Market risk

The Group’s market risk measurement allows monitoring of all of the risk types, that is generic risk (including interest rate risk, foreign exchange risk, equity risk), non-linear risk, specific risk and commodity risk. In 2016 the nonlinear risk and commodities risk did not exist in the Group. The equity risk assumed to be irrelevant since the Group’s engagement in equity instruments is immaterial.

Each market risk type is measured individually using an appropriate risk models and then integrated measurement of total market risk is built from those assessments without considering any type of diversification between the four risk types (the worst case scenario).

The main measure used by the Group to evaluate market risks (interest rate risk, foreign exchange risk, equity risk) is the parametric VaR (Value at Risk) model – an expected loss that may arise on the portfolio over a specified period of time (holding period) and with specified probability (confidence level) from an adverse market movement.

The Value at Risk in the Group (VaR) is calculated considering the holding period of 10 working days and a 99% confidence level (one tail).  In order to adapt to regulatory requirements of CRDIV / CRR, since April 2014 the volatility associated with each market risk vertex considered in the VaR model (and respective correlation between them) has been estimated by the equally weighted changes of market parameters using the effective observation period of historical data of last year. Previously applied EWMA method (exponentially weighted moving average method) with effectively shorter observation period is now only justified by a significant upsurge in price volatility.

In order to monitor and limit the positions in instruments, for which it is not possible to properly assess market risk with the use of the VaR model (non-linear risk, commodity risk and specific risk), the appropriate assessment rules were defined. The non-linear risk is measured according to internally developed methodology which is in line with the VaR methodology – the same time horizon and significant level is used. Specific and commodities’ risks are measured through standard approach defined in supervisory regulations, with a corresponding change of the time horizon considered.

The market risk measurement is carried out daily, both on an individual basis for each of the areas responsible for risk taking and risk management, and also in consolidated terms considering the effect of the diversification that exists between the particular portfolios.

To ensure that the VaR model adopted is appropriate for the evaluation of the risks involved in the open positions, a back-testing process has been instituted and is carried out daily.

All reported excesses are documented. This includes an explanation of their causes and their incorporation in one of the three classes of excess explanation: adequacy of the model, insufficient model accuracy or unanticipated market movements.

Parallel to the VaR calculation the portfolios are subject to a set of stress scenarios, in order to:

• Estimate the potential economic loss resulting from extreme variations in market risk factors,
• Identify the market risk movements, possibly not captured by VaR, to which the portfolios are more sensitive,
• Identify the actions that can be taken to reduce the impact of extreme variations in the risk factors.

The following types of market scenarios are being applied:

• Parallel shifts of the yield curves;
• More steep or flat shape of the yield curves;
• Variations of the exchange rates;
• Historical adverse scenarios.

The VaR calculation process is carried out using Web-based software, which allows having on-line access to the risk exposures in terms of VaR in all market risk management areas (intra-day and end-of-day).

The VaR is used as a measure in assessing the risks incurred by the positions in consolidated terms and separately for the Trading and Banking Book. In addition, each Book is divided into the risk management areas. The global limit is expressed as a fraction of the consolidated Own Funds and then limit is divided into the books, risk management areas and various types of risk, which enables the Group for full measurement, monitoring and control of market risk. The market risk exposure (VaR) together with the limit utilization is reported daily to all areas responsible for management and control of market risk in the Group.

The market risk limits are revised at least once a year and in order to take into account, inter alia, the change of the consolidated Own Funds, current and projected balance sheet structure as well as the market environment. The current limits in place have been valid since 1^st October 2016.

In 2016 the VaR indicators for the Group remained on average at the level of PLN 44.0 million (15% of the limit) and PLN 38.7 million (12% of the limit) as of the end of December 2016. The VaR indicators presented in the table below reflect joint exposures to market risk in the Group, that is Trading Book and the Banking Book. The diversification effect applies to the generic risk and reflects correlation between its constituents. The low level of diversification effect is connected with the fact that the Group’s market risk is mainly the interest rate risk. The figures in the Table include also the exposures to market risk generated in subordinated companies, as the Bank manages market risk at central level.

