Depending on their type, risks fall into the following categories:
- Credit Risk.
- Market Risk.
- Operational Risk.
- Structural Risks.
- Liquidity Risk
There follows a description of the risk measurement systems and tools for each kind of risk.
1.5.1. Credit risk
Credit risk arises from the probability that one party to a financial instrument will fail to meet its contractual obligations for reasons of insolvency or inability to pay and cause a financial loss for the other party. This includes management of counterparty risk, issuer credit risk, liquidation risk and country risk.
BBVA quantifies its credit risk using two main metrics: expected loss (EL) and economic capital (EC). The expected loss reflects the average value of losses and is considered a business cost. Economic capital is the amount of capital considered necessary to cover unexpected losses if actual losses are greater than expected losses.
These risk metrics are combined with information on profitability in value-based management, thus building the profitability-risk binomial into decision-making, from the definition of business strategy to approval of individual loans, price setting, assessment of non-performing portfolios, incentives to areas in the Group, etc.
There are three essential parameters in the process of calculating the EL and EC measurements: the probability of default (PD), loss given default (LGD) and exposure at default (EAD). These are generally estimated using historical information available in the systems. They are assigned to operations and customers according to their characteristics. In this context, the credit rating tools (ratings and scorings) assess the risk in each transaction/customer according to their credit quality by assigning them a score, which is used in assigning risk metrics together with other additional information: transaction seasoning, loan to value ratio, customer segment, etc.
Point 4.5.1.7 of this document details the definitions, methods and data used by the Group to determine the capital requirements for estimating and validating the parameters of probability of default (PD), loss given default (LGD) and exposure at default (EAD).
The credit risk for the BBVA Group's global portfolio is measured through a Portfolio Model that includes the effects of concentration and diversification. The aim is to study the loan book as a whole, and to analyze and capture the effect of the interrelations between the different portfolios.
In addition to enabling a more comprehensive calculation of economic capital needs, this model is a key tool for credit risk management, as it establishes loan limits based on the contribution of each unit to total risk in a global, diversified setting.
The Portfolio Model considers that risk comes from various sources (it is a multi-factor model). This feature implies that economic capital is sensitive to geographic diversification, a crucial aspect in a global entity like BBVA. These effects have been made more apparent against the current backdrop in which, despite the stress undergone by some economies, the BBVA Group's presence in different geographical areas, subject to different shocks and different moments in the cycle, have contributed to bolster the bank's solvency. In addition, the tool is sensitive to concentration in certain credit exposures of the entity’s large clients.
Lastly, the results of the Portfolio Model are integrated into management within the framework of the Asset Allocation project, where business concentrations are analyzed in order to establish the entity's risk profile.
The analysis of the entity's RWA structure shows that 84% corresponds to Credit Risk.
(See Chapter 4 “Credit risk”).
1.5.2. Market risk
Market risk originates in the possibility that there may be losses in the value of positions held due to movements in the market variables that affect the valuation of financial products and assets in trading activity.
The main risks generated may be classified into the following groups:
- Interest-rate risk: They arise as a result of exposure to the movement in the different interest-rate curves on which there is trading. Although the typical products generating sensitivity to movements in interest rates are money market products (deposits, futures on interest rates, call money swaps, etc.) and the traditional interest-rate derivatives (swaps, interest-rate options such as caps, floors, swaptions, etc.), practically all the financial products have some exposure to movements in interest rates due to the effect of the financial discount in valuing them.
- Equity Risk: Arises as a result of movements in the price of shares. This risk is generated in the spot share price positions, as well as any derivative product whose underlying is a share or equity index. Dividend risk is a sub-risk of equity risk, as an input of any equity option. Its variability may affect the valuation of positions and thus it is a factor that generates risk on the books.
- Currency risk: It occurs due to a movement in the exchange rates of the currencies in which the position is held. As in the case of equity risk, this risk is generated in the spot foreign-currency positions, as well as any derivative product whose underlying is an exchange rate.
