach. We chose Zanders because it was clear that they knew the Dutch market and regulation very well, while showing a good understanding of the specific risk aspects of our bank – so this met our needs.

Nuriye Plotkin, managing director with responsibility for risk management at Anadolubank.

As a result, in January 2013, the ‘Risk Management Review’ project was initiated, covering three consecutive phases. In the first phase, completed in March, Zanders performed a scan of the risk management framework. The detailed review of the existing situation resulted in a number of recommendations for further improvements. “It showed exactly what we were missing,” says Mrs. Plotkin. The completion of the second phase provided a risk governance and policy update, which was approved by both the bank’s management board and supervisory board. The main objective of the third phase, which started in July 2013, was to improve and implement the risk models and corresponding risk reports. A practical approach was adopted that dealt with the most relevant items, in line with current best market practices and took into account the limited size of, and capacity within, Anadolubank.

“For instance, a model was developed that forecasts future cash flows for various purposes, such as interest rate and liquidity risk analysis, including the expected behavior of our savings portfolios,” Mrs. Plotkin says. Charles Zondag, executive consultant at Zanders, adds: “Many elements played a role in the project. As a small bank, you need to be flexible; continuously balancing between the importance and consequences of relevant topics, in order to make the right decisions.”

This last phase of the project was completed in November 2013. During the entire project, Zanders partner Jaap Karelse was impressed by the way Anadolubank worked.

A small but fast-growing company like Anadolubank has to deal with a lot of challenges. Regulators, the parent company, and customers all demand fast follow-up to their requests. But everyone at Anadolubank was so dedicated and worked incredibly hard – it was really impressive to see.

Jaap Karelse, Partner at Zanders.

Comprehensive

The bank’s steering committee continuously monitored and evaluated the project and took appropriate steps where necessary. The project team members, consisting of both Anadolubank employees and Zanders consultants, met on a bi-weekly basis to discuss the progress of the various deliverables, identify action points, and update the planning. “We are a small, new bank with new people entering the organization throughout the year. So you have to set clear standards. And this project helped us to do so,” Mrs. Plotkin emphasizes.

Anadolubank’s Lütfi Öztürker, who was responsible for all credit risk activities within the project, agrees: “In the past, the bank primarily relied on its banking experience. Now we have a written framework with guidelines for our day-to-day credit risk management operations. If you have a problem or a specific risk issue, we know how to best handle it. It’s clearer for everybody in the organization now.”

His colleague Ersoy Erturk adds: “As we mentioned in the beginning, the financial sector has been the most influenced by the volatile conditions of the financial crisis. In order to promote confidence among financial institution stakeholders – including regulators, supervisors, and shareholders – the bank must endorse strong risk management within their organization. This project was embraced by all team members. In our experience, behind the success of the project we have both a top-down and a bottom-up approach – risk management is mandated and supported from senior management, and each team member is empowered to speak up and take action.”

Turkish differences

“Risk management is a very deep and wide field of expertise,” adds Efsun Degertekin, risk manager at Anadolubank. “It is not easy to implement a framework into a growing organization that can deal with many changing elements in regulation and the current market.”
Besides that, the Dutch business differs from the Turkish one, adds Mrs. Plotkin. Both the parent bank and Dutch subsidiary have corporate clients. Mr. Öztürker points out: “In terms of credit assessment, both banks are conservative. But in the Netherlands, we work with larger international corporates sensitive to interest rates, while our parent bank prefers small- and medium-sized enterprises.” According to Mr. Öztürker, the main issue is the difference in regulation. “For a foreign bank in the Netherlands, that is a challenge. You have to adapt your strategies in a short period because of the different regulations. For the Turkish head office, however, this also brings useful know-how.”

Conservative approach

What about competition with other Turkish banks? Mrs. Plotkin notes: “Anadolubank’s principal strategy is to continue healthy growth in each line of business and capitalize on the growth potential of the Dutch market.” The bank achieved this growth while maintaining its conservative credit approval processes although in the corporate lending business the competition is high.
“Anadolubank has adopted a different but prudent and conservative lending approach since establishment,” Mr. Öztürker adds. “Risk management is primarily associated with the flexibility of organizational structures. Reacting in different ways and responding quickly in spite of changing conditions is a flexible approach. And both banks, parent and Anadolubank N.V., have a conservative approach but adaptive capacity.”

Future steps

For Anadolubank, 2014 will have additional challenges, says Mrs. Plotkin. “We plan to improve the reporting system. We received more feedback than we expected from Zanders. We learned a lot during the project.”
Mr. Öztürker adds: “It was a time issue to finish all items, but we managed it. And we now have the necessary know-how to scope all remaining items.”

What are Anadolubank’s plans for the next five years? Mrs. Plotkin explains: “First, we get started in the right direction and we need to stay on track. Our objective is to maintain a dynamic risk management framework to ensure we profoundly address regulatory challenges and the changing economic environment.”