The market risk in terms of VaR for the Group (‘000 PLN):

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VaR measures for market risk (‘000 PLN)	VaR (2016)
	31.12.2015	Average	Maximum	Minimum	31.12.2016
Total risk	35 818	43 997	60 779	24 223	38 738
Generic risk	33 864	41 865	58 556	22 186	36 702
Interest Rate VaR	33 861	41 873	58 510	22 109	36 692
FX Risk	41	149	3 844	7	32
Diversification Effect	0.10%				0.10%
Specific risk	1 954	2 132	3 334	1 921	2 036

The corresponding exposures as of 2015 respectively amounted to (‘000 PLN):

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VaR measures for market risk (‘000 PLN)	VaR (2015)
	31.12. 2014	Average	Maximum	Minimum	31.12.2015
Total risk	61 005	42 071	68 401	18 377	35 818
Generic risk	58 499	39 690	65 916	16 155	33 864
Interest Rate VaR	58 492	39 698	65 788	16 144	33 861
FX Risk	107	249	3 090	8	41
Diversification Effect	0.20%				0.10%
Specific risk	2 497	2 381	2 498	1 954	1 954

The market risk exposure divided into Trading Book and Banking Book together with risk type division is presented in the table below (‘000 PLN):

Banking Book:

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VaR measures for market risk (‘000 PLN)	VaR (2016)
	31.12.2015	Średnio	Maksimum	Minimum	31.12.2016
Total risk	33 957	43 920	61 222	24 660	38 638
Generic risk	32 010	41 836	59 008	22 627	36 607
Interest Rate VaR	32 010	41 835	59 002	22 626	36 606
FX Risk	0	2	8	0	3
Diversification Effect	0.00%				0.00%
Specific risk	1 947	2 085	2 339	1 913	2 031

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VaR measures for market risk (‘000 PLN)	VaR (2015)
	31.12.2014	Average	Maximum	Minimum	31.12.2015
Total risk	58 442	40 179	65 235	17 128	33 957
Generic risk	55 962	37 806	62 755	14 912	32 010
Interest Rate VaR	55 962	37 806	62 755	14 912	32 010
FX Risk	0	0	0	0	0
Diversification Effect	0.00%				0.00%
Specific risk	2 480				1 947

Trading Book:

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VaR measures for market risk (‘000 PLN)	VaR (2016)
	31.12.2015	Average	Maximum	Minimum	31.12.2016
Total risk	3 245	1 759	8 361	194	741
Generic risk	3 238	1 711	8 245	189	736
Interest Rate VaR	3 236	1 673	8 267	190	729
FX Risk	41	148	3 848	7	32
Diversification Effect	1.20%				3.40%
Specific risk	7	47	995	4	4

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VaR measures for market risk (‘000 PLN)	VaR (2015)
	31.12.2014	Average	Maximum	Minimum	31.12.2015
Total risk	5 350	5 321	12 358	1 747	3 245
Generic risk	5 323	5 314	12 353	1 740	3 238
Interest Rate VaR	5 316	5 299	12 398	1 721	3 236
FX Risk	107	251	3 090	8	41
Diversification Effect	1.90%				1.20%
Specific risk	18				7

In 2016, risk limits in terms of VaR were not breached – neither for the whole Group nor for the Banking Book and Trading Book, separately.

All eventual excesses of market risk limits are always reported, documented and ratified at the proper competence level.

Open positions mostly included interest-rate instruments and FX risk instruments. The FX risk covers all the foreign exchange exposures of the Group. According to the Risk Strategy approved in the Group, the FX open position is allowed, however should be kept at low levels.  For this purpose, the Group has introduced a system of conservative limits for FX open positions (both Intraday and Overnight limits) and allows keeping FX open positions mainly in Trading Book. In June 2016, due to extraordinary cash payment in EUR connected with being a beneficiary of the transaction between Visa Inc. and Visa Europe Ltd, the Bank’s Management Board approved the temporary FX open position above the established limits. The FX open position reached temporarily the level of PLN 111.2 million and was closed to the levels well below maximum limits in place within four working days after receiving the payment on 21^st June 2016.

Evolution of the total FX open position (Overnight) in Trading Portfolio (PLN thousand):

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Total position	Period Average	Period Minimum	Period Maximum	The Last Day of Period
2016	7 151	1 501	111 170	25 199
2015	7 945	1 685	40 100	4 421

In addition to above mentioned market risk limits, the stop loss limits are introduced for the financial markets portfolios. The aim is to limit the maximum losses of the trading activity of the Group. In case the limit is reached, a review of the management strategy and assumptions for the positions in question must be undertaken.

In the back-testing calculation for VaR model, four excesses were detected during the last twelve months (see table below, PLN thousand).

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Reporting Date	VaR (generic risk)	Theoretical change in the value of the portfolio (absolute values)	Number of excesses in last 12 months*
2016-12-31	36 702	35 150	4
2015-12-31	33 864	2 593	3

*The excess is said to happen whenever the difference between the absolute change in portfolio value and VaR measure is positive.