- In addition, the quanto effect (transactions where the underlying and the nominal of the transaction are denominated in different currencies) means that in certain transactions where the underlying is not a currency an exchange-rate risk is generated that has to be measured and monitored.
- Credit-spread risk: Credit spread is a market indicator of the credit quality of an issuer. The spread risk takes place due to variations in the levels of spread in corporate or government issuers and affects both bond and credit derivative positions.
- Volatility risk: This occurs as a result of variations in the levels of implied volatility in the price of different market instruments in which derivatives are traded. This risk, unlike the others, is exclusively a component of derivative transactions and is defined as a risk of first-order convexity that is generated in all the possible underlyings where there are products with an optionality that require a volatility input for their valuation.
The metrics developed for the control and monitoring of market risk in BBVA Group are aligned with the best market practices and implemented consistently in all the local market risk units. The standard metric for measuring market risk is Value at Risk (VaR), which indicates the maximum losses that may be incurred in the portfolios at a given confidence level (99%) and time horizon (one day).
Chapter 5.2 explains in more detail the risk measurement models used in BBVA Group, focused on internal models approved by the Bank of Spain for BBVA S.A. and BBVA Bancomer for the purpose of calculating the capital for positions in the trading portfolio. Both entities contribute around 80% of the market risk of the Group's trading portfolio. For the rest of the geographical areas (South America and Compass), the calculation of capital for the risk positions in the trading portfolio is carried out using the standard model.
The analysis of the entity's RWA structure shows that 3% corresponds to Market Risk.
(See Chapter 5 "Market risk in trading book activities").
1.5.3. Operational risk
Operational risk is defined as the one that could potentially cause losses due to human errors, inadequate or faulty internal processes, system failures or external events. This definition includes legal risk, but excludes strategic and/or business risk and reputational risk.
Operational risk is inherent to all banking activities, products, systems and processes. Its origins are diverse (processes, internal and external fraud, technology, human resources, commercial practices, disasters and suppliers). Operational risk management is integrated into the BBVA Group's global risk management structure.
The analysis of the entity's RWA structure shows that 9% corresponds to Operational Risk.
(See Chapter 6 “Operational Risk”).
1.5.4. Structural risks
Below is a description of the different types of structural risk:
1.5.4.1. Structural interest rate risk.
The aim of managing balance-sheet interest rate risk is to maintain the BBVA Group's exposure to variations in interest rates at levels in line with its strategy and target risk profile.
Movements in interest rates lead to changes in a bank’s net interest income and book value, and constitute a key source of asset and liability interest-rate risk.
The extent of these impacts will depend on the bank's exposure to changes in interest rates. This exposure is mainly the result of the time difference between the different maturity and repricing terms of the assets and liabilities on the banking book and the off-balance-sheet positions.
A financial institution’s exposure to adverse changes in market rates is a risk inherent in the banking business, while at the same time representing an opportunity to generate value. That is why the structural interest rate should be managed effectively and have a reasonable relation both to the bank's capital base and the expected economic result. This function is handled by the Balance-Sheet Management unit, within the Financial Management area. Through the Asset and Liability Committee (ALCO) it is in charge of maximizing the Bank's economic value, preserving the net interest income and collateraling the generation of recurrent earnings. In pursuance of this, the ALCO develops strategies based on its market expectations, within the risk profile defined by the BBVA Group's management bodies and balance the expected results and the level of risk assumed. BBVA has a transfer pricing system that centralizes its interest-rate risk on ALCO’s books and helps to ensure that balance-sheet risk is being properly managed.
The corporate GRM area is responsible for controlling and monitoring structural interest-rate risk, acting as an independent unit to collateral that the risk management and control functions are properly segregated. This policy is in line with the Basel Committee on Banking Supervision recommendations. It constructs the asset and liability interest-rate risk measurements used by the Group's management, as well as designing models and measurement systems and developing monitoring, information and control systems. At the same time, the Global Risk Management Committee (GRMC) carries out the function of risk control and analysis reporting to the main governing bodies, such as the Executive Committee and the Board of Director’s Risk Committee.