In the 150 years of its existence, Swiss Re has grown to be one of the world’s largest providers of reinsurance and insurance-based forms of risk transfer. Reinsurers are mostly associated with insurance for extreme loss events, such as natural catastrophes. However, Swiss Re’s services cover the entire insurance spectrum: Swiss Re is the counterparty to risks which primary insurance companies and large corporates decide to mitigate.

Liquidity risk

Usually, liquidity is not the first topic that comes to mind as a key risk for reinsurance companies. “The general view was, and kind of still is, that reinsurance companies do not run a lot of liquidity risk, like a bank,” Martin Ramseyer says. For banks, the main driver of liquidity risk is a sudden customer run on deposits. The risk for reinsurers is rather that claims can reach the order of billions, sometimes to be paid out at short notice relative to the magnitude. If sufficient assets cannot be liquidated at a reasonable price within the required time frame, the company not only puts its reputation at stake but also risks bankruptcy – regardless of its solvency or profitability.

From a capital perspective, expanding services across businesses yields a risk diversification benefit. But that benefit does not extend to liquidity, Ramseyer clarifies: “There are many legal limitations imposed by different jurisdictions that limit our abilities to move assets between subsidiaries within the group.” A joint effort of risk and treasury was initiated several years ago to create a framework to measure and manage funding liquidity risk. Initially, the primary objective was to identify potential liquidity constraints for the major legal entities. Calculations gradually grew more extensive, and the framework evolved into an important scenario analysis mechanism used to support executive management decisions. Its execution had become time-consuming, and the operational risk inherent in manual calculations increasingly relevant. The time was ripe to streamline and automate liquidity risk analysis and the reporting process. Andreas Tonn became the business project manager for the system selection and implementation.

Implementation

The choice was made for a vendor solution. “The core advantage is that they provide a framework, which reduces implementation time and facilitates the translation of needs into requirements,” Tonn says. “But as you will never find the perfect tool, it is important to have a clear focus.” Liquidity risk measurement models for the insurance business in vendor systems are still in evolution phase. Flexibility was therefore a key priority for Swiss Re, as the majority of the logic needed to be implemented from scratch. Swiss Re embarked on an intensive proof-of-concept phase, and asked vendors to provide a working demonstration that addressed all aspects of its liquidity risk framework. They chose Wolters Kluwer’s RiskPro, as it proved both mature and sufficiently flexible at the same time.

A phased implementation approach was chosen to gradually introduce the solution into the reporting cycle. However, after the first release, it became apparent the project team would need additional business support if it was to cover all the aspects thoroughly within the stated time frame. “Our internal resources were too committed to other tasks and could not provide support to the extent an intensive project requires,” Tonn says, “but external resources are actually only beneficial to a project if they bring the right expertise to the table.” There were very positive experiences with Zanders on other treasury projects so a request was made for support.

Jeroen van der Heide from Zanders was asked to join the project team: “His ample experience with functional design of various systems across risk domains convinced us that he would indeed accelerate our project.”

Andreas Tonn, business project manager for the system selection and implementation

Challenges

As with many system implementations, getting the data delivered in a systematic fashion was a challenge: different departments have different priorities and downstream reporting is often not on top of their list. Afterwards, the interpretation for modeling was not always clear either as it was complicated by the global reach of the company in which data ownership spans across time zones. For example, intra-group funding was previously measured using a net aggregate approach. With the implementation of RiskPro, the choice made sense to model each debt contract based on its characteristics as booked in the system. Understanding how to calculate the impact of all implicit options automatically for different scenarios required detailed discussions across teams and continents.

The project team has worked relentlessly during the past year in close cooperation with business and IT colleagues. A total of six minor and major releases were accomplished, during which the necessary data and calculations with respect to investments, collateral, reinsurance portfolios, debt, internal cash flows, and contingent funding requirements were added to the system. The RiskPro results were embedded in existing reporting templates, and the change analysis process between reporting dates was partly automated. They were very satisfied with the Zanders support: “Of great benefit was Jeroen’s talent to quickly gain insight out of a huge amount of information, and present the newly created results in such a way to make them understandable to the business user and fit right into existing business processes. That has been a very valuable business contribution.”

Looking towards the future

With the system up and running, the team is able to provide reporting and analytics for the major legal entities within the group and across business segments and branches, rather than only for those with the largest impact from a risk perspective. “It allows us to understand and represent the liquidity dynamics in a more systematic way across the group,” Ramseyer says. The next step is to increase the quantity and quality of the information flow between local business units and treasury. “It will really enhance the risk awareness of local boards and empower them in their active steering efforts. With their feedback they will help improve the framework in return.”

Developments within Treasury Business Services don’t stop there. The system contains the vast majority of Swiss Re’s economic balance sheet down to the transaction and cash flow level. “The vendor software is designed to be an integrated risk system. With the market data and contract data available in full detail, we have a suitable basis to extend the scope of the solution to other domains,” Tonn says. The plan for the next two years, therefore, is to gradually support other analyses, for example with respect to currency risk, funding cost, liquidity planning, and ALM. The consistency between and efficiency of the analyses will improve, enabling the treasury teams to dedicate more time to proactive analysis and steering. Zanders will continue to support these efforts: “Given his successful contribution to the project and his interest to continue to support Swiss Re, we asked Jeroen to manage next year’s project,” Tonn says, “But first things first: we are very much looking forward to the daily use of the implemented solution.”

