Risk management
Risk management framework
The Group's risk management principles and risk management framework cover the full spectrum of risks that a group, that encompasses both banking and insurance businesses, would encounter.
The Group uses an enterprise-wide risk management framework for the identification, assessment, measurement and management of risk, designed to meet its customers' needs. It seeks to maximise value for shareholders over time by aligning risk management with the corporate strategy, assessing the impact of emerging risks from legislation, new technologies or the market, and developing risk tolerances and mitigating strategies. The framework seeks to strengthen the Group's ability to identify and assess risks; aggregate group wide risks and define the corporate risk appetite; develop solutions for reducing or transferring risk, where appropriate; and exploit risks to gain competitive advantage, thereby seeking to increase shareholder value. The principal elements of the risk management framework are shown in Table 1.2.
The risk management framework above comprises 10 interdependent activities which map to the components of the internal control-integrated framework issued by the committee of Sponsoring Organisations of the Treadway Commission (COSO).
The framework is dynamic and allows for proportionate adjustment of policies and controls where business strategy and risk appetite is amended in response to changes in market conditions.
The Lloyds TSB Group business strategy is used to determine the Group's high level risk principles and risk appetite measures and metrics for the primary risk drivers (see Table 1.3). A key focus has been to develop earnings volatility measures to complement existing capital measures for risk appetite. The risk appetite is proposed by the group chief executive and reviewed by various governance bodies including the group executive committee and the risk oversight committee. Responsibility for the approval of risk appetite rests with the board. The approved high level appetite and limits are delegated to individual group executive directors by the group chief executive.
The more detailed description of the risk principles and distribution of the risk appetite measures amongst the divisions and businesses are determined by the group chief executive, in consultation with the group business risk committee and the group asset and liability committee.
The risk principles are executed through the policy framework and accountabilities. These principles are supported by the policy levels below:
Principles – high level principles for the six primary risk drivers
High level Group policy – policy for the main risk types aligned to the risk drivers
Detailed Group policy – detailed policy that applies across the Group
Divisional policy – local policy that specifically applies to a division
Business unit policy – local policy that specifically applies to a business unit
Divisional and business unit policy is only produced by exception and is not necessary unless there is a specific area for which a particular division or business unit requires a greater level of detail than is appropriate for group level policy. The governance arrangements for development of, and compliance with, group, divisional and business unit policy and the associated accountabilities are clearly outlined. All staff are expected to be aware of the policies and procedures which apply to them and their work and to observe the relevant policies and procedures. Line management in each business area has primary responsibility for ensuring that group policies and the relevant local policies and procedures are known and observed by all staff within that area.
Group and divisional risk functions have responsibility for overseeing effective implementation of policy. Group audit provides independent assurance to the board about the effectiveness of the Group's control framework and adherence to policy. Policies are reviewed annually to ensure they remain fit for purpose.
Proportionate control activity strategy is in place to design mitigating controls, to transfer risk where appropriate and ensure executives are content with the residual level of risk accepted.
Risk and control assessments are undertaken to assess the effectiveness of current mitigations and whether risks taken are consistent with the Group's risk appetite (this includes the annual control self-assessment exercise).
The impact of risks and issues (including financial, reputational and regulatory capital) are determined through effective risk measurement including modelling and stress testing.
The outcomes of independent reviews (including internal and external audit and regulatory reviews) are integrated into risk management activities and action plans.
Risk reporting is standardised through the use of standard definitions when reporting, to enable risk aggregation. Divisions monitor their risk levels against their risk appetite, seeking to ensure effective mitigating action is being taken where appropriate. Divisional risk reports are reviewed by divisional executive committees to ensure that respective senior management are satisfied with the overall risk profile, risk accountabilities and progress on any necessary mitigating actions. Reporting, including that of performance against relevant limits or policies, is in place to provide a level of detail appropriate to the exposures concerned and regular information is provided to group risk for review and aggregate reporting. Any significant issues identified in the monitoring process are appropriately reported, and an escalation process is in place to report significant losses to appropriate levels of management. Group risk reports on risk exposures and material issues quarterly to the group asset and liability committee, group business risk committee, group executive committee, risk oversight committee and the board.
At group level a consolidated risk report is produced which is reviewed and debated by the group business risk committee, group executive committee, risk oversight committee and the board to ensure senior management and the board are satisfied with the overall risk profile, risk accountabilities and mitigating actions. The consolidated risk report provides a regular assessment of the aggregate residual risk for the primary risk drivers, comparing the assessment with the previous quarter and providing a forecast for the next 12 months.
Risk drivers
The Group's risk language is designed to capture the Group's principal risks referred to as the 'primary risk drivers'. A description of each risk, including definition, appetite, control and exposures, is included below. These are further broken down into 28 more granular risk types to enable more detailed review and facilitate appropriate reporting and monitoring, as set out in Table 1.3.
Through the Group's risk management processes these risks are assessed on an ongoing basis to ensure optimisation of risk and reward and that, where required, appropriate mitigation is in place. Both quantitative and qualitative factors are considered in assessing the Group's current and potential future risks.
Principal risks
At present the most significant risks faced by the Group are:
People risk: the Group's recent improvement to its people risk exposure, driven by leadership development and succession planning strategies, is now challenged by integration events and market disruption. External pressure on incentivisation in the banking industry increases the risk of losing specialist resources. The Group is addressing these pressures and taking the necessary steps to retain resources.
