Risk management

Organization of risk management

For FMO, acting in its role as Fund Manager ("FMO") to be able to carry out the Fund’s strategy, it is essential to have an adequate risk management system in place to identify, measure, monitor and mitigate financial risks. The DFCD Land Use Facility ("the Fund") has a pre-defined risk appetite translated into limits per client/ project, country and region. Limit usages are monitored on a monthly basis and for each proposed transaction.

The LUF Facility Manager reviews each transaction and provides consent to eligible proposals. Departmental Investment Committees, comprising of senior representatives of several departments, review financing proposals for new transactions. Each financing proposal is assessed in terms of specific counterparty, product risk as well as country risk and environmental, social and governance (“ESG”) risk. All financing proposals are accompanied by the advice of the Credit department before approval. This department is responsible for credit risk assessment of both new transactions and the existing portfolio.

In addition, clients are subject to a periodic client review, which are in general executed annually. Exposures requiring specific attention are reviewed by the Investment Review Committee (IRC). The large and higher risk exposures are accompanied by the advice of the Credit department. If the Investment Review Committee concludes that a client has difficulty in meeting its payment obligations, the client is transferred to the Special Operations department – responsible for the management of distressed assets – where it is intensely monitored.

Financial risk

Credit risk

Credit risk is defined as the risk that the Fund will suffer economic loss because a counterparty cannot fulfill its financial or other contractual obligations arising from a financial contract. Credit risk is expected to become the main risk within the Fund and occurs on investments in emerging markets and off-balance instruments such as loan commitments.

Management of credit risk is FMO’s core business, both in the context of project selection and project monitoring. In this process, a set of investment criteria per sector is used that reflects benchmarks for the required financial strength of FMO’s clients. This is further supported by internal scorecards that are used for risk classification. As to project monitoring, the Fund’s clients are subject to periodic reviews. Credit policies and guidelines are reviewed regularly and approved by the Investment Review Committee.

The lending process is based on formalized and strict procedures. Decisions on authorizations depend on the risk profile of the financing instrument. For distressed assets, the Special Operations department applies an advanced workout and restructuring approach.

Credit quality analysis

In addition to on balance loans, irrevocable facilities (off-balance) represent commitments to extend finance to clients and consist of contracts signed but not disbursed yet which are usually not immediately and fully drawn.

The following tables provide insights in the credit risk allocation of loan portfolio, loan commitments and financial guarantees according to internal ratings.

Loans past due

Non-Performing Loans (NPL) are defined as loans with a counterparty-specific impairment and/or loans with interest and/or principal payments that are past due 90 days or more. The NPL percentage for the loan portfolio is 0.0% as there are no non - performing loans in LUF’s loan portfolio.

Modified financial assets

Changes in terms and conditions usually include extending the maturity, changing the interest margin and changing the timing of interest payments. When the terms and conditions are modified due to financial difficulties, these loans are qualified as forborne. Refer to paragraph related to 'Modification of financial assets' in the Accounting Policies chapter. 

Equity risk

Equity risk is the risk that the fair value of an equity investment decreases. It also includes exit risk, which is the risk that the Fund’s stake cannot be sold for a reasonable price and in a sufficiently liquid market.

The Fund has a long-term view on equity investments. The Fund can accommodate an increase in the average holding period of its equity investments and so wait for markets to improve again to realize exits. There are no deadlines regarding the exit date of equity investments. Equity investments will be assessed in terms of specific obligor as well as country risk. The performance of the equity investments in the portfolio will be periodically analyzed during the fair value process. Based on this performance and the market circumstances, exits will be pursued in close cooperation with our co-investing partners.

Concentration risk

Diversification within the Fund’s portfolio is ensured through limits on country, region and maximum exposures per client/ project. The fund has a limit that no more than thirty percent (30%) of the total aggregate funding commitments can be allocated to a single mandate country. In addition, no more than fifty (50%) of total commitments can be allocated to a specific region: Africa, Asia, or Latin America. In the fund risk appetite, the maximum customer exposure for investment is set at EUR 10 million.

The following tables present how the Fund’s loan portfolio is concentrated according to country ratings. The comparison with FMO demonstrates that loan portfolio of the Fund is concentrated in countries with higher ratings and is relatively prone to higher credit risk.

Liquidity risk

Liquidity risk is the risk that insufficient funds are available to meet financial commitments. The Fund has a conservative liquidity management to ensure sufficient liquidity is available. In case of a liquidity shortfall, the Fund can make a funding request to FMO for up to a maximum of 10% of the Fund’s net portfolio.

Market risk

Market risk can be divided into interest rate risk and currency risk.

The interest rate risk is the risk of potential loss due to adverse movements in interest rates. Changing interest rates mainly have an effect on the value of fixed interest balance sheet items.

Currency risk is defined as the risk that changes in foreign currency exchange rates have an adverse effect on the value of the Fund’s financial position and future cash flows. The Fund offers financing in both hard and local currencies. Aim is to match currency needs of the clients, thereby reducing their currency risk. All equity deals are considered local currency given the local exposure.

Non- financial risk

Reputation risk

Reputation risk is inevitable given the nature of the Fund's operations in developing countries, focusing on water and land-use specific interventions. FMO has a moderate appetite for reputation risk, accepting that reputational impact of activities may incidentally lead to negative press coverage, NGO attention or undesirable client feedback, as long as these activities clearly contribute to FMO’s mission.