BBVA's structural interest-rate risk management procedure has a sophisticated set of metrics and tools that enable its risk profile to be monitored precisely. This model is based on a carefully studied set of hypotheses which aim to characterize the behavior of the balance sheet exactly. The measurement of interest-rate risk includes probabilistic metrics, as well as a calculation of sensitivity to a parallel movement of +/- 100 basis points in the market curves.
There is regular measurement of the Bank's earnings at risk (EaR) and economic capital, defined as the maximum adverse deviations in net interest income and economic value, respectively, for a particular confidence level and time horizon.
The deviations are obtained by applying a method for simulating interest-rate curves that takes into account other sources of risk in addition to changes in direction, such as changes in the slope and curvature, as well as considering the diversification between currencies and business units. The model is subject to regular internal validation, which includes backtesting.
The risk measurement model is supplemented by analysis of specific scenarios and stress tests. Stress tests have taken on particular importance in recent years. Stress testing has become particularly important in recent years, so a greater emphasis has been placed on the analysis of extreme scenarios in a possible breakthrough in both current interest-rate levels and historical correlations and volatility. At the same time, the evaluation of scenarios forecast by the Economic Research Department has been maintained.
1.5.4.2. Structural exchange rate risk.
This risk is basically caused by exposure to variations in currency exchange rates that arise in the BBVA Group’s foreign subsidiaries and the provision of funds to foreign branches financed in a different currency to that of the investment. The BBVA Group’s structural exchange-rate risk management aims to minimize the potential negative impact from fluctuations in exchange rates on the solvency ratios and on the contribution to earnings of international investments maintained on a permanent basis by the Group.
The GRM corporate area acts as an independent unit that is responsible for monitoring and analyzing risks, standardizing risk management metrics and providing tools that can anticipate potential deviations from targets. It also monitors the level of compliance of established risk limits, and reports regularly to the Global Risk Management Committee (GRMC), the Board of Directors' Risks Committee and the Executive Committee, particularly in the case of deviation or tension in the levels of risk assumed.
The Balance Sheet Management unit, through ALCO, designs and executes the hedging strategies with the main purpose of minimizing the effect of exchange-rate fluctuations on capital ratios, as well as assuring the equivalent value in euros of the foreign-currency earnings of the Group's subsidiaries, adjusting transactions according to market expectations and hedging costs. The Balance-Sheet Management area carries out this work by ensuring that the Group's risk profile is at all times adapted to the framework defined by the limits structure authorized by the Executive Committee. To do so, it uses risk metrics obtained according to the corporate model designed by the Global Risk Management area.
The corporate measurement model uses an exchange rate scenario simulation which, based on historical changes, quantifies possible changes in value for a given confidence interval and a pre-established time horizon, assessing the impacts in three management areas: in the capital ratio, equity and the Group's income statement. The calculation of risk estimates takes into account the risk mitigation measures aimed at reducing the exchange-rate risk exposure. The diversification resulting from investments in different geographical areas is also considered.
In addition to monitoring in terms of exposure and sensitivity to the different currencies, risk control and management are based on probabilistic metrics that estimate maximum impacts for different confidence levels in each area, for which limits and alerts are set according to the tolerance levels established by the Group. Structural exchange-rate risk control is completed with the analysis of marginal contributions to currency risk, the diversification effects, the effectiveness of hedging, and scenario and stress analysis. This provides a complete overview of the Group's exposure to this risk.
Below is a visual display of the changes in the main currencies that make up the Group's structural exchange-rate risk and that explain the trends in the exposure and RWAs of foreign companies due to the effect of changing currency prices.