Credit risk: arising in the Retail and Wholesale and International Banking divisions and the Treasury function reflecting the risks inherent in the Group's lending activities. Over the last year the banking crisis has impacted the financial services industry resulting in high profile losses and writedowns. The deteriorating economic outlook, both in the UK and overseas, is also leading to significant rises in impairments. The Group is impacted by the economic downturn and a further worsening of the business environment could adversely impact earnings. This poses a major risk to the Group and its lending businesses in:
- Retail, where rising unemployment impacts the ability of customers to meet repayment dates on unsecured and secured lending and leads to a consequent increase in arrears. Additionally, the downturn in the housing market reduces collateral values for residential property and this impacts upon the profitability of secured lending.
- Wholesale, where companies are facing increasingly difficult conditions, resulting in corporate default levels rising and leading to increases in corporate impairment.
The Group follows a through the economic cycle, relationship based, business model with robust risk management processes, appropriate appetites and experienced staff in place.
Liquidity and funding: arising in the banking business of the Group and impacting the Retail and Wholesale and International Banking divisions reflecting the risk that the Group is unable to attract and retain retail/wholesale deposits or issue debt securities. Like all major banks, the Group is dependent on confidence in the short and longer term wholesale funding markets; should the Group, due to exceptional circumstances, be unable to continue to source sustainable funding and provide liquidity when necessary, it could impact its ability to fund its financial obligations. Throughout the market dislocation, the Group has maintained a robust liquidity position based on its significant retail and corporate deposit base and has funded strongly in the wholesale markets. Since completion of the HBOS transaction, the Group has been able to fund the Enlarged Group in the wholesale markets at rates comparable to the period prior to completion. In addition the Group has reinforced its strong funding position by actively participating in the support initiatives introduced by the Bank of England and HM Treasury. Prior to the year end 2008 additional liquidity resilience was built up to mitigate the potential for hightened liquidity risk faced by Lloyds TSB Group plc upon the acquisition of HBOS plc. The recent down grade by rating agencies has not had a material impact on the cost of short term wholesale funding.
Capital: during the year there was unprecedented turbulence in global financial markets which led to the UK Government taking action to stabilise the UK banking system. After discussion with HM Treasury on the additional capital required by the UK Government if the Group was to continue to have access to the Government backed provision of liquidity, the board decided it was in the best interests of shareholders for the Group to participate in the industry wide recapitalisation exercise which took place in October 2008. However, should the economic downturn worsen and consequently the Group sustain further sudden and significant shocks to its capital base, it could be necessary to raise additional capital to remain above the FSA's minimum target ratios. Any additional capital raised which was not taken up by existing shareholders would be dilutive to their earnings.
Market risk: In terms of potential impact on economic value, the principal market risks are a fall in equity markets reducing the value of assets in the Group's pension schemes and in the Insurance and Investments division, and exposure to a fall in real interest rates increasing the value of liabilities in the Group's pension schemes. In terms of potential impact on earnings, the principal market risks are exposure to a fall in equity markets reducing the value of assets in the Insurance and Investments division, and exposure to a widening of credit spreads reducing the value of assets in the Insurance and Investment division and in the Trading Book. Also, in the retail banking businesses, there is a potential impact on earnings arising from margin compression in a lower base rate environment. All risks are subject to regular review and mitigation activity via specific initiatives monitored by the group and senior asset and liability committees, including engagement with the pension scheme trustees.
Insurance risk: arising in Insurance and Investments division and the Group's pension schemes reflecting the exposure to increasing longevity of annuitants and pensioners. The main mitigation option open to the Group is to hedge the risk in the reinsurance or the capital markets and the Group actively monitors the attractiveness of potential opportunities in these markets.
Legal and regulatory risk: arising in all divisions and reflecting the legal and regulatory environment in which the Group operates and the volume and pace of change from within the UK and the rest of the world. This impacts the Group, both operationally in terms of cost of compliance with uncertainty about legal and regulatory expectations, and strategically through pressure on key earnings streams. The latter could potentially result in changes to business and pricing models, particularly in the UK retail and smaller business markets. Our business planning processes continue to reflect change to the legal and regulatory environment. Major current legal and regulatory reviews and proceedings are described in Regulation. In addition, the Group faces risk where legal or regulatory proceedings are brought against it. Regardless of whether such claims have merit, the outcome of such proceedings is inherently uncertain and could result in financial loss.
Integration risk: A further risk arises as a result of the acquisition of HBOS plc by Lloyds TSB Group plc reflecting the risk that Lloyds Banking Group may fail to realise the business growth opportunities, revenue benefits, cost synergies, operational efficiencies and other benefits anticipated from, or may incur unanticipated costs and losses associated with, the acquisition of HBOS plc. As a consequence Lloyds Banking Group results may suffer as a result of operational, financial, management and other integration risks. The Group has created an integration committee as a sub-committee to the group executive committee to oversee the integration process.
IMPACT OF LLOYDS TSB RISK MANAGEMENT PRACTICES ON HBOS
Following completion of the HBOS plc transaction, Lloyds Banking Group has moved swiftly to apply its risk management practices to the HBOS Group. As part of the completion process, we have amended Lloyds TSB Group high level policies so that they could be introduced for Lloyds Banking Group.
The way we manage risk is central to the success of Lloyds Banking Group. The board takes its responsibility for risk management very seriously and all of the Group's senior executives are actively involved in overseeing the risk profile for Lloyds Banking Group.
On the completion date the Lloyds TSB governance structure became the overriding governance structure for Lloyds Banking Group. This represented a change to the committee structures and delegated authorities for the heritage HBOS businesses. The major areas of change included material event escalation, sanctions, conflicts of interest, delegated authorities for expenditure and the credit sanctioning process where authorities were changed to align with those within the heritage Lloyds TSB Group plc businesses.