1.4. Risk management policies and targets

1.4.1. General principles of risk management

The aim of the Global Risk Management (GRM) function is to preserve the BBVA Group’s solvency, help define its strategy with respect to the risks it takes and facilitate the carrying out of its businesses.

Its activity is governed by the following principles:

The risk management function is unique, independent and global.
The risks assumed by the Group must be compatible with the capital adequacy target and must be identified, measured and assessed. Risk monitoring and management procedures and sound control and mitigation systems must likewise be in place.
All risks must be managed integrally during their life cycle, and be treated differently depending on their nature and with active portfolio management based on a common measure (economic capital).
It is each business area’s responsibility to propose and maintain its own risk profile, within its autonomy in the corporate action framework (defined as the set of risk control policies and procedures defined by the Group), using an appropriate risk infrastructure to control risks.
The infrastructures created for risk control must be equipped with means (in terms of people, tools, databases, information systems and procedures) that are sufficient for their purpose, so that there is a clear definition of roles and responsibilities, thus ensuring efficient assignment of resources among the corporate area and the risk units in business areas.
In the light of these principles, integrated risk management comprises 5 main components:
A system of governance and organization of the risk function, which considers:

1) Definition of roles and responsibilities in the various functions and areas.

2) Organizational structure of the Corporate GRM Area and the Risk Units of the Business Areas, including the relationship mechanisms and co-dependencies.

3) Group of Committees at Corporate and Business Area level.

4) Structure for delegation of risks and functions.

5) System of internal control in line with the nature and size of the risks assumed.

A general framework of appetite for risk, which defines the Group’s target risk profile and the levels of tolerance that the Group is willing to assume to carry out its strategic plan without significant deviations, even in situations of tension.
A corporate risk management scheme that includes:

1) A set of policies and procedures.

2) An annual risk planning scheme through which the appetite for risk is incorporated into the Group’s business decisions.

3) Ongoing management of financial and non-financial risks.

A framework for Identification, Assessment, Monitoring and Reporting of the risks assumed, in baseline and stress scenarios, to enable a prospective and dynamic assessment of risk.
An infrastructure that includes the set of tools, methodologies and risk culture that make up the basis on which the differentiated risk management scheme is shaped.

1.4.2. Corporate governance layout

The BBVA Group has developed a system of corporate governance that is in line with the best international practices and adapted it to the requirements of the regulators in the country in which its different units operate.

According to the Board Regulations, the Board of Directors is the body responsible for approving the risk control and management policy, as well as for periodic monitoring of the internal reporting and control systems.

Based on the general policies laid down by the Board of Directors, the Executive Committee sets the necessary corporate policies that put into practice those approved by the Board of Directors, as well as the Group’s risk limits by geographical areas, sectors and portfolios, all of which make up the corporate action framework for risk management. In this context and for the proper performance of its duties, the Executive Committee is assisted by the Board’s Risk Committee which, among other functions, analyzes and assesses the proposals on these matters submitted to the Executive Committee for approval, constantly monitoring the development of risks and approving those transactions considered relevant for qualitative or quantitative reasons.

1.4.3. The risk function

The risk management and control function is distributed among the risk units within the business areas and the Corporate Global Risk Management (GRM) area, which ensures compliance with global policy and strategies. The risk units in the business areas propose and manage the risk profiles within their area of autonomy, though they always respect the corporate framework for action.

The Corporate GRM area combines a vision by risk type with a global vision. It is divided into six units, as follows:

Corporate Risk Management: Responsible for corporate management of the Bank’s financial risks. In addition, this unit centralizes the management of fiduciary, insurance and asset management risks, as well as the cross-cutting vision of the retail banking business.
Operational Risk and Control: Manages operational risk, internal control of the risk area and internal validation of the measurement models and the acceptance of new risks.
Technology & Methodologies: Responsible for the management of the technological and methodological developments required for risk management in the Group.
Technical Secretary: Checks from a technical point of view the proposals submitted to the Risk Management Committee and to the Risk Committee.
Planning, Monitoring & Reporting: Responsible for developing, defining and monitoring the apetite for risk. Integrates at corporate level the functions related to planning, risk monitoring, analysis of scenarios, capital models and innovation in risks. It is also responsible for both internal and regulatory reporting of the risks the Group is exposed to.
South America GRM: Responsible for managing and monitoring risk in South America.

This structure therefore gives the Corporate GRM area reasonable security with respect to:

Integration, control and management of all the Group’s risks.
The application throughout the Group of standard principles, policies and metrics.
The necessary knowledge of each geographical area and each business.

This organizational scheme is complemented by various committees, which include the following:

The Risk Management Committee: This committee is made up of the risk managers from the risk units located in the business areas and the managers of the Corporate GRM area units. This body meets on a monthly basis and is responsible for the following:
- Drawing up the proposal for the Bank’s risk strategy for approval by the appropriate governing bodies and, in particular, by the Board of Directors.
- Monitoring risk management and control in the Bank.
- Adopting any measures necessary.
The Risk Management Committee: Its permanent members are the Global Risk Management Director, the Corporate Risk Management Director and the Technical Secretary. The rest