These risks cannot be completely avoided, but they are mitigated as much as possible through strict policies, upfront assessment and, when necessary, through agreements with the Fund’s clients. Potential impact is conducted by feasibility studies and impact assessments, evaluated either by professionals or as needed, by specialist third party consultants.

FMO has in place a Sustainability Policy, as well as statements on human rights, land rights, and gender positions. FMO and CFM have established an Independent Complaints Mechanism consisting of an Independent Expert Panel for assessing issues and breaches of their respective policies.

Environmental, social and governance (“ESG”) risk

Environmental & Social (E&S) risk refers to potential adverse impacts of the FMO investments on the environment, the employees, the communities, and other stakeholders. Corporate Governance (G) risks refers primarily to risk to client business. In addition to impacts on the environment, employees and workers, communities and other stakeholders, ESG risks can result in non-compliance with applicable regulation, NGO and press attention, reputation damage and financial loss where such risk adversely affects operational and financial performance. These risks stem from the nature of the Fund’ projects in difficult markets, where regulations on ESG are less institutionalized. FMO has an appetite for managed risk, accepting ESG performance below standards when we first start working with a client. ESG risks are mitigated through environmental and social action plans, monitoring and technical assistance. The risk appetite for deviations from the exclusion list and human rights violations is zero. We furthermore expect the highest standards in professional conduct.

Compliance risk

Compliance Risk is the risk of failure to comply with laws, regulations, rules, related self-regulatory organization, standards and codes of conduct applicable to FMO’s services and activities.

Financial Economic Crime, incl. sanctions

Fund’s customers follow FMO’s procedures regarding financial economic crime, which includes screening of clients on compliance with applicable anti-money laundering, counter financing of terrorism and international sanctions laws and regulations. Due diligence is performed on clients, which includes checks such as verifying the ultimate beneficial owners of the client we finance, identifying politically exposed persons, and screening against mandatory international sanction lists. These checks are also performed regularly during the relationship with existing clients.

In 2021, FMO continued the FEC Enhancement program initiated in 2019 and met the agreed deadline with DNB to finalize the remediation project on December 31, 2021. All active KYC-files are remediated – using a new KYC tool - and meet the standards of the renewed CDD-AML Policy and CDD-AML Manual. In the second half of 2021, the renewed KYC organization was implemented in the front-office (first line) and business as usual processes were restarted, amongst others periodic reviews of KYC-files. Independent external validation confirmed that the remediated efforts and KYC files are demonstrably compliant with the relevant requirements, after which the Management Board provided a compliance statement to DNB end of 2021.

There is always a risk that a client is involved or alleged to be involved in illicit acts (e.g. money laundering, fraud or corruption). If such an event occurs, FMO will initiate a dialogue with the client, if possible and appropriate given the circumstances, to understand the background in order to be able to assess and investigate the severity. When FMO is of the opinion that there is a breach of law that cannot be remedied or that no improvement by the client will be achieved (e.g. awareness, implementing controls) or that the risk to FMO’s reputation is unacceptably high, FMO may be able to exercise certain remedies under the contract such as the right to cancel a loan or suspend upcoming disbursements and will report to regulatory authorities if deemed necessary.

General Data Protection Act (GDPR)

In 2021, FMO started a project to further develop and enhance privacy data protection capabilities including engaging a dedicated privacy officer and privacy champions within various departments. Specific trainings will be deployed to stimulate awareness. The project aims to finish in 2022. The privacy officer monitors FMOs privacy compliance periodically. The privacy officer is involved in a.o. change management activities and new projects to advise on privacy risks and risk mitigation.

Corruption

Corruption is a global problem, requiring a global response. FMO is guided by the OECD Convention on Combating  Bribery and the UN Convention against Corruption, and is dedicated to fight corruption and bribery not only to adhere to the law, but also because such acts undermine sustainable development and the achievement of higher levels of economic and social welfare. Good governance, fair business practices and public trust in the private sector is necessary to unlock the full potential of an economy and its citizens. Corruption can be best prevented collaborative and FMO actively supports the Transparency International’s Netherlands branch and the International Chamber of Commerce in order to share best practices and stimulate the dialogue between Dutch corporates on best practices in doing international business.

Operational risk

Operational risk is the risk of loss resulting from inadequate or failed processes, people and systems or loss caused by external events. Operational risks are not actively sought and have no direct material upside in terms of return/income generation, yet operational risk events are inherent in operating a business. Operational risk events can result in non- compliance with applicable (internal and external) standards, financial losses or misstatements in the financial reports, and reputational damage.

FMO has in place an operational risk framework that governs the process of identifying, measuring, monitoring, reporting and mitigating operational risks, based on the ‘three lines of defense’ governance principle. Management of the first line is primarily responsible for managing (embedded)risks in the day-to-day business processes. The first line acts within the risk management framework and supporting guidelines defined by specialized risk departments and committees, the second line of defense. Internal Audit, as the third line, provides independent assurance on the effectiveness of the first  and second lines.

FMO has defined risk appetite levels for risk events (P&L impact) and misstatements in financial reporting (P&L impact). Despite all preventive measures, operational risk events will occur. FMO systematically collects risk event information and analyses such events to take appropriate actions.