The Dutch cabinet is implementing three transitions in the social domain: the introduction of the Participatiewet (the participation act); the transition of youth care; and the migration of the AWBZ (the general act for extraordinary sickness costs) and personal care to the WMO (the social support act). The integrated approach that the cabinet has in mind will ensure that professionals from different agencies coordinate their provision of social support for individuals and families. Dutch municipalities are preparing for the crucial role they will play in all this. And that includes the municipalities of Hardenberg and Ommen, which, through a joint department known as the Ommen-Hardenberg administrative service, are working on the implementation of these transitions.

Coherence

Annette Wittich has a financial background and is department head of the Maatschappelijk or ‘social’ Domain (known as MD) at the administrative department (‘Bestuursdienst’). “The challenge we faced was how we as municipalities could realize budgetary benefits and efficiency gains by taking a different view of the existing problems,” she says. “We are responsible for huge amounts of money and are expected to hit major targets, so the choices we have to make cannot be based solely on experience. In what is essentially a politically sensitive environment there is a pressing need for good-quality, well-founded decision-making, with sound coherence between the various policy areas.” It’s difficult to keep track of a lot of what this involves for the municipalities, particularly in financial terms. “That’s why we were looking for an instrument that will enable us to provide good support for the two municipalities in our policy choices,” she adds.

Wittich was familiar with Zanders’ services and she recognized the affinity between the models that Zanders works with and the financial repercussions of the transitions. So she contacted consultant Charles Zondag to sound him out on the financial challenges and the possibilities of applying a calculation model to the transitions taking place in the social domain.

These transitions are difficult for municipalities to quantify, there was a need for something new, something outside the ‘old’ box.

Charles Zondag, Business Associate at Zanders.

Together with fellow consultant, Sylvia Temminck, Zondag discussed the matter with Wittich and her colleagues. Plans for constructing a model capable of mapping the whole complex situation started taking shape.

Better informed decisions

As a councillor of the municipality of Hardenberg, René de Vent embraced the MD’s ideas. “These social domain transitions will mean that municipalities will have a lot on their hands,” he cautions. “We want to know exactly what and who we are talking about, which is why we decided to tackle it with this social domain transition project. Using a form of social database we want to establish the various areas and how they correlate with each other. This will then make it clear which policy-influencing ‘knobs’ we can adjust and what the consequences will be.” It will enable both municipalities to make better-informed decisions. Ommen councillor Ko Scheele was also quick to see the potential of the initiative: “The transitions will give municipalities more room for their own interpretation of the policy. To a much greater extent than before, we’ll have to know exactly what we’re talking about. We’re now taking stock of the complete situation so we can make more informed decisions. Measures pertaining to the social domain often affect one another; if you remove something in one place it pops up in another form somewhere else. We want the calculation model to make things clear so we can define a well-thought-out policy for our citizens.”

De Vent adds: “We don’t just want to do things well; we also want to do the right things. This is important because it concerns policy that affects people very directly and often vulnerable groups too. It has to be handled carefully. If we organize the information properly, we’ll be optimally placed to define the policy so that we can exploit the opportunities and possibilities that these transitions offer municipalities. We’ll then be in a position to steer them more effectively.” Both municipalities mainly want a model they can adjust to their own needs and one that will help them make informed decisions without requiring specific external knowledge.

New approaches

The next step is for the model to map out the financial repercussions in several policy areas for a change in one of them. “A cut in education spending, for example, could lead to more youth unemployment and thus higher costs in benefits and allowances,” explains Temminck. In other words, a saving in one area can mean having to spend more in another. Zondag says: “Developing this kind of dynamic calls for a combination of substantive knowledge of the relevant policy areas and technical modeling. That’s the cool thing about this project: it bridges two often-contrasting disciplines that are rarely associated with one another. For both the municipalities and for Zanders this project goes far beyond ‘taking a peek in the neighbor’s kitchen’.”

The model will eventually have to accommodate a total of 20 different areas of social services. During special workshops policy staff will provide input for the calculation model, both for their own and related disciplines. Then as it fleshes out it will grow in complexity, and be extended to other areas. This summer saw the development of the model’s ninth area. The end result cannot yet be exactly predicted.

“However, the results so far are already making a positive contribution to the solution for the problem,” says Wittich. “The framework has been put in place, we liaise on a regular basis and there is already a first spinoff: we’re getting questions from all sorts of new perspectives. I think this has everything to do with the workshop approach. We’re taking smaller steps and paying attention to details that a municipality sometimes misses. Thanks to this modeled approach employees are being confronted by the repercussions of their own activities - and thinking about them differently.” This last factor, according to Jaap van Middelkoop, who leads the social domain transitions project on behalf of the administrative service, is exactly what differentiates it from all previous initiatives carried out within the municipalities. “Many municipalities are looking in this direction so as to get a good all-round picture,” he says, “but this working method helps us stand out. We’re going into specific detail and talking to our people to learn about their work. They, in turn, get a keener sense that they are part of a larger whole and that their work is not isolated. This is a big help in finding links between the different parts and defining an integrated policy.” Moreover, rather than focusing exclusively on cuts, the project tries to apply policy changes as intelligently as possible, given a tighter budget. “Employees are enthusiastic about this innovative approach to extrapolating changes,” says Middelkoop. “They are more committed and, what’s more, they don’t just focus on their own expertise, but come up with ideas and new approaches for all the transitions.”

