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Effective risk management plays an essential role in the Bank’s ability to remain financially sound and responsible through the identification, assessment, management and monitoring of all applicable types of risk. The Bank is primarily exposed to credit, liquidity, interest rate and operational types of risk.
Senior management is responsible for defining the framework for identifying risks and developing the appropriate risk management policies. The Board of Directors, both directly or through its committees, reviews and approves key policies, and implements specific reporting procedures to enable them to monitor compliance over significant areas of risk.
The emergence of COVID-19 and the potential for prolonged adverse general business and economic conditions combined with stimulus interest rate environment has elevated certain risk factors that impacts financial results.
Credit risk is the risk that a financial loss will be incurred as a result of the failure of a customer to honour their contractual commitment or obligation to the Bank. The Bank has developed a Risk Appetite Statement, tailoring our risk position on a case-by-case basis as new opportunities are considered by the Bank.
To help mitigate credit risk on the retail loan portfolio, the Bank has established a maximum retail loan amount limit of $150,000, based on credit quality, amount to finance, and lending parameters that clearly define the type, nature and qualification requirements of a prospective debtor. Any loan approvals falling outside of the Bank’s established lending parameters require the post concurrence of senior management. A standardized credit risk rating classification guideline is used to monitor the ongoing quality of the loan portfolio upon initial approval, renewal, or when information becomes available indicating a material adverse change in the customers’ financial affairs. Loans that have fallen more than 45 days into arrears are brought to the attention of a senior credit manager to facilitate the early recognition of problem accounts and implementation of the steps necessary to secure the Bank’s interest in the loan collateral.
For commercial lending, the Bank has established a large exposure limits and a credit risk policy that has established targets for portfolio concentration and diversification by asset type and geography, and a risk rating system to monitor the quality of each loan at inception and during its life. The size and nature of the portfolio is such that each loan receives ongoing management attention to monitor performance and any change in the conditions affecting the security value or operating environment of the borrower.
The credit risk related to the Bank’s preferred shares is that an issuer experiences financial difficulties and is unable to pay its preferred share obligations as they come due. To help mitigate this risk the Bank has purchased preferred shares rated as P-3 or better.
To limit the spread of COVID-19, businesses across many industries ceased or substantially reduced operations in response to government mandates to close non-essential businesses, resulting in employee layoffs or furloughs, with small- and medium-sized businesses particularly hard hit. Programs put in place by government agencies have provided temporary relief to retail customers and the relaxation of mandated containment measures has begun to positively impact the economy. The conclusion of payment deferrals and government relief programs, as well as further extended periods of curtailed economic activity combined with continued elevated levels of unemployment and existing levels of household debt, may adversely impact credit risk and could result in higher credit loss experience in future periods. As initial payment deferral arrangements concluded, predominantly under three-month terms, the Bank has been successful in working with customers to resume normal payments. Requests for new, additional, or extended payment deferrals have largely subsided. The Bank’s exposure within industries particularly affected by the economic shutdown is well-diversified and supported by high-quality retail and commercial borrowers and high collateral values.
Liquidity risk is the risk that there will be insufficient cash to meet the Bank’s obligations as they come due. This risk can occur from both fluctuations in cash flows from lending, deposit taking and investment activities. Effective liquidity management ensures that an adequate amount of cash is available to honour all existing and short term cash outflow obligations. The Bank’s liquidity policy includes the ongoing measurement and forecast of cash flows, the maintenance of a pool of high quality liquid assets, and the monitoring of the Bank’s loan portfolio diversification as to geographic concentration. The Bank matches its asset and liability maturities so that assets reprice and liabilities mature at approximately the same time.
Market volatility and prolonged periods of economic stress impact how customers manage their deposits and loans. Market disruption may also impact the Bank’s ability to access other funding sources on a cost-effective basis. Despite initial turmoil in funding markets at the onset of the COVID-19 pandemic, the Bank of Canada, alongside other federal bodies, was quick to react with various programs to provide systemwide liquidity and funding costs have normalized. The Bank’s liquidity position increased during fiscal 2020 as the Bank continues to prudently manage liquidity as the economy recovers.
Market risk is the impact on earnings resulting from changes in financial market variables, such as interest rates and foreign exchange rates. Market risk arises when making loans, taking deposits, and making investments. The Bank does not undertake trading activities and therefore does not have risk related to activities such as market making, arbitrage or proprietary trading. The Bank does not hold or trade in foreign currencies, and consequently is not exposed to foreign exchange risk. The Bank’s material market risk is confined to interest rates, as discussed below.
Interest rate risk
Interest rate risk is the impact on net interest income, both current and future, resulting from a change in market interest rates. This risk and potential variability in earnings arises primarily when cash flows stemming from interest sensitive assets and liabilities have different repricing dates. A positive gap arises when interest sensitive assets exceed interest sensitive liabilities for a specific maturity or when interest sensitive assets reprice earlier than interest sensitive liabilities. A negative gap arises when the opposite occurs. The impact of a change in market interest rates on earnings will depend on the magnitude of the change, on the size and maturity structure of the cumulative interest rate gap position and the management of those positions over time.
To mitigate the risk of changing interest rates with respect to variable rate commercial loans funded predominantly with fixed rate deposits, the Bank has entered into interest rate swaps.