Market risk consists of market price risk, currency risk and interest rate risk.

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1 Market Risk Market risk consists of market price risk, currency risk and interest rate risk. Market price risk the risk to incur losses due to the revaluation of balance sheet and off-balance sheet items, which is related to changes in the market prices of financial instruments, including derivatives. Foreign exchange risk the risk to incur losses due to the revaluation of balance and off-balance sheet items denominated in a foreign currency when currency exchange rates change. Interest rate risk the risk that changes in interest rates may result in an adverse effect on the bank's income / expenditure. Market price and foreign currency rate risks. Risk management strategies and policies The market risk management in the Bank is defined by the general Risk Management Policy, Trading Portfolio Policy and Foreign Currency Risk Management Policy. The Trading Portfolio Policy provides an accurate and clear understanding of the principles by which the Bank is governed in maintaining the investment operations with financial instruments included in the trading portfolio, provides accurate guidelines for the Bank to account for the performed investments; and determines restrictions and limits, as well as general principles of control. The Foreign Currency Risk Management Policy specifies general guidelines which govern the Bank in creation of its asset-liability structure itemized by currency, in general day-to-day control and management of currency risk of the Bank, and in defining its protection mechanism against contingent currency risks. The main function of the Foreign Currency Risk Management Policy is to maintain the optimum ratio between the Bank s open foreign currency position and profitability of the Bank and to ensure that the Bank complies with regulatory requirements in managing its currency risk. Structure and organization of the risk management function Resources Committee (hereinafter ALCO), Resources Management Division and Securities Market and Bank Investment Division (hereinafter SD), as well as other subdivisions of the Bank, involved in risk management, are responsible for management and control of market risk. Methodology used by the Bank for risk management and mitigation ALCO is responsible for the overall control of the trading portfolio (hereinafter - TP) and it entrusts management of certain TP positions and position groups to the SD. ALCO determines the necessary limits for creation of the TP: maximum TP limit; TP duration; risk concentration limits by country; possible limits for specific financial instruments (hereinafter FI); maximum TP loss level; maximum short position limit and maturity for each FI. While managing the TP, ALCO regularly (at least once a year) sets and reviews transaction limits for partners. In an emergency situation (crisis in the market), ALCO may pass a special resolution in regard to holding of TP positions: decide to sell positions before reaching the Stop Loss Level; TRASTA KOMERCBANKA, JSC 1

2 decide on holding securities until their maturity or until adoption of a separate ALCO resolution; cancel/change previously determined TP limits; cancel the Stop Loss Level for a separate position or for all positions. To ensure control of currency risk, ALCO defines limits for currency risk to which it can be exposed and keeps track of whether its assets are in a balanced position in relation to liabilities in the respective currencies (maintains as minimal as possible its currency positions and the total currency position). To control its currency exposure, the Bank determines restrictions as to the size of positions in each foreign currency and of the total open position and their relation against the capital, as well as various types of limits. As a result, the Bank complies with the required standards. According to the Law on Credit Institutions, the total open foreign currency position cannot exceed 20% of Bank s capital. The Bank sets certain limits for open currency positions in order to minimize currency risks: daily broker s limit for one currency; total daily brokers limit; brokers overnight limit for one currency; total brokers overnight limit; limits for Bank s special speculative positions; marginal trading limits; some requisite restrictions and limits that would protect the Bank from incurring big losses due to fluctuations of currency rates. Employment of risk control mechanisms is one of the key principles of risk management. The Risk Control Division provides control of TP limits and restrictions. The Bank is implementing a procedure for daily monitoring of open positions. The Bank ensures that it uses such accounting and management system that allows receiving information about foreign currency positions in the real-time mode. Description of reporting system The Risk Control Division once a month shall report to ALCO about compliance with the TP limits and other restrictions. The Risk Control Division on a regular basis (daily) ensures that all FI included in the TP are evaluated and recognised by their true value. ALCO reviews at least once every two weeks: TP condition; notices from the Risk Control Division (once a month); any other significant information concerning TP; reports from account managers of TP positions in regard to respective positions and the TP in general. ALCO on a regular basis (once a quarter) reports to the Board of the Bank on results of performed actions with assets held in the TP. The Risk Control Division controls compliance with foreign currency risk transaction limits and currency risk limits. At least once a month, the Risk Control Division submits to ALCO the following reports for the previous month concerning compliance with the limits: on dealers losses incurred during the previous month; on status of the currency position as of the last business day of a month and compliance with the cash limits as of the last business day of a month; TRASTA KOMERCBANKA, JSC 2