In terms of interpreting the model, Wittich sees it as an advantage that Zondag and Temminck, as external advisers, are relatively unfamiliar with council work. “It draws you further out of your comfort zone and enables you to make more reasoned and objective assessments. We are often asked surprising questions that really get us thinking.”

Act quickly

The model’s various areas differ from one another in depth and complexity. “Before investigating a particular area, there’s no way of knowing how deep it might go,” says Temminck. “You don’t know how many links there will be either, although it does become clearer with time.” Examples of the areas concerned include minimum-income policy, debt counseling, and transport. Van Middelkoop notes: “Transport is a good example of an area that pops up across the board. We treat it as a connecting area. Areas like WMO and WSW (the sheltered employment act) each have their own transport component. The aim is to work more effectively and make substantial collective savings on all transport components.”

“With an area like transport it’s important that you can see the connections because relevant measures need to be taken quickly,” adds Wittich. The transitions will start in 2015, but we must take a number of measures in 2014. From January 1, 2015, municipalities will assume responsibility for all transport, with the exception of patient transport that is, because the government has decided we can do it better and cheaper. But we’ll need to act quickly because ongoing contracts with external parties are affected and they will have to be checked and acted on in a timely manner. Later in the year we want to use the calculation model to demonstrate to municipal bodies how we see the transitions, along with their associated cross-linkages.”

The link between social databanks and the calculation model will also become clearer. “We’ll be able to correlate the model’s results with the social databanks, even at district level. It fits in well with what we need to know in that area,” says Ingrid Schepers, an employee working on the social domain transitions project.

Dialogue with other municipalities

One of the problems the administrative service anticipates is how to achieve a nuanced focus on the deluge of decisions that will have to be taken if austerity targets are to be met. A municipality has to contend with administrative elements to a far greater degree than a company does, for example. Finances, in conjunction with legislation, are what define the constraints. “But it’s not just a matter of dealing with constraints,” insists Wittich. “Investing in one project can also make other projects more efficient, and now policy makers will actually be able to demonstrate this.”

In Wittich’s view, working with the model will also help in other areas of decision-making. “It will enable the council to present proposals in different, more transparent ways."Fwitii

Annette Wittich, department head of the Maatschappelijk.

With policy proposals, for example, ones that are substantiated on the basis of all sorts of variables, drawn from different scenarios. Whereas it used to be mainly down to the policy makers, executive employees are now much more involved. Policy makers still come up with the ideas, but now their financial repercussions are tested.” So thanks to the model, councillors will be able to take more-informed decisions. Wittich adds: “Councillors’ choices are based on their political leanings. Obviously, this will affect the available budget because it could mean you’d no longer be able to finance other important things. Now, thanks to the model, they will be confronted with those financial repercussions.”

This is why she feels it would be a good idea if other municipalities also used it. “The Dutch Home Office is actually a proponent of entering into dialogue with other municipalities about this. The formation of the Ommen-Hardenberg administrative service means that the MD department is working for two municipalities, each with its own political standpoints and preferences. By using this model, we are comparing two municipalities with each other in terms of implementation and standpoints. In conjunction with the social databases, the calculation model gives us a sounder and more objective basis for policy development.

In the Netherlands of the eighteenth century, a diverse range of regional funds was set up to reduce the risk of setbacks in certain professions or in vulnerable regions. Two national life insurance companies, De Nederlanden van 1845 and Nationale Levensverzekering-Bank, over the course of the nineteenth and twentieth centuries, took over many of these funds. In 1963, these two large insurance companies merged, creating Nationale-Nederlanden. Due to the strong financial position acquired by this new company, it continued to grow abroad, particularly in the United States. As of last year, the products supplied by the Dutch insurance company RVS, which was acquired in 1984, also form part of the Nationale-Nederlanden brand. Nationale-Nederlanden now has over five million private and commercial customers who are using a broad package of financial products and services, such as pension plans, life insurance, non-life insurance, and income insurance. Nationale-Nederlanden has recently also started offering bank savings products and mortgages.

Uncoupled

The idea of starting up a bank arose in response to market trends observed in recent years: the life insurance market continued to shrink, while the bank savings market, on the contrary, was expanding. Prior to this, Dutch insurance companies had been able to offer tax-related and wealth creation products for years. In 2008, a new legislative proposal eliminated the monopoly held by insurance companies on such products. This opened up a very lucrative market for banks. At the same time, Nationale-Nederlanden, which formed part of the huge ING enterprise, did not have the independence required to provide such bank savings products. Then the European Commission ruled that ING, with its government support, was required to uncouple its insurance business from its banking operations. This meant that offering bank savings products became an attractive possibility. At the same time, it made it possible to offset the increasingly contracting life insurance portfolio with the new bank savings portfolio.

