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Financial and capital risk management

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Financial risk management

The group's activities expose it to a variety of financial risks, which can be categorised as credit risk, liquidity risk, interest rate risk and foreign exchange rate risk. The objective of the group's risk management framework is to identify and assess the risks facing the group and to minimise the potential adverse effects of these risks on the group's financial performance.

Financial risk management is overseen by the risk advisory committee and further detail on the group's risk management framework is described within the Key Governance principles section.

(a) Credit risk

Credit risk is the risk that the group will suffer loss in the event of a default by a customer or a bank counterparty. A default occurs when the customer or bank fails to honour repayments as they fall due.

(i) Amounts receivable from customers

The group's maximum exposure to credit risk on amounts receivable from customers as at 31 December 2009 is the carrying value of amounts receivable from customers of £1,139.3m (2008: £1,063.3m).

CONSUMER CREDIT DIVISION (CCD)

Credit risk within CCD is managed by the CCD credit committee which meets at least every two months and is responsible for approving product criteria and pricing.

Credit risk is managed using a combination of lending policy criteria, credit scoring (including behavioural scoring), policy rules, individual lending approval limits, central underwriting, and a home visit to make a decision on applications for credit.

The loans offered by the weekly home credit business are short-term, typically a contractual period of around a year, with an average value of less than £400. The loans are underwritten in the home by an agent with emphasis placed on any previous lending experience with the customer and the home credit agent's assessment of the credit risk based on a completed application form and the home visit. Once a loan has been made, the agent visits the customer weekly to collect the weekly payment. The agent is well placed to identify signs of strain on a customer's income and can moderate lending accordingly. Equally, the regular contact and professional relationship that the agent has with the customer allows them to manage customers' repayments effectively even when the household budget is tight. This can be in the form of taking part payments, allowing missed payments or occasionally restructuring the debt in order to maximise cash collections.

Agents are paid commission for what they collect and not for what they lend so their primary focus is on ensuring loans are affordable at the point of issue and then on collecting cash. Affordability is reassessed by the agent each time an existing customer is re-served, or not as the case may be. This normally takes place within 12 months of the previous loan because of the short-term nature of the product.

Underwriting of monthly unsecured direct repayment loans is performed in the home. The emphasis is placed on employment and residential history, credit bureau reports, bank statements, salary slips, disposable income calculations and the home visit. Average loans sizes are typically £1,800 repayable monthly via direct debit over a two-year period.

Arrears management for both home credit loans and monthly unsecured direct repayment loans is a combination of central letters, central telephony, and field activity undertaken by field management. This will often involve a home visit to discuss the customer's reasons for non-payment and to agree a resolution.

VANQUIS BANK

Credit risk within Vanquis Bank is managed by the Vanquis Bank credit committee which meets at least quarterly and is responsible for ensuring that the approach to lending is within sound risk and financial parameters and that key metrics are reviewed to ensure compliance to policy.

A customer's risk profile and credit line is evaluated at the point of application and at various times during the agreement. Internally generated scorecards based on historic payment patterns of customers are used to assess the applicant's potential default risk and their ability to manage a specific credit line. For new customers, the scorecards incorporate data from the applicant, such as income and employment, and data from external credit bureau. Initial credit limits are low, typically £250. For existing customers, the scorecards also incorporate data on actual payment performance and product utilisation and take data from an external credit bureau each month to refresh customers' payment performance position with other lenders. Credit lines can go up as well as down according to this point in time risk assessment.

Arrears management is a combination of central letters, inbound and outbound telephony and outsourced debt collection agency activities. Contact is made with the customer to discuss the reasons for non-payment and specific strategies are employed to support the customer in recovering to a good standing.

(ii) Bank counterparties

The group's maximum exposure to credit risk on bank counterparties as at 31 December 2009 was £13.6m (2008: £29.7m).

Counterparty credit risk arises as a result of cash deposits placed with banks and the use of derivative financial instruments with banks and other financial institutions which are used to hedge interest rate risk and foreign exchange rate risk.

Counterparty credit risk is managed by the group's treasury committee and is governed by a board approved counterparty policy which ensures that the group's cash deposits and derivative financial instruments are only made with high quality counterparties with the level of permitted exposure to a counterparty firmly linked to the strength of its credit rating. In addition, there is a maximum exposure limit for all institutions, regardless of credit rating. This is linked to the group's regulatory capital base in line with the group's regulatory reporting requirements on large exposures to the Financial Services Authority (FSA).

(b) Liquidity risk

Liquidity risk is the risk that the group will have insufficient liquid resources available to fulfil its operational plans and/or to meet its financial obligations as they fall due.

Liquidity risk is managed by the group's centralised treasury department through daily monitoring of expected cash flows in accordance with a board approved group funding and liquidity policy. This process is monitored regularly by the treasury committee.