CHART 3: Trends in the main currencies comprising the Group's exposure to structural exchange-rate risk
TABLE 5: Trends in the main currencies comprising the Group's exposure to structural exchange-rate risk
| Month | USD | VEF | TRY | MXN | PEN |
|---|---|---|---|---|---|
| Dec.-13 | 1.379 | 8.677 | 2.960 | 18.073 | 3.853 |
| Jan.-14 | 1.352 | 15.354 | 3.074 | 18.161 | 3.813 |
| Feb.-14 | 1.381 | 16.299 | 3.055 | 18.309 | 3.863 |
| Mar.-14 | 1.379 | 14.753 | 2.969 | 18.015 | 3.872 |
| Apr.-14 | 1.385 | 13.850 | 2.933 | 18.153 | 3.886 |
| May.-14 | 1.361 | 13.607 | 2.850 | 17.483 | 3.764 |
| Jun.-14 | 1.366 | 14.477 | 2.897 | 17.712 | 3.813 |
| Jul.-14 | 1.338 | 14.717 | 2.855 | 17.635 | 3.739 |
| Aug.-14 | 1.319 | 15.166 | 2.851 | 17.266 | 3.751 |
| Sep.-14 | 1.258 | 15.100 | 2.878 | 16.998 | 3.638 |
| Oct.-14 | 1.252 | 15.029 | 2.777 | 16.871 | 3.661 |
| Nov.-14 | 1.248 | 14.980 | 2.759 | 17.271 | 3.645 |
| Dec.-14 | 1.214 | 14.569 | 2.832 | 17.868 | 3.614 |
| Average Rate | 1.321 | 14.825 | 2.894 | 17.645 | 3.755 |
| Annual % change | -11.96% | 67.90% | -4.34% | -1.13% | -6.20% |
As can be seen above, the euro has depreciated in general against the rest of the currencies, except for the Venezuelan bolivar. This generates an increase in exposure and RWAs referenced to the USD, MXN, TRY and PEN and a notable reduction in exposures and RWAs with respect to the Venezuelan bolivar. The result is that in the standard credit risk the net final effect is a slight fall.
Finally, it should be noted that the specific capital requirements for exchange-rate risk have fallen by €48 million with respect to 2013 (from €780 million to €732 million, as can be seen in section 3.1 of this document).
This change has been the result of the fall in operating positions, mainly in Mexican pesos, dollars and Turkish lira, which have offset the increase in the Chinese yuan, as well as the greater market value of BBVA's stake in CNCB.
1.5.4.3. Structural risk in the equity portfolio.
The BBVA Group’s exposure to structural risk in the equity portfolio basically results from the holdings in industrial and financial companies, with medium/long-term investment horizons. It includes the holdings consolidated in the Group, although their variations in value have no immediate effect on equity in this case.
This exposure is mitigated through net short positions held in derivatives on their underlying assets, which are used to limit portfolio sensitivity to potential falls in prices.
The GRM corporate area acts as an independent unit that is responsible for monitoring and analyzing risks, standardizing risk management metrics and providing tools that can anticipate potential deviations from targets.
It also monitors the level of compliance with the limits set, according to the Risk Appetite and as authorized by the Executive Committee. It reports on these levels regularly to the Global Risk Management Committee (GRMC), the Board's Risk Committee and the Executive Committee, particularly in the case of significant levels of risk assumed, in line with the current corporate policy.
The mechanisms of risk control and limitation hinge on the key aspects of exposure, earnings and economic capital. The structural equity risk management metrics designed by GRM according to the corporate model contribute to effective risk monitoring by estimating the sensitivity figures and the capital needed to cover possible unexpected losses due to the variations in the value of the companies making up the Group’s equity portfolio, at a confidence level that corresponds to the institution’s target rating, and taking into account the liquidity of the positions and the statistical performance of the assets under consideration. To carry out a more in-depth analysis, stress tests and sensitivity analyses are carried out from time to time against different simulated scenarios, using both past crisis situations and forecasts by BBVA Research as the base. On a monthly basis, backtesting is carried out on the risk measurement model used.