“While we had a financial background as an insurance company, we did not have a banking background,” says Peter Verberne, CFRO of the Nationale-Nederlanden Bank. “Banking is completely different from insuring. The complexity associated with banking requires proper management. This is why we asked Zanders to advise and guide us in this area. For example, when the time came for us to apply for permits from De Nederlandsche Bank (DNB), after we had developed our bank savings products. “The earning model for a bank requires you to have sufficient size in order to be viable and operate with a profit.”

The consultants [from Zanders] developed the bank’s risk management system for us. This made the complex risk management subject matter very transparent and tangible without detracting from its complexity.

Peter Verberne, CFRO of the Nationale-Nederlanden Bank

Volume Ahead of Profit

The collaboration with Zanders started approximately two years ago. In June 2011, DNB granted Nationale-Nederlanden permission to start up a bank. Finally, after making provisions for the legislated capital requirements, the company opened up its banking savings products counter in the third quarter of 2011. The new bank commenced by offering golden handshake-related products and products for the annuity market.

At that point, Nationale-Nederlanden, as a bank, was also required to start offering credit products on the Dutch market. This resulted in the creation of the Nationale-Nederlanden Bank’s mortgage arm in the first half of 2012.

Verberne says: “This is an entirely different discipline from collecting savings. We therefore prepared a number of acceptance criteria and adjusted the risk management system to incorporate the risks that apply to the granting of loans. The program that emerged from this has been used for providing mortgages since the third quarter of 2012.” The management of the core mortgage lending processes was contracted out to a third party.

“However, as an entity, you must look after the risk management process in-house,” Verberne continues. “The financial risk management, the credit risk management, the operational risk management, compliance – we outsource as much as possible, but the core functions are carried out within the bank, including risk management in its broadest sense.”

When we took our first steps on the banking market, volume was a key factor. “The earning model for a bank requires you to have sufficient size in order to be viable and operate with a profit,” Verberne explains. “This is why we wanted to offer regular savings in addition to bank savings, and this is why we will be introducing two additional regular savings products in the near future. Zanders also designed the risk management systems here. The volumes that the Nationale-Nederlanden Bank is aiming to achieve with these savings products are significantly higher than with bank savings. We are aiming to become a serious player on the savings market within a short period of time. The basic principle remains that we will continue to offer simple banking products. In other words, straightforward banking with what-you-see-is-what-you-get products.”

Transparent Products

What is the situation with respect to the new competitive position in relation to ING? Verberne explains: “Our mortgages and savings products mean that we already compete with ING. We pursue an independent pricing policy in this respect. Furthermore, Nationale-Nederlanden is one of the best-known and strongest financial brands that is simply offering a far more extensive range of services.” “By leaving out the bells and whistles, we can offer a more competitive rate.”

“In addition, there is currently also a trend for increasingly simple products,” says Yvonne Sijm, a Zanders consultant. “Especially private customers opting for wealth creation products, for example for their pension, can now obtain such products not only from their insurance company, but also from their bank. At a bank, this is far more transparent because, in contrast to an insurance company, you do not pay a risk premium. Private customers opt for these transparent products, and this is why you are now seeing a shift to more straightforward banking products.”

The insurers of pension and life insurance products are most affected by this trend. The non-life and term life insurance sectors still have a clear raison d’être. A financial institution is required to provide transparency and to be straightforward, but at the same time, the customer wants security. What the customer is prepared to pay for the risks the company takes therefore also comes into play. “This is a difficult issue,” says Verberne. “You have to offer customers an interest-rate refixing period, which affects your own interest rate risk. This also applies to mortgages. While you can add a lot of bells and whistles to these products, they all carry risk, and these risks come at a price. On the other hand, by leaving out these bells and whistles, we can offer a more competitive rate.”

Risk Horizon

With the help of the Nationale-Nederlanden’s strong name, the bank must take its planned powerful steps into the banking market. Life insurance policies were traditionally primarily sold via intermediaries. This also applies to bank savings and mortgages, which, in part due to the fiscal aspects of these products, are true financial advice products. In terms of the regular savings products, Nationale-Nederlanden will primarily focus on direct channels.

“The targeted bank savings customers include all Dutch citizens involved in wealth creation,” says Verberne. “For example, these customers may have a maturing annuity policy or want to terminate this policy, but it can also include customers who received a golden handshake when they were dismissed and who want to put it aside or convert it into a payment stream. In terms of the mortgages, this includes all Dutch citizens who are referred to us via their mortgage broker. And for the regular savings products, it can be anyone who wants to save.”

According to Verberne, Zanders has supplied the tools needed to ensure the new entity will work in practice. “This sometimes entailed very practical matters that are the same in the insurance world, but that have been given a different name in the banking world. In addition, the risk horizon considered by an insurer is longer than that of a banker. This can cause misunderstandings, but I think that we have taken a solid step in this area.” The basis for this will be established later this year through a merger with a key component of the Westland-Utrecht Bank. As such, the banking market will have one more player, with a well-known name and a competitive capacity, no matter what happens.

