Credit-related Environmental Risk While our day-to-day operations do not have a material impact on the environment, we face certain environmental risks including the risk of loss if a borrower is unable to repay loans due to environmental clean-up costs, and the risk of damage to our reputation resulting from the same. To manage these risks, and help mitigate our overall impact on the environment, we evaluate potential environmental risks as part of the credit granting process. If potential environmental risks are identified that cannot be resolved to our satisfaction, the loan application will be denied. Where financing is provided, Internal Audit provides third line oversight of the adherence to related lending policies. Reports on environmental inspections and findings are provided quarterly to the Board Risk Committee. For details on our evolving approach to climate risk, refer to the Business and Strategic Risk section.
MARKET RISK
Market risk is the impact on earnings and on economic value of equity (EVE) resulting from changes in financial market variables such as interest rates and foreign exchange rates. Our market risk is primarily comprised of interest rate risk in the banking book (IRRBB) and foreign exchange risk.
Risk Overview Our most significant market risks are those related to changes in interest rates. We do not have a trading book and do not undertake market activities such as market making, arbitrage or proprietary trading and, therefore, do not have direct risks related to those activities. We maintain a cash and securities portfolio that is primarily comprised of high-quality debt instruments issued or guaranteed by federal (Canada or United States), provincial or municipal governments which are used exclusively for liquidity management purposes and typically held to maturity. These instruments are subject to price fluctuations based on movements in interest rates and volatility in financial markets. We have limited direct exposure to foreign exchange risk. Risk Governance Market risk is managed in accordance with the approved Market Risk Management policy, second line standard and accompanying first line directive. The Market Risk Management policy is reviewed by ALCo and the Executive Risk Committee and approved by the Board Risk Committee every three years, at a minimum. As the first line of defence, our Treasury team manages our market risk on a daily basis. ALCo provides tactical and strategic direction and is responsible for ongoing oversight, review and endorsement of operational guidelines. The Market Risk, Liquidity and Profitability Oversight function provides independent second line monitoring and reporting of market risk exposure against our risk appetite to ALCo, the Executive Risk Committee and the Board Risk Committee.
Subcategories of Market Risk INTEREST RATE RISK
Interest rate risk is the impact on earnings and economic value of equity resulting from changes in interest rates.
Risk Overview IRRBB arises when changes in interest rates affect the cash flows, earnings and values of assets and liabilities. The objective of IRRBB management is to maintain an appropriate balance between earnings volatility and economic value volatility, while keeping both within their respective risk appetite limits. IRRBB arises due to the duration mismatch between assets and liabilities. Adverse interest rate movements may cause a reduction in earnings, and/or a reduction in the economic value of our assets, and/or an increase in the economic value of our liabilities. IRRBB is primarily comprised of duration mismatch risk and option risk embedded within the structure of products. Duration mismatch risk arises when there are differences in the scheduled maturity, repricing dates or reference rates of assets, liabilities and derivatives. The net duration mismatch is managed to a target profile through interest rate swaps and our debt securities portfolio. Product-embedded option risk arises when product features allow customers to alter scheduled maturity or repricing dates. Such features include loan prepayment, deposit redemption privileges and interest rate commitments on un-advanced loans. Variation in market interest rates can affect net interest income by altering cash flows and spreads. Variation in market interest rates can also affect the economic value of our assets, liabilities and off-balance sheet (OBS) positions. The sensitivity of our economic value to fluctuations in interest rates is an important consideration for management, regulators and shareholders. The economic value of an instrument represents an assessment of the present value of the expected net cash flows, discounted to reflect market rates. By extension, the economic value of our equity can be viewed as the present value of our expected net cash flows, defined as the expected cash flows on interest-sensitive assets minus the expected cash flows on interest-sensitive liabilities plus the expected net cash flows on OBS positions. Economic value provides a perspective on the sensitivity of our net worth to fluctuations in interest rates. Risk Management IRRBB is managed to ensure sustainable earnings over time, balancing the impact on current year earnings against changes in economic value at risk over the life of the asset and liability portfolios. Our Market Risk Management policy, which includes IRRBB, establishes risk tolerance limits, defines a management framework to ensure the ongoing identification, measurement, monitoring and control of IRRBB, and defines authority levels and responsibilities. We manage the economic value of the balance sheet within a range around a target duration. Management of the benchmark duration is the responsibility of the first line of defence and is managed within Board approved limits, with the resulting risk exposure maintained within our risk appetite.
48 | CWB Financial Group 2023 Annual Report
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