Most significant risks in the risk appetite framework

The significant risks to Banco Sabadell are reflected in graph G1.

Of all types of risk, credit is the most significant in Banco Sabadell's portfolio (G2).

Below are some of the main characteristics of managing each of these risks. More comprehensive information with respect to the Directors' Report and the financial statements are available on the Bank's website.

Credit risk

Credit risk is the possibility that losses may be incurred as a result of borrowers failing to meet their obligations or through losses in value due simply to deterioration in borrower quality.

Diagram G3 illustrates the breakdown of credit risk among the Group's various segments and portfolios.

G1 Main risks

To maximize the business opportunities provided by each customer and to guarantee an appropriate degree of security, responsibility for approving and monitoring risks is shared between the relationship manager and the risk analyst, who are thus able to obtain a comprehensive view of each customer’s individual circumstances.

Of special note are the advanced internal credit rating models for clients and operations:

• Rating: credit risk exposures to corporate customers, real estate developers, specialized financing projects, retailers and sole proprietors, financial institutions and countries are assessed according to a system of credit ratings based on predictive factors and internal estimates of the probability of default (Diagram G4 reflects the breakdown of companies as a function of their rating).
• Scoring: credit risk exposures to individual customers are classified by means of scoring systems which make use of quantitative modelling based on historical data to identify key predictive factors (Diagram G5 reflects the breakdown of individuals as a function of their scoring).
• Early alert tool: there are early alert tools for both companies and individuals. With an early warning system, the quality of a risk can be monitored in an integrated way and risks transferred to recovery specialists who are best equipped to determine the most suitable type of recovery procedure in each case.

G4 Individual customer loan portfolio
credit rating profile

* EAD (exposure at default)

G5 Individual customer loan portfolio
credit score profile

* EAD (exposure at default)

Country risk

Country risk is defined as the risk of a country's debts taken as a whole due to factors other than credit risk. It is manifested in the possible inability of a borrower to meet its payment obligations in different currencies to foreign creditors as a result of not being allowed access to the currency, of not being allowed to transfer it, or of legal action being unenforceable against the borrower for reasons of sovereignty.Breakdown by country risk (G6).

Counterparty risk

This also includes credit risk on financial market transactions that is borne with other financial institutions. It arises from financial trades, both cash (where the risk amount is comparable to the transaction's nominal amount) and that arising from derivatives not traded in organised markets (whose amount is less than the notional value, in the vast majority of cases). Breakdown of counterparty risk by rating (G7 & G8).

Concentration risk

In addition to credit risk, concentration risk refers to exposures that can potentially generate losses large enough to threaten the financial health of an institution or the viability of its ordinary business activity.

Concentration risk is controlled and managed on the basis of the definition in the risk appetite statement, which establishes limits in terms of exposure to concentration, at both individual and sector level.

Liquidity risk

Liquidity risk is due to the possibility of losses being incurred as a result of the Bank’s being unable, albeit temporarily, to honour payment commitments due to a lack of liquid assets, or of its being unable to access the markets to refinance debts at a reasonable cost. This may be associated with factors of a systemic nature or specific to the Bank itself.

Liquidity risk management is established around the basic requirement that the Group have, at all times, liquidity at least sufficient to comply with the levels established by regulation and by the Bank's internal risk management policies.

As an additional policy, it has been decided that the Bank must have a cushion to cover liquidity needs.This cushion materialised in the form of liquid assets classified as eligible collateral by the European Central Bank that are sufficient to fund debt issued on the capital markets that matures in the next 12 months.

Market risk

Market risk arises from possible fluctuations in the fair value or future cash flows of a financial instrument as a result of changes in market risk factors. Several types of market risk factors can be distinguished, the main types being interest rate risk, exchange rate risk, equity price risk and credit spread risk.

Different approaches are taken to manage this risk, depending on which of the Group's main business lines has given rise to it:

• Risk arising from proprietary trading as part of the strategy of focusing on customer business. Risk that is primarily attributable to Treasury and Capital Market operations using currency instruments, equities and fixed-income, in both the cash and derivatives markets.
• Risks arising from the Group's commercial banking with customers and its corporate banking businesses known as structural balance sheet risk. These risks can be sub-classified into interest rate risk and currency risk. This risk is defined as arising from the possibility of loss in the market value of financial asset positions due to variations in risk factors with an impact on their market prices, volatility or correlation between then (e.g. stock prices, interest rates, exchange rates).

Trading

A number of tools are used to measure market risk, including notably:

• VaR (Value at Risk), which allows the risks on different types of financial market transaction to be analysed as a single class. The VaR method provides an estimate of the potential maximum loss on a position that would result from an adverse, though plausible, movement in any of the factors that affect market risk.
• Specific simuilations of extreme market situations (stress testing) which analyse a range of historical and theoretical extreme scenarios and their potential impact on the trading portfolio.