The regulatory changes in the healthcare sector have put smaller establishments with specific care functions in a tight corner. Audiological centers, such as those run by Pento, are among them. In audiological care, the outlay precedes the benefits, yet the bank is setting more stringent financing conditions. How is Pento dealing with this?

The causes of hearing loss are many and varied, from congenital to ‘acquired’ or even psychogenic. Fortunately, thanks to audiological care, there are also many solutions that enable people with hearing impediments to participate in society. The first audiological initiatives in this regard originated in the Netherlands, in the 1960s, when the measurement of hearing using scientific - and therefore reliable - methods became a specialist field in itself. Developments and support in the sphere of language and speech soon followed, because these are closely associated with hearing.

Tensions

In 2007, five audiological centers (AC) decided to merge to form Pento. ‘Penta’ refers to the Greek word for five. There are now six centers and a hearing support service, all located in the central, eastern, and northern areas of the country. Following a referral by a doctor, an AC advises the audiological patient on the appropriate hearing aids and other solutions.

The AC itself does not provide any medical treatment and only employs paramedical staff. Working according to a multidisciplinary approach—which often also involves speech therapy, psychology, and social work—its staff ascertains and analyzes the possible cause of the hearing problem and what can be done about it or offers assistance with the initial use of a hearing aid. The techniques are improving, and hearing impairment is becoming less of a taboo subject.

However, audiological centers too are feeling the effects of the major changes affecting healthcare sector budgets. A free-market system has been introduced along with a new funding system, bringing with it a whole host of changes to the billing process. There are around 30 audiological centers in the Netherlands, a market worth approximately 40 million euros. This means that the audiological sector accounts for less than one percent of the entire healthcare sector. “This is reflected in the tensions that arise whenever you are faced with new government regulations or new policies introduced by health insurers,” explains Jeroen Taalman, director at Pento. “Less account is taken of you. They don’t want to make exceptions to their policies for a small player.” Pento represents a market share of roughly 20% of the audiological sector, making it a big fish in what is a small pond relative to the healthcare sector as a whole. “Consequently, the outside world looks at you differently; people sometimes expect more professionalism in our internal operations than we were able to offer.” The same can be said of Pento’s position and its role as a model within FENAC, the Federation of Dutch Audiological Centers, which represents the centers’ interests. “

In the early years, we took a ‘sticking plaster’ approach to most of our financial decisions,” says Taalman. “So we were often closing the stable door after the horse had bolted, and that was unsustainable. Now, all the necessary arrangements are in place and the structure is clear. We have appointed a financial manager, and an audit committee has been formed, made up of members of the supervisory board. All of which is positive, but our approach remains pragmatic; there are few organizational layers, and we deal with situations as and when they arise. And we are aware that there is a lot more scope for development.”

No capital

What we needed was scenario thinking: what scenarios can we develop for the future and how can we create a future-proof financing structure?

Jeroen Taalman, Director at Pento

The new laws and regulations in the healthcare sector created a quagmire of uncertainties for Pento, chiefly due to the changes in the funding system. “In the space of six months, it all mounted up to such an extent that we felt the ground was slipping away beneath us,” says Taalman. “There were still no contracts in place with health insurers, the fees for each consultation weren’t transparent, and yet we had to calculate the number of consultations we had to reach from a cost perspective. In other words: both the price and the volume were under scrutiny.”

As regards the volume it can achieve, Pento is largely reliant on the referrers, although the law stipulates that various treatments may only be provided by an AC. At the same time, the purchasing ceiling for health insurers means that Pento is only allowed to carry out a maximum number of treatments for a specific fee. Taalman says: “Health insurers are now recognizing that the only way to be able to estimate volume is to form a partnership. The healthcare sector is riddled with inter-dependencies and mutual responsibilities. If we were to suddenly stop or refuse AC care, we would create problems for the health insurer.”

Meanwhile, Pento was contending with another serious financing problem because, until the end of 2011, it was not allowed to build up any equity capital. Under the original funding system, ACs did not generate any profits or losses. Taalman adds: “Being ‘budget-funded’, we had to post a nil result. And if we didn’t, we had to offset the surplus or shortfall against fees the following year. So we were faced with a plethora of rules but weren’t allowed to form any buffers.” This system was dropped in its entirety with effect from 1 January 2012.

Scenario thinking

Back in 2004, FENAC had already warned that if an AC got into financial difficulties, there would be no funds in the coffers to get them out of trouble. Moreover, under the new funding and billing system, ACs would have to finance around half of their annual turnover in advance. Taalman notes: “For a lot of long-term, and therefore expensive, treatments, you can’t send a bill until a year after the first patient visit. So the introduction of a free-market system meant that our bank was also faced with all kinds of uncertainties. As a result, it adopted a very commercially-driven view of us, introducing financial ratios and subjecting them to critical review. A bank expects a certain amount of equity, an order portfolio, and contracts with health insurers. All of which were uncertain factors for us.”