The excesses in the process of VaR model back testing were caused by unanticipated market movements, that is mainly PLN bond yield curves in January, June and December 2016. The number of excesses proves the model adequacy (green zone: 1 – 8 excesses acceptable).

VaR assessment is supplemented by monitoring the sensitivity to the above-mentioned stress tests scenarios of portfolios carrying market risk.

The results of stress tests for market risk were reported to the Capital, Assets and Liabilities Committee. In keeping with principles adopted by the Group the limits for stress test results based on the probability of the scenario materialization are triple as high as limits for daily management of market risk. In 2016 the limits for market risk exposure under stress scenarios were not exceeded.

In case of the Banking Book, the main component of the market risk is interest rate risk. As a rule, FX position generated in the Banking Book is fully transferred to the Trading Book where it is managed on a daily basis. Conservative limits applied to FX position guarantees that the market risk generated by open FX positions is residual in the Group (see table above).

Exposure to interest rate risk in the Banking Book are primarily generated by the unbalance between assets and liabilities (including equity) that have fixed rate (or zero rate) and also, to a lower extent, by the different repricing dates of assets and liabilities as well as its reference indexes, if contractually existing. Additionally, due to specificity of the polish legal system, the interest rate of consumer credits is limited (from January 2016 cannot exceed two times Reference Rate of the National Bank of Poland increased by 7 percentage points). In situations of decreasing interest rates, the impact on Net Interest Income is negative and depend on the percentage of the loan portfolio that is affected by the new maximum rate.

Regarding the interest rate risk in Banking Book, the following principles are in place:

• The market risk that results from the commercial banking activity is hedged or transferred on the monthly basis to areas that actively manage market risk and that are measured in terms of risk and profit and loss,
• The Bank uses natural hedging between loans and deposits as well as fixed rate bonds and derivatives to manage interest rate risk with the main purpose of protecting the net interest income.

The variations in market interest rate have an influence on the Group’s net interest income, both under a short and medium-term perspective, affecting also its economic value in the long term. The measurement of both is complementary in understanding the complete scope of interest rate risk in Banking Book.

For this reason, apart from daily market risk measurement in terms of value at risk, the scope of the additional measurement of interest rate risk covers both earnings-based and economic value measures, that is quarterly:

• the economic value of equity that measures the theoretical change in the net present value of all Group’s positions resulting from different upward/downward parallel basis points shocks applied to market interest rates curves (0% floor in a low interest rate environment is assumed^[1]). Therefore, the results shows the impact on the Group’s economic value resulting from the interest rate change,

[1] According to EBA guidelines on the management of interest rate risk arising from non-trading activities (IRRBB) (EBA/GL/2015/08).

and monthly:

• the interest rate sensitivity in terms of BPVx100, that is the change of the portfolio’s value for the parallel movement in the yield curve by 1 basis point multiply by 100,
• the impact on net interest income over a time horizon of next 12 months resulting from one-off interest rate shock of 100 basis points.

The measurement is carried for all the risk management areas in the Bank, with the particular attention on Banking Book. For the purpose of above mentioned analysis for non-maturing assets and liabilities or for the instruments with Client’s option embedded, the Group is defining specific assumptions, including:

• Due date for non-maturing deposits is defined on the basis of historical data regarding customer behaviour, taking into account the stability of the volumes and with assumption of a maximum maturity of 3 years,
• In the interest rate risk measurement process a tendency to faster repayment of receivables than contractually scheduled is taken under consideration. On the basis of historical data a prepayment rate is determined in respect to all relevant Bank’s loan portfolios. It should be noted, that mortgages loans that are the Group’s loan product with a dominant share, are indexed to floating interest rate. This causes that the tendency to early repayment is less important for the interest rate risk.
• The equity, fixed and other assets are assumed to have repricing period of 1 year.

The results of the above mentioned analysis as of the end of 2016 and 2015 did not exceed internally defined limits. The results for interest rate sensitivity in terms of BPVx100 are presented in Table below (PLN thousand). The internally defined limits were not exceeded.

Sensitivity of the Banking Book to changes of interest rates was as follows (‘000 PLN):

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	31.12.2016	31.12.2015
	BPVx100	BPVx100
PLN	(42 537)	(70 893)
CHF	20 468	17 151
EUR	21 075	16 340
USD	7 354	7 806
Other	2 758	2 128
TOTAL	9 118	(27 468)
Equity, fixed and other assets	60 085	53 622
TOTAL	69 203	26 154