Notes to the accounts
for the year ended 31 December 2007
28. Financial instrument risk management
The Group is subject to market risk throughout its business as discussed in the business review. In addition, operational, liquidity and credit risk exposures exist within the business. The effectiveness of the Group's risk management process is, therefore, critical to its soundness and profitability and considerable resources are dedicated to this area. Risk management is the direct responsibility of the Group's senior management. The Schroder Group Risk and Compliance functions are responsible for monitoring the overall risk environment. The Group has established a control environment that ensures risks are reviewed regularly and that all risk controls operating throughout the Group are in accordance with regulatory requirements. In addition, an independent assessment of the risk management process and the fundamental risk assumptions is provided by Schroder Group Internal Audit.
Credit risk
The Group has exposure to credit risk from its normal activities where the risk is that a counterparty will be unable to pay in full amounts when due. The Group, through the Principal Risk Committee (‘PRC'), carefully manages its exposure to credit risk by approving lending policies including types of acceptable collateral and minimal lending margins, setting limits for individual exposures and sectors and security.
All individual facility requests are presented to the PRC and exposures against limits are monitored daily. The Group's maximum exposure to credit risk is represented by the carrying value of its financial assets less the collateral held on its loans and advances to customers.
Loans and receivables at amortised cost
Financial assets at amortised cost principally comprise loans and advances to customers, fee debtors, settlement accounts and cash and cash equivalents:
Loans and advances to customers are fully secured on a range of assets including property (both residential and commercial), cash, client portfolios and insurance policies. It is the policy of the Group's Private Banking entities not to advance client facilities on an unsecured basis.
Fee debtors arise principally within the Group's institutional business and amounts are monitored regularly by local offices. Historically, default levels have been insignificant, and, unless a client has withdrawn funds, there is an ongoing relationship between the Group and the client. Although the Group is usually managing client cash representing a large multiple of the amount owed to the Group by the client, the Group does not hold any of the assets it invests on behalf of its clients as collateral.
The Group's fee debtors that are past due but are not considered to be impaired as at 31 December are presented below. Factors considered in determining whether impairment has taken place include how many days past the due date a receivable is, deterioration in the credit quality of a counterparty, and knowledge of specific events that could influence a debtor's ability to repay an amount due.
| 2007 £mn |
2006 £mn |
|
|---|---|---|
| Not older than 30 days | 3.0 | 1.9 |
| Older than 30 days not older than 45 days | 1.0 | 0.5 |
| Older than 45 days not older than 60 days | 2.7 | 0.8 |
| Older than 60 days not older than 90 days | 1.4 | 1.3 |
| Older than 90 days not older than 120 days | 1.2 | 1.4 |
| Older than 120 days not older than 180 days | 0.9 | 2.0 |
| Older than 180 days | 1.5 | 2.0 |
| 11.7 | 9.9 |
The credit risk attributable to settlement accounts is 100 per cent. of the nominal amount involved. However, the period of exposure is very short and the majority of the counterparties are unit trusts managed by the Group. In other markets, it is expected (as experience has shown) that market co-operation and official intervention would prevent loss.
The Group's cash and cash equivalents are concentrated principally in its Private Banking entities and fall within their treasury portfolios (see the ‘Held to maturity financial assets' section below). The remainder of the Group's cash and cash equivalents is invested primarily in current accounts with well-rated UK and overseas banks.
Held to maturity financial assets
All assets within the Private Banks' treasury book are classified as held to maturity financial assets and are unsecured. Policies and limits are set by the PRC and monitored daily. 100 per cent. of the treasury portfolio is rated A or better. The portfolio has no exposures to emerging markets, sub-investment grade assets or any asset backed securities.
The Private Banks take a conservative approach to their treasury investments which are concentrated in terms of industrial sectors purely to well-rated UK and overseas banks and government securities. All assets within the treasury book are unsecured.
No held to maturity financial assets or loans and advances to banks were impaired during the year (2006: nil) or are past due as at 31 December 2007 (2006: nil).