The G9 graph shows the movement of the 1-day VaR for market trading operations in the year 2014 at a 99% confidence level.The T1 table shows a stress analysis of this kind for the treasury portfolio.

G9 Market risk
(million euro)

Structural risks

Interest rate risk
Interest rate risk is caused by changes, as reflected in the position or the slope of the yield curve, in the interest rates to which asset, liability and off-balance sheet positions are linked. Gaps or mismatches arise between these items because of differences in repricing and maturity dates so that rate changes affect them at different times; this in turn affects the robustness and stability of results. The sensitivity of net interest income and shareholders’ equity to a 100 basis point change in interest rates is illustrated in diagram G10.

Exchange rate risk
Structural exchange rate risk arises as a result of changes in the exchange rates between different currencies and the possibility that these movements may result in losses on financial investments and on permanent investments in foreign offices and subsidiaries.

This risk is managed on a centralised basis by the Treasury and Capital Markets Department and the finance Department by delegation from ALC, to which the Board of Directors has delegated. The financial, Country and Bank Risk Department tracks this risk and the established limits.

G10 Structural interest rate risk
(sensitivity to interest rates)

T1 Stress test results at 2014 year-end
(million euro)

Operational and fiscal risk

Operational risk is defined as the risk of loss resulting from failures or inadequacies in people, processes, and systems or from unforeseen external events. This definition includes model, technology and reputational risk (the latter includes behavioural risk).

Senior managers and the Board of Directors play a direct, hands-on role in managing operational risk by approving the management framework and its implementation as proposed by an Operational Risk Committee made up of senior managers from different functional areas of the Group. They also ensure that regular audits are carried out on the management strategy being applied, the reliability of the information being reported, and the internal validation tests required by the operational risk model.

Operational risk includes management and control of the following main risks:

• Reputational risk: the possibility of losses arising from negative publicity related to the Bank's practices and activities, potentially leading to a loss of trust in the institution with an impact on its solvency.
• Technology risk: possibility of losses due to the inability of the systems infrastructure to fully support the continuation of ordinary business activity.
• Model risk: the possibility of losses arising from decision-making based on the use of inadequate models.

The Banco Sabadell Group's objective in this area is to ensure compliance with tax obligations while guaranteeing adequate returns for our shareholders.

Compliance risk

Compliance risk is defined as the risk of incurring legal or administrative penalties, significant financial loss or an impairment of reputation due to a breach of laws, regulations, internal rules and codes of conduct applicable to the banking industry.

One of the essential aspects of the Banco Sabadell Group's policy, and the basis of its organizational culture, is rigorous compliance with all legal provisions. The pursuit of our business objectives must be compliant at all times with the current legislation and with best practice.

With this aim in view, the Group has a compliance policy that handles the setting of policies, procedures and controls centrally at head o∞ce and delegates implementation to its subsidiaries and branches in other countries. This is a flexible risk-focused approach that can adapt with agility to the Group's strategy at any given time and which takes advantage of synergy.

In particular, in the area of money laundering and terrorist financing, the Group has implemented strict control measures that cover both customer identification and the know-your-customer (KYC) process at the time of initiating commercial relations as well as monitoring of activity using systems for tracking suspicious transactions, checking block lists, analysing deviations and operational profiles and constantly keeping KYC documents up to date.

Key actions implemented in 2014 included the following:

• Constantly updated anti-money laundering monitoring systems and Know-your-Customer and Customer Acceptance procedures.
• Progress in complying with Spanish anti-money laundering legislation on the keeping and updating of customer documents and due diligence procedures.

In connection with the other compliance functions, the following actions were taken in 2014:

• Expanded and more rigorous measures to bring greater transparency to all dealings with customers, particularly in the marketing of products and the terms of contracts; making available to the public all fees, commissions, costs and expenses actually charged on the more common banking products and services.
• Improving investor protection by implementing new procedures to evaluate the timeliness and suitability of investments.
• Strengthening the Group’s resources for the detection of possible market abuse by incorporating additional risk parameters; this will make alerts systems more sensitive and extend the range of possible suspicious behaviour patterns.
• Strengthening the mechanisms for overseeing compliance with the Group’s Internal Code of Conduct for trading on the securities market.
• Promoting and monitoring implementation of the Foreign Account Tax Compliance Act (FATCA).
• Implementing these compliance systems at branches taken over following the acquisition of assets from Banco Gallego and SabadellSolbank (formerly Lloyds Bank España).