1.5.5. Liquidity risk.
Liquidity and funding risk management aims to ensure in the short term that a bank does not have any difficulties in duly meeting its payment commitments, and that it does not have to resort to funding under burdensome terms which may harm the bank's image or reputation.
In the medium term the aim is to ensure that the Group’s financing structure is ideal and that it is moving in the right direction with respect to the economic situation, the markets and regulatory changes. Management of structural funding and short-term liquidity is decentralized in BBVA Group.
Management of structural funding and liquidity within the BBVA Group is based on the principle of financial self-sufficiency of the entities that make it up. This approach helps prevent and limit liquidity risk by reducing the Group’s vulnerability during periods of high risk. This decentralized management prevents possible contagion from a crisis affecting only one or a few BBVA Group entities, which must act independently to meet their liquidity requirements in the markets where they operate. As regards liquidity and funding management, the BBVA Group is organized around eleven Liquidity Management Units (UGL) made up of the parent company and the banking subsidiaries in each geographical area, plus their dependent branches, even when these branches raise funding in different currencies.
One of the objectives of the BBVA Group's principle of financial self-sufficiency of liquidity management in the subsidiaries is to ensure that price formation reflects the cost of liquidity correctly. That is why each entity holds explicit assets available for the management of liquidity at individual level, whether Banco Bilbao Vizcaya Argentaria S.A. or its subsidiaries.
The only exception to this principle is Banco Bilbao Vizcaya Argentaria (Portugal), S.A., which is financed by Banco Bilbao Vizcaya Argentaria, S.A. Banco Bilbao Vizcaya Argentaria (Portugal), S.A. represented 0.8% of total consolidated assets and 0.5% of total consolidated liabilities as of December 31, 2014.
The BBVA Group's policy for managing liquidity and funding risk is also the basis of the model's robustness in terms of planning and integration of risk management into the budgeting process of each UGL, according to the appetite for funding risk it decides to assume in its business. In order to implement this principle of anticipation, limits are set on an annual basis for the main management metrics that form part of the budgeting process for the liquidity balance. This framework of limits contributes to the planning of the joint evolutionary performance of:
- The loan book, considering the types of assets and their degree of liquidity, a well as their validity as collateral in collateralized funding.
- Stable customer funds, based on the application of a methodology for establishing which segments and customer balances are considered to be stable or volatile funds based on the principle of sustainability and recurrence of these funds.
- The credit gap projection, in order to require a degree of self-funding that is defined in terms of the difference between the loan-book and stable customer funds.
- Incorporating the planning of securities portfolios into the banking book, which include both fixed-interest and equity securities, and are classified as available-for-sale or held-to-maturity portfolios, and additionally on trading portfolios.
- The structural gap projection, as a result of assessing the funding needs generated both from the credit gap and by the securities portfolio in the banking book, together with the rest of on-balance-sheet wholesale funding needs, excluding trading portfolios. This gap therefore needs to be funded with customer funds that are not considered stable or on wholesale markets.
As a result of these funding needs, the BBVA Group plans in each UGL the target wholesale funding structure according to the tolerance set. Thus, once the structural gap has been identified and after resorting to wholesale markets, the amount and composition of wholesale structural funding is established in subsequent years, in order to maintain a diversified funding mix and collateral that there is not a high reliance on short-term funding (short-term wholesale funding plus volatile customer funds).
In practice, the execution of the principles of planning and self-funding at the different UGLs results in the Group's main source of funding being customer deposits, which consist mainly of demand deposits, savings deposits and time deposits. As sources of funding, customer deposits are complemented by access to the interbank market and the domestic and international capital markets in order to address additional liquidity requirements, implementing domestic and international programs for the issuance of commercial paper and medium and long-term debt.
(See Chapter 9 "Liquidity and funding risk").