Breakdown per investment grade as at 31 December:
| 2007 | 2006 | |
|---|---|---|
| Credit rating1: | ||
| AA+ | 27% | 19% |
| AA | 7% | 21% |
| AA- | 27% | 34% |
| A+ | 29% | 12% |
| A | 10% | 14% |
| 100% | 100% |
Financial assets held at fair value
Such assets comprise investments in equities, debt securities and derivative instruments with positive fair values.
Substantially all of the Group's investments in equities at fair value are in listed companies or in unlisted funds managed by the Group. The Group also has investments in unlisted private equity funds. All investments are unsecured. For each type of equity and debt security investment, the maximum credit risk is the carrying value.
Breakdown of debt securities per investment grade as at 31 December:
| 2007 | 2006 | |
|---|---|---|
| Credit rating2: | ||
| Sovereign | 12% | 9% |
| AAA | 54% | 65% |
| AA+ | - | 1% |
| AA | 4% | 3% |
| A+ | 17% | 9% |
| A | 5% | 5% |
| A- | - | 1% |
| BBB+ | - | 1% |
| BBB | - | 1% |
| Non-investment grade | 8% | 5% |
| 100% | 100% |
Liquidity risk
Liquidity risk is the risk that Schroders cannot meet its obligations as they fall due or can only do so at a cost. The principal liquidity risk the Group faces concerns its Private Banking liabilities. The liquidity policy is to maintain sufficient liquidity to cover any cash flow funding, meet all obligations as they fall due and maintain the solvency of the Private Banks as well as the rest of the Group.
This is maintained through the management of the Private Banks' treasury against limits set and monitored daily. For details of maturity analyses, see notes 18, 24, 25, 26 and 27, although, in practice, customer deposits tend to be repaid later than on the earliest date on which repayment can be required.
In terms of non Private Banking liquidity, the Group has investment capital which is invested in fixed income and money market portfolios. Liquidity in these portfolios is monitored by the Group on a regular basis.
Schroders has no committed standby lines (2006: £nil).
Interest rate risk
Interest rate risk is the risk that the fair value or future cash flows of financial instruments will fluctuate because of changes in market interest rates.
In the Private Banks, interest rates are monitored daily against policies and limits set by the PRC.
Schroders' treasury policy is to hedge fixed rated assets and liabilities back to the floating rate as much as possible and therefore outright interest rate risk arises mainly from the decision to allow a limited amount of mismatch between the cash flows.
Within the Private Banks, two methods are used for monitoring interest rate risk:
Sensitivity analysis (PV01) - this assesses the impact on Schroders' current net worth against a one basis point parallel rise in interest rates and is calculated daily for each currency (although the main risk is from Sterling positions) and then in aggregate.
Stress testing (PV200) - this is calculated in the same way as the PV01, but against the much more severe change of a 200 basis point movement both up and down in interest rates.
Interest rate risk in the Private Bank is limited due to the short-term nature of the Private Bank's financial assets. In the case of changes in market interest rates, the Private Bank's treasurer can reprice the assets within an average of three months.
Cash held by the operating companies is not normally expected to be placed on deposit for longer than a month and much is invested in short-term liquidity funds with virtually no interest rate risk. The Group's capital includes investments in fixed income and money market portfolios, funds managed by the Group's fixed income fund managers and short-term liquidity funds. These investments are managed to a maximum average duration of 18 months. The fund managers may reduce the average duration with the use of futures contracts at their discretion.
At 31 December 2007, if interest rates had been 200 basis points higher/lower with all other variables held constant, post-tax profit for the year would have been £8.2 million (2006: £4.9 million) higher/lower, mainly as a result of higher/lower interest income on the Group's floating rate debt securities and cash; other components of equity would have been unaffected.
The following are underlying assumptions made in the model used to calculate the effect on post-tax profits in the Private Banks:
- the fair values of assets and liabilities will not be affected by a change in interest rates
- within the Private Bank, the fixed rate financial assets will be repriced to the higher/lower market interest rates
- the average term for repricing is three months.
The following are underlying assumptions made in the model used to calculate the effect on post-tax profits in the rest of the Group:
- the fair values of assets and liabilities will not be affected by a change in interest rates
- funds would be reinvested in similar variable interest bearing debt securities on maturity.
Foreign exchange risk
Foreign exchange risk is the risk that the fair value or future cash flows of financial instruments will fluctuate because of changes in foreign exchange rates.