3 on breaches of the limits established for marginal trading. Capital requirements In order to calculate capital adequacy, the Bank applies the methods prescribed by FCMC. Capital requirements for market risk as of 31 December 2013 (in thousands lats): Group Bank Total capital requirements for position, foreign currency and product risks, in accordance with standardized approach Traded debt instruments Capital instruments - Foreign currency According to the capital adequacy assessment results, the Bank's internal capital requirement for market risks is 338 thousand lats. Interest rate risk is the risk that market changes in interest rates may result in an adverse effect on the bank's income / expenditure, amount and economic value of own funds of the Bank. If the spread between average interest rates of allocated funds and interest rates of borrowed funds decreases, the probability increases that the interest income can drop or even cause losses in the principal activities of the Bank (granting loans and accepting deposits). Interest rate risk shows how changes in interest rates may affect financial standing of the Bank. The day-to-day activity of the Bank is related to interest rate exposure which is affected by maturity dates of the assets, liabilities and off-balance sheet items that are related to interest income and expenses and interest rate revision dates. The Bank provides thorough assessment of these risks, both from the long-term perspective by preparation of annual budgets, and from the short-term perspective by providing regular asset-liability diversification and revision of interest rates. To measure the exposure to interest rate risk, the Bank applies the spread analysis method. This method sets the net position of interest rate risk as the difference between interest rate sensitive assets, liabilities and off-balance sheet items according to their remaining terms-to-maturity. Risk management strategy and policies The Interest Rate Risk Management Policy of the Bank is implemented according to the legislation of Republic of Latvia, statutory acts of the Bank of Latvia and the Financial and Capital Market Commission, and the Bank s own Articles of Association and development strategy. The goal of the Bank's Interest Rate Risk Management Policy is to determine risk minimization methods within the scope of controlling the bank s profitability, liquidity and risks. The Interest Rate Risk Management Policy of the Bank defines the interest rate risk measurement methodology which covers the main sources of interest rate exposures and allows assessing the impact of interest rate exposure on earnings of the Bank and its economic value; internal limits of interest rate risk, and measures to be taken in case of non-compliance with these limits; procedure for stress testing and its TRASTA KOMERCBANKA, JSC 3

4 frequency, including assumptions of possible development scenarios; circumstances under which the Bank may incur substantial losses due to interest rate exposure (if the losses thereof exceed 15% of the ); and assumptions and a contingency plan. Structure and organization of the risk management function The Board of the Bank and ALCO are responsible for compliance with the Interest Rate Risk Management Policy. The Risk Control Division provides control over interest rate risks and compliance with internal limits. In the event of a crisis, the Bank shall work out an anti-crisis plan and the responsibility for its implementation shall rest with the Board. Methodology used by the Bank for risk management and mitigation To measure interest rate risk, TKB uses the gap analysis method. This tool determines the difference between interest rate sensitive assets, liabilities and off-balance sheet items according to their remaining terms-to-maturity. The Bank sets limits for maximum spreads between interest income and interest expenses by a maturity and by major currencies Stress testing is performed on a regular basis. Based on results of the stress testing, the Bank estimates an impact on its earnings, provided that there are changes in interest rates. ALCO assesses the probability of such changes in market interest rates for certain future periods from the perspective of the risk source and the economic effect of hedging. Upon occurrence of the situation where consolidated losses from market interest rates and losses by currency are 15% and 5% respectively, Chairman of the Board may decide to form a special commission that should include heads of ALCO, Loan Committee, Customer Service Department, and Finance Trade Department heads. The task of this commission is to coordinate measures designed to eliminate the situation in question with as little damage as possible. Chairman of the Board shall be the chair of the commission. In every specific case, the commission develops an anti-crisis plan and, if necessary, chooses a hedging solution that needs to be approved by the Board of the Bank Description of reporting system Every month, the Statistics and Norms Calculation Division prepares a report monthly on compliance with the consolidated interest rate net position, and total position and loss limits, as well as reports on compliance with the consolidated interest rate net position, total position and authorized loss limits separately in currencies in which recognised assets and liabilities exceed 5% of the balance sheet. Every month, ALCO assesses Bank s exposure to interest rate risks based on information provided by the Risk Control Committee about compliance with the internal limits. ALCO provides recommendations to the Loan Committee in regard to interest rates to be applied by the Bank. TRASTA KOMERCBANKA, JSC 4

5 Once a quarter, the Risk Analysis Division analyzes interest rate risk of internal models by calculating any of the following indicators, per its choice: o Simulation of changes in Bank s income/expense in different scenarios related to interest rate changes o Economic estimation: how the value of Bank s assets, liabilities and rate-sensitive off-balance sheet items will change as a result of changes in interest rates o Sensitivity of Bank s profit and in different scenarios involving changes of interest rates, including stress testing, for instance, unexpected changes in the overall level of interest rates, changes in the yield curve slope and contour, liquidity changes in the leading markets, etc. Results are submitted to ALCO for assessment of interest rates risk. Analysis of the Bank s exposure to interest rate risks (thousands of lats) Currency Changes in basis points Changes in profit basis profit before tax points before tax LVL USD EUR -25 (69) (49) -25 (79) (59) Currency Changes in basis points Changes in profit basis profit before tax points before tax LVL (213) (260) USD (72) (61) (75) (67) EUR (3) (12) (209) (268) The Bank assesses on a regular basis the interest rate risk for each currency for which the extent of the Bank s assets or liabilities exceeds 5% of the total balance and for all currencies on the whole. The analysis of exposure to interest rate risks is calculated as the effect on the net interest income per year (which equals the effect of pre-tax profit or loss), assuming that the interest rates grew concurrently (regardless of the initial term) by 1% (or 100 basis points). When calculating the effect of interest rate changes, the interest rate risk s net open position as of 31 December 2013 and 31 December 2012 is multiplied by expected change in interest rates expressed as basis points. Decrease of economic value as of (thousands of lats) Currency code Weighted value of interest rate risk position in lats (thousands lats) LVL 225 TRASTA KOMERCBANKA, JSC 5

6 EUR 262 USD 441 Other - Interest rate risk position weighted value of 928 non-trade portfolio (total) Equity Ratio of the interest rate risk position absolute weighted value against the, 3.07 % TRASTA KOMERCBANKA, JSC 6

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