In the spring of 2012, health insurers were locked in negotiations chiefly with the large hospitals. The ACs would follow later. Says Taalman: “They were in no hurry, so we had to ask the bank to keep us afloat. But the bank wasn’t going to readily agree. The bank placed Pento under ‘special management’, setting special, stricter requirements with regard to the provision of information and increasing its risk premiums. We had our backs up against the wall.” Pento felt this problem was becoming too big for it to solve alone. “What we needed was scenario thinking: what scenarios can we develop for the future and how can we create a future-proof financing structure? To do this, you need to bring in outsiders who can think fast and develop models. That’s how we began working with Zanders. It bought us some time with the bank.”

A cure for financial ailments

“Continuity was a very real problem; there were doom scenarios of having to shut down certain Pento centers or services,” says Taalman. “When we were up to our neck in problems, we consciously sought media contact through the newspapers. We were taking a risk, but it opened the health insurers’ eyes. They felt a responsibility to help us.”

During that period, Zanders analyzed the situation and created various scenarios for the financing structure. This went hand in hand with an analysis of internal management and the viability of the Pento organization. The bank then had a clear picture of Pento’s prospects and financing risks. At the same time, Pento was able to conclude contracts with insurers, including a generous advance for the care provided in 2012. These developments earned Pento more time from the bank and led to constructive talks about provisional financing arrangements.

“We were able to work out the impact of the fees and volumes from the contracts on Pento’s liquidity position. Things were soon looking up. In the end, our financial ailments only lasted six months,” Taalman continues. “We now have good arrangements in place with the bank, including regarding the anticipated definitive amount of a residual expense that has to be met in connection with the end of the budget-based funding system, with its adjusted fees. We’re talking a huge sum of money, hardly an amount we can readily afford, so it’s very reassuring that we are now discussing the situation with the bank. It means we can start focusing more on care again, which is our raison d’être.”

Billing for 2012 couldn’t even start until January 2013—a problem affecting the whole of the healthcare sector. Because a new funding and billing system has been introduced, the turnaround times for both healthcare providers and health insurers are even longer. “Billing takes place retrospectively, and yet, historically, Pento has not been able to form any buffers. And that puts huge pressure on your working capital,” explains Zanders’ consultant Marlous Pleijte. “Consequently, agreements have been reached with the bank and the health insurers so that Pento can maintain its working capital at a reasonable level.”

Quality improvements

The agreements have worked for 2012, but the whole palaver is starting again for 2013, says Taalman. “According to the Ministry of Health, Welfare and Sport’s macro-management instrument, from 2010 onwards, the healthcare sector is allowed to grow by a maximum of 2.5% above inflation. The expectation is that we will remain within that limit in 2013, because of the internal budget targets we have set and the highly critical review we have undertaken of our investment policy. Moreover, from 2012 onwards, Pento can build equity capital.”

A number of measures have been taken to enable it to satisfy the bank’s requirements. Pleijte explains: “In the end, we set up a financing structure with a loan portfolio and repayment schedules that work well for Pento, with a clear distinction between working capital and long-term loans. Zanders has also designed some practical tools for managing cash flows and long-term financial planning. Taalman concludes: “This gives us a much better overall picture and, by extension, greater clarity, so we are also better equipped to fulfill our obligations, both internally and vis-à-vis the bank. The result has been a huge improvement in quality. We are now in better shape than ever; business was good last year, and the outlook is healthy. All of which is in stark contrast to the situation a year ago.”

As a bank providing financial services to business enterprises and financial institutions located in North and Sub-Saharan Africa, the Middle East, and the Indian Subcontinent, Banca UBAE relies on accurate and customized credit ratings for its counterparties. While its previous credit rating process didn’t allow for a tailor-made approach, Banca UBAE has recently begun using the EAGLE internal ratings methodology, which gives its credit analysts the transparency and flexibility they need.

The ongoing changes in its markets make counterparty risk assessment more important than ever for Banca UBAE. This Italian bank, headquartered in Rome, has been operating in countries around the Mediterranean and the Middle East since 1972. Trade finance is Banca UBAE’s single most important line of business, and its main products and services include letters of credit, letters of guarantee, discounting, and forfaiting.

In April 2012, the bank implemented the EAGLE corporate rating model, developed by Zanders and available through the FACT web-based platform, developed by Bureau van Dijk.

Customized Ratings

While an external ratings agency such as Fitch Ratings or Standard & Poor’s has a standard and fixed methodology for calculating a rating, Banca UBAE needed a customizable approach, with a tailor-made and transparent credit rating model for each of its counterparties. This is essential considering the specialized and risk-sensitive nature of the bank’s business.

Fabrizia Calvello, a senior credit analyst at Banca UBAE, explains how the bank’s credit analysts customize the counterparty ratings: “In an internal rating, we evaluate qualitative and quantitative information. The analyst is very well acquainted with the client’s core business and balance sheet, as well as the market within which the client operates, so they can insert qualitative data into the internal ratings model.” An important factor is that data is automatically uploaded from the database into the credit rating model. Calvello adds: “For us as a small bank, it is very important to customize the service to our needs.”