In the Private Banks, some loans and advances to clients as well as a proportion of the treasury activities are undertaken in foreign currencies; however, this is hedged on a daily basis to reduce currency exposures to low levels. Limits regarding the amount of foreign currency risk that the Group is exposed to are set by the PRC and monitored daily.
Given the low level of currency mismatch within the Group, the FSA's Basic Methodology for calculating the exposure is used.
The Group's policy in relation to revenue and expenditure currency exposure is not to hedge, as the Group's revenue is earned and expenditure incurred in many currencies and the resulting exposure is considered part of the business.
The Group hedges some of its investments in foreign operations using forward foreign exchange contracts with third parties to mitigate exposure to currency movements where it is considered that the Sterling values of such amounts are at risk. The use of such instruments is limited and is subject to the approval of the Group Capital Committee.
At 31 December 2007, if the US dollar had strengthened/weakened by 10 per cent. against Sterling with all other variables held constant, post-tax profit for the year would increase/decrease by £13.0 million/£10.6 million respectively (2006: £6.3 million/£5.2 million) principally as a result of the increase/decrease in assets and liabilities denominated in foreign currencies; other components of equity would increase/decrease by £9.8 million/£8.0 million (2006: £9.3 million/£7.6 million), principally as a result of the unhedged portion of net investment in foreign operations.
At 31 December 2007, if the Euro had strengthened/weakened by 10 per cent. against Sterling with all other variables held constant, post-tax profit for the year would increase/decrease by £5.1 million/£4.1 million respectively (2006: £4.6 million/£3.8 million) principally as a result of the increase/decrease in assets and liabilities denominated in foreign currencies; other components of equity would increase/decrease by £15.2 million/£12.4 million (2006: £9.3 million/£7.6 million), principally as a result of the unhedged portion of net investment in foreign operations.
Pricing risk
Pricing risk is the risk that the fair value or future cash flows of financial instruments will fluctuate because of market changes.
The Group holds equity investments in its seed capital portfolio. Equity market exposure is hedged where it is considered that the amount at risk is material and an effective hedge is available. The Group also holds debt security investments in its fixed income and money market portfolios. Pricing risk of these investments is partially mitigated by their short term nature.
At 31 December 2007, if the FTSE All Share Index had been 20 per cent. higher/lower with all other variables held constant, the effect on post-tax profit would be an increase/decrease of £105.9 million/£69.4 million respectively (2006: £81.5 million/£71.3 million respectively), principally as a result of an increase/decrease in management and performance fees receivable and in the fair values of equities held at fair value through profit or loss; other components of equity would increase/decrease by £26.9 million (2006: £30.6 million), principally as a result of the increase/decrease in fair values of available-for-sale investments.
The following are underlying assumptions made in the model used to calculate the effect on post-tax profits and other components of equity:
- changes in the FTSE All Share Index correlate to changes in the Group's equity funds
- performance fees, being principally based on returns relative to specific indices, would be unaffected by changes in the index
- the Group's investments in debt securities and hedge funds are assumed to have no correlation to the FTSE All Share Index
- the Group's Private Equity investments are assumed to have perfect correlation to the FTSE All Share Index for all but property investments, which are assumed to have no correlation.
Capital management
Investment capital is the Group's capital that is not required for the regulatory and working capital requirements of the business. It is invested in the following areas:
- Fixed income and money market portfolios
- Seed capital
- Private equity
- Third party hedge funds
- Other investments, such as property, warehousing and legacy investments.
The investment capital is held to assist existing products and businesses and to accelerate their development; to support the organic development of new businesses which fit with the existing asset management franchise; and to respond to other investment and growth opportunities, such as acquisitions that will accelerate the development of the business, as they arise.
The investments in seed capital, property funds, warehousing and non-legacy private equity are primarily to support the business.
The remainder of the investment capital is invested in fixed income securities and a portfolio of third party hedge funds. The objectives are to maintain liquidity and to optimise the return on investments while minimising the risk of capital losses.
Other structural considerations underlying the way in which investment capital is deployed are to avoid or hedge exposure to markets so as not to increase the Group's operational gearing and to minimise currency exposure by hedging into Sterling.