Risk Management

The Bank operates several committees to manage risk. The Board Risk Committee (BRIC) is responsible for supervising the Bank’s risk management framework, risk appetite and internal capital adequacy assessment process (ICAAP) and internal liquidity adequacy assessment process (ILAAP). The Asset and Liability Committee (ALCO), chaired by the CEO or his deputy, is responsible for managing the asset-liability mismatch, liquidity risk, market risk, interest rate risk, and capital management. The Underwriting and Investment Committee (UIC) decides on underwriting and investments. The role of the Data Committee (DC) is to ensure the appropriate management of data. The Security Committee (SC) is responsible for security issues, both information security and physical security.

The Bank has three credit committees: The Board Credit Committee (BCC), which decides on all major credit risk exposures; the Arion Credit Committee (ACC), which operates within limits specified as a fraction of the Bank’s capital; and the Retail Branch Committee (RBC), which operate within tighter credit granting limits. There are also five valuation committees whose role is to establish criteria for estimating collateral and also to inspect valuations of securities owned by the Bank.

The most significant risks the Bank is exposed to are credit risk, liquidity risk, interest rate risk, concentration risk, cyber risk and business risk. The Bank’s Pillar 3 Risk Disclosures 2019 report discusses risk factors and risk management in detail.

Capital Adequacy

The Bank’s capital is intended to meet the risk of unexpected losses in its operations. The extent of the Bank’s own funds should reflect the risk at any given time and potential adverse future development. Risk on the Bank’s balance sheet is assessed by calculating the risk-weighted exposure value (REA). The Bank uses a standardized approach for calculating REA which is generally designed to be more conservative than methods based on internal models. Capital is calculated in accordance with the Financial Undertakings Act No. 161/2002 and Regulations on Prudential Requirements for Financial Institutions No. 233/2017, under which the European Union’s capital requirement directives, CRD IV and CRR, both based on Basel III, are being implemented in Iceland. Provisions for a capital charge supporting factor for small and medium enterprises had not been implemented in Iceland at year-end 2019 but came into force in 2020 when the EU Capital Requirements Regulation (CRR) was incorporated into the EEA Agreement. 

The Bank’s total own funds were ISK 173.0 billion at the end of 2019. Of this total, Common Equity Tier 1 capital (CET1) accounted for ISK 152.7 billion. Issuance of subordinated bonds in 2019 contributed to ISK 13.5 billion of new Tier 2 capital, which completes the first phase of capital normalization. . The calculation of own funds at 31 December 2019 accounts for a foreseeable equity reduction of ISK 14.2 billion (adjusted for own shares), which is the aggregation of the Bank's own shares buy-back plan and dividend distribution as approved by the Board of Directors.

The Bank’s REA was ISK 719.8 billion at the end of 2019, decreasing by ISK 76.9 billion over the year. The reduced REA can primarily be attributed to the contraction of the corporate loan book, sale of equity positions and sale of Arion Bank Mortgages Institutional Investor Fund mortgage portfolio. Calculations of the Bank's capital adequacy are based on the Group’s consolidated situation according to prudential requirements and do not take into account subsidiaries in the insurance sector, to which special solvency requirements apply. The Bank’s average risk-weighting (REA as a percentage of total assets of the Group’s consolidated situation) was 68.1%.

The Bank’s capital ratio at the end of 2019 was 24.0% and CET1 ratio was 21.2%.

In addition to measuring its minimum capital requirement under Pillar 1 in accordance with the rules on prudential requirements, the Bank also assesses its additional capital requirement by performing an Internal Capital Adequacy Assessment Process (ICAAP). ICAAP is designed to ensure that the Bank has in place sufficient risk management processes and systems to identify, manage and measure the Bank’s total risk exposure. ICAAP is designed to identify and measure the Group’s risk across all risk types, including those which are not provided for under Pillar 1, and to ensure that the Group has sufficient capital in accordance with its risk profile. The Financial Supervisory Authority (FME) supervises the Group, receives the Group’s internal estimate of capital adequacy and sets additional capital requirements for the Group following a Supervisory Review and Evaluation Process (SREP). The capital adequacy in respect of the FME's evaluation, in addition to the mandatory Pillar 1 requirement of 8% of REA, is called an additional capital requirement under Pillar 2. The Pillar 2 additional requirement, determined on the basis of the Group’s financial position as at the end of 2019, is 3.1% of REA and this figure is based on the Group’s consolidated situation which excludes subsidiaries in the insurance sector.

Under the Financial Undertakings Act No. 161/2002 the Bank must meet a combined capital buffer requirement, which is designed to ensure that the Bank maintains a minimum level of capital despite severe shocks. The FME has decided on the level of capital buffer in accordance with a proposal from the Financial Stability Council and it has defined Arion Bank as a systemically important financial institution in Iceland. The combined capital buffer requirement was 9.25% at the end of 2019. Effective capital requirements for the countercyclical capital buffer are determined using the weighted average capital buffer in the countries where the Bank has exposure and risk-weighting is decided by the percentage of credit risk in RWA. Furthermore, the systemic risk buffer only applies to domestic exposures. The other capital buffers are the capital conservation buffer and the buffer for systemically important financial institutions. The effective combined capital buffer for the Bank was 9.0% at the end of the 2019. FME has announced a 0.25% increase to the countercyclical capital buffer which will raise the Group’s combined effective capital buffer to 9.2% effective as of February 2020.

Strong mortgage portfolio with low default rates and high loan-to-value

The quality of the mortgage portfolio has improved in recent years with lower average loan-to-value and a reduction in default rates, but last year the default rates increased slightly.

Well diversified loan portfolio

Single name concentration decreasing

Collateral coverage of loans to customers

Loan book quality is steadily improving

Operational risk

Operational risk is the risk of direct or indirect loss, or damage to the Bank's reputation resulting from inadequate or failed internal processes or systems, from human error or external events that affect the Bank's image and operational earnings. Business risk, strategic risk, legal risk, conduct risk, model risk and IT risk are among others subcategories of operational risk.

Each business unit within the Bank is responsible for taking and managing its operational risk. The Bank’s Operational Risk department is responsible for developing and maintaining tools for identifying, measuring, monitoring and controlling operational risk. The operational risk management framework is based on the effectiveness of managing processes, their risks and controls, analyzing deviations from best practices and continuously improving the operation. 

The Bank has managed to substantially reduce equity price risk through a structured sale timetable in the last few years. At the beginning of 2016 the Bank’s holding in Bakkavör Group Ltd. was sold, bringing the Bank’s position in associate companies to a negligible level. In 2018, the Bank divested its shares in the beverage manufacturer Refresco and in 2019 the Bank sold its shares in Stoðir hf. The Bank’s position in other listed equity has also decreased significantly in recent years following further asset divestment.

The Bank’s position in equities in the proprietary trading book and in respect of securities margin lending was relatively stable in the last year. Risk Management closely monitors the associated risk and ensures that positions are kept within limits and that collateral is in place.

Foreign exchange risk is the risk that movements in the exchange rate of the Icelandic króna could have a negative impact on the Bank's earnings. The Group’s currency imbalance at the end of 2019 was negative ISK 9.9 billion. The Bank uses derivatives to hedge against foreign exchange risk.

The net position of the Bank’s indexed assets and liabilities at the end of 2019 was ISK 88.9 billion, decreasing by ISK 12 billion from the previous year. The decrease is explained by prepayments of indexed loans, issuance of indexed covered bonds and new derivatives positions.