Evert de Vries, one of the two Zanders consultants dedicated to the implementation of EAGLE at Banca UBAE, acknowledges that the need for the customized ratings methodology lies in the nature of the bank’s core business. He says: “The bank is working in a challenging environment, so of course it’s very important for them to be able to calculate specific risks.”

Partnership

Considering the specialized nature of Banca UBAE’s business, there was a need for a customizable ratings methodology. The bank had a long-standing working relationship with Bureau van Dijk, a leading publisher of company information and provider of credit risk management solutions. This relationship developed into a regular and established collaboration when, in 2011, Zanders and Bureau van Dijk joined forces to offer a specialized and flexible credit rating product. The EAGLE ratings methodology is based on Bureau van Dijk’s credit risk management platform, FACT, which integrates information from financial databases such as Amadeus.

Thomas Van der Ghinst, business development manager EMEA at Bureau van Dijk, explains how the project was structured and how the elements led to its success: “Zanders was able to customize the standard EAGLE ratings model and calibrate the model according to specific industry sectors – this is one of their strengths. The combination of the Amadeus database, the FACT platform, and the EAGLE credit ratings model makes this a very competitive solution.” He adds: “For me, EAGLE was a perfect fit for Banca UBAE – it met all the requirements of the project goals.”

Bureau van Dijk’s Van der Ghinst also explains that banks often require customizable credit ratings to be more independent from rating agencies. He says: “Working with EAGLE has helped Banca UBAE to better reflect their risk appetite. Internal ratings also help the bank to provide an instant assessment of new clients – this is the key benefit for Banca UBAE. The added value is that you can rate and evaluate companies that don’t have a rating from a rating agency. You can rate any company in the Amadeus database.”

The combination of the Amadeus database, the FACT platform and the EAGLE credit ratings model makes this a very competitive solution.

Jacopo Ribichini, head of the credit department at Banca UBAE.

Smooth Implementation

Banca UBAE implemented EAGLE in April 2012, and the implementation process took about three weeks. So what benefits has Banca UBAE seen since moving to the EAGLE customizable ratings methodology? Jacopo Ribichini, head of the credit department at Banca UBAE, explains: “The product facilitated and sped up the analysis process. At the same time, it became more transparent and precise. The functionality that allows us to adapt the product score from EAGLE with the specific knowledge Banca UBAE has for each customer allows the correct assessment for the commercial relationship our bank has with each counterparty.”

“Furthermore, the product complies with requirements imposed by EU legislation related to risk analysis. The result is a final assessment that is extremely clear, concise, and exhaustive, offering the best conditions for our deliberating bodies to make business decisions,” he adds.

Overall, Ribichini reports that EAGLE had increased the professionalism and efficiency of his department. The implementation was smooth, and Ribichini sums up his thoughts: “Lastly, thanks to the efficient support offered by the Zanders team, I managed the migration to EAGLE without affecting the regular activities carried out by my department.”

Flexibility and Transparency

Reinoud Lyppens, a consultant at Zanders, works with Evert de Vries on the project and adds that other than providing some independence from ratings agencies, EAGLE has two other main advantages: “It is one single platform that enables you to calculate a credit rating for many different industry sectors and counterparties – and, moreover, it is customizable. These two factors were our prime advantages over our competition. We are very open – the model is well documented and validated every year, so I think that transparency is what really makes EAGLE stand out. The client should always understand the process.”

De Vries adds: “Zanders and Bureau van Dijk worked with Banca UBAE throughout the project, not just during implementation but also at later stages, providing advice and support. This post-implementation service is very important in a project like this – when our customer has a question, we are there to support them. We also did some fine-tuning for the oil & gas and commodities sectors for the model. I think the project went well.”

Van der Ghinst adds: “To date, the project has been a real success. The flexibility and professionalism of the Zanders team have resulted in a very positive outcome, which has been appreciated by the client.”

As Banca UBAE is currently expanding and establishing its presence further afield, in Vietnam and Mozambique (as a result of oil & gas exploration), the flexible and transparent internal ratings methodology will be increasingly important to its business.

About Banca UBAE

Banca UBAE, established in 1972 as ‘Unione delle Banche Arabe ed Europee’, is a banking corporation funded by Italian and Arab capital. Shareholders include major banks such as Libyan Foreign Bank, Banque Centrale Populaire, Banque Marocaine du Commerce Extérieur, UniCredit, Intesa Sanpaolo, and large Italian corporate groups like Eni Group, Sansedoni, and Telecom Italia.

Since 1972, Banca UBAE has acted as a trusted consultant and privileged partner for companies and financial institutions wishing to establish or develop commercial, industrial, financial, and economic relations between Europe and countries in North and Sub-Saharan Africa, the Middle East, and the Indian Subcontinent.

Banca UBAE offers a wide range of services and boasts unique expertise in every form of banking relevant to clients engaged in business on Arab markets, from export financing, letters of credit, and documents for collection to finance, syndications of loans and risks, and on-site professional assistance.