The group's funding and liquidity policy is designed to ensure that the group is able to continue to fund the growth of the business through its existing borrowing facilities. The group therefore maintains committed borrowing facilities in excess of expected borrowing requirements to ensure a significant and continuing headroom above forecast requirements at all times for at least the following 12 months. In determining the forecast borrowing requirement, attention is paid to the currently undrawn credit lines granted by Vanquis Bank. As at 31 December 2009, the group's committed borrowing facilities had a weighted average maturity of 3.5 years (2008: 3.0 years) and the headroom on these committed facilities amounted to £331.0m (2008: £251.2m).

The group is less exposed than other mainstream lenders to liquidity risk as the loans issued by the home credit business, the group's largest business, are of short-term duration (typically around one year) whereas the group's borrowings extend over a number of years.

A maturity analysis of the undiscounted contractual cash flows of the group's bank and other borrowings, including derivative financial instruments settled on a net and gross basis, is shown below. It should be noted that borrowings drawn under the group's revolving bank facilities are shown below as being repaid in less than one year. The group may then redraw these amounts until the contractual maturity of the underlying facility.

Financial liabilities

2009 Repayable on demand
£m
< 1 year
£m
1–2 years
£m
2–5 years
£m
Over 5 years
£m
Total
£m
Bank and other borrowings:            
– senior public bonds 20.0 20.0 60.0 350.0 450.0
– private placement loan notes 39.1 84.4 103.4 226.9
– subordinated loan notes 0.4 0.4 1.1 6.3 8.2
– other 4.9 236.4 200.0 441.3
Total bank and other borrowings 4.9 295.9 104.8 364.5 356.3 1,126.4
Derivative financial instruments – settled gross 1.5 2.3 2.1 5.9
Derivative financial instruments – settled net 27.0 4.3 31.3
Total derivative financial instruments 28.5 6.6 2.1 37.2
Trade and other payables 48.0 48.0
Total 4.9 372.4 111.4 366.6 356.3 1,211.6

Financial assets

2009 Repayable on demand
£m
< 1 year
£m
1–2 years
£m
2–5 years
£m
Over 5 years
£m
Total
£m
Derivative financial instruments – settled gross 2.3 5.2 15.8 23.3
Total 2.3 5.2 15.8 23.3

Financial assets

2008 Repayable on demand
£m
< 1 year
£m
1–2 years
£m
2–5 years
£m
Over 5 years
£m
Total
£m
Bank and other borrowings:            
– private placement loan notes 13.6 63.6 144.5 41.4 263.1
– subordinated loan notes 7.1 7.1 21.4 114.3 149.9
– other 2.6 322.7 200.0 525.3
Total bank and other borrowings 2.6 343.4 70.7 365.9 155.7 938.3
Derivative financial instruments settled gross 0.4 0.4
Derivative financial instruments settled net 7.5 13.5 0.7 21.7
Total derivative financial instruments 7.5 13.5 1.1 22.1
Trade and other payables 64.0 64.0
Total 2.6 414.9 84.2 367.0 155.7 1,024.4

Financial assets

2008 Repayable on demand
£m
< 1 year
£m
1–2 years
£m
2–5 years
£m
Over 5 years
£m
Total
£m
Derivative financial instruments – settled gross 2.0 3.9 11.4 11.0 28.3
Total 2.0 3.9 11.4 11.0 28.3

(c) Interest rate risk

Interest rate risk is the risk of a change in external interest rates which leads to an increase in the group's cost of borrowing.

The group's interest cost is a relatively small part of the group's cost base, representing only 7.0% (2008: 7.3%) of total costs for the year ended 31 December 2009.

The group's exposure to movements in interest rates is managed monthly by the treasury committee and is governed by a board approved interest rate hedging policy which forms part of the group's treasury policies.

The group seeks to limit the net exposure to changes in sterling interest rates. This is achieved through a combination of issuing fixed rate debt and by the use of derivative financial instruments such as interest rate swaps.

A 2% movement in the interest rate applied to borrowings during 2009 and 2008 would not have had a material impact on the group's profit before taxation as the group's interest rate risk was substantially hedged.

(d) Foreign exchange rate risk

Foreign exchange rate risk is the risk of a change in foreign currency exchange rates leading to a reduction in profits or equity.

The group's exposure to movements in foreign exchange rates is monitored monthly by the treasury committee and is governed by a board approved foreign exchange rate risk management policy which forms part of the group's treasury policies.

The group's exposures to foreign exchange rate risk arise solely from (i) the issuance of US dollar private placement loan notes, which are fully hedged into sterling through the use of cross-currency swaps, and (ii) the home credit operations in the Republic of Ireland, which are hedged by matching euro denominated net assets with euro denominated borrowings as closely as practicable.

As at 31 December 2009, a 2% movement in the sterling to US dollar exchange rate would have led to a £8.9m (2008: £4.2m) movement in external borrowings with an opposite movement of £8.9m (2008: £4.2m) in the hedging reserve within equity. Due to the hedging arrangements in place, there would have been no impact on reported profits.

As at 31 December 2009, a 2% movement in the sterling to euro exchange rate would have led to a £1.0m (2008: £1.0m) movement in customer receivables with an opposite movement of £1.0m (2008: £1.0m) in external borrowings. Due to the natural hedging of matching euro denominated assets with euro denominated liabilities, there would have been no impact on reported profits or equity.

(e) Market risk

Market risk is the risk of loss due to adverse market movements caused by active trading positions taken in interest rates, foreign exchange markets, bonds and equities.

The group's policies do not permit it to undertake position taking or trading books of this type and therefore it does not do so.

Capital risk management

The group's objective in respect of capital risk management is to maintain an efficient capital structure whilst satisfying the requirements of the group's banking covenants, regulatory capital requirements and the requirements of Fitch Ratings, who provide the group's external credit rating.

The group manages its capital base against two measures as described below:

(a) Ordinary shareholders' capital to receivables

The group has an internal target ratio of ordinary shareholders' capital to receivables of 15%. This target has been set as the optimum ratio to ensure that the group's capital risk management objective is met. For the purposes of this ratio, ordinary shareholders' capital excludes the group's pension asset, net of deferred tax, the fair value of derivative financial instruments being held for hedging purposes within the hedging reserve, and is stated after deducting proposed dividends. The group monitors ordinary shareholders' capital to receivables on a monthly basis as part of the group's management accounts and the ratio is forecast forward for five years as part of the group's budgeting process. The level of surplus capital retained within the group is assessed by the board on an ongoing basis against the group's strategic objectives and growth plans.

As at 31 December 2009, the group's ordinary shareholders' capital to receivables ratio was 18.9% (2008: 19.1%) as set out below:

  Note 2009
£m
2008
£m
Receivables 14 1,139.3 1,063.3
Shareholders' equity   268.4 277.9
Pension asset 18 (19.9) (50.9)
Deferred tax on pension asset   5.6 14.3
Hedging reserve (net of deferred tax) 26 12.6 12.0
Proposed final dividend 7 (51.2) (50.6)
Ordinary shareholders' capital   215.5 202.7
Ordinary shareholders' capital to receivables ratio   18.9% 19.1%

The reduction in the ordinary shareholders' capital to receivables ratio compared with 2008 principally reflects the investment in the loan books of the Consumer Credit Division and Vanquis Bank. Based on the group's target ratio of 15%, and after taking into account operational seasonality and the timing of dividend payments, this implies surplus capital of approximately £50m exists at 31 December 2009 (2008: £55m). The surplus capital is being retained to fund growth opportunities and provide a sensible degree of strategic flexibility.

(b) Regulatory capital

The group is the subject of consolidated supervision by the FSA. As part of this supervision, the group is required to maintain a certain level of regulatory capital to mitigate against unexpected losses. Regulatory capital differs from the group's equity base included in the balance sheet as it excludes items such as intangible assets and the group's pension asset, but includes the group's subordinated loan notes. Risk weighted assets principally comprise receivables and other assets of the group but exclude the group's pension asset and intangible assets.

On 1 January 2008, the group made the transition from reporting under the old BASEL I regulatory framework to reporting under the new BASEL II framework. Following this transition, the group has been operating under interim capital guidance set by the FSA whilst the FSA was considering the group's ICAAP (see Financial review section). In September 2009, final Individual Capital Guidance (ICG) was received from the FSA.

The treasury committee monitors the level of regulatory capital, and capital adequacy is reported to the board on a monthly basis in the group's management accounts. The group regularly forecasts regulatory capital requirements as part of the budgeting and strategic planning process. The group is required to report twice annually to the FSA on the level of regulatory capital it holds. Under the BASEL II framework, the group is required to report its regulatory capital as a percentage of its Pillar I minimum capital requirement which is determined based on pre-determined formulas for calculating credit risk and operational risk. As at 31 December 2009, the regulatory capital held by the group as a percentage of the Pillar I minimum capital requirement was 293% (2008: 419%) as set out below:

  2009
£m
2008
£m
Pillar I minimum capital requirement 85.6 79.4
Tier 1 capital 245.1 232.8
Tier 2 capital subordinated loan notes 6.0 100.0
Total regulatory capital 251.1 332.8
Total regulatory capital as a percentage of Pillar I minimum capital requirement 293% 419%

The group's total regulatory capital as a percentage of the Pillar I minimum capital requirement was comfortably in excess of the ICG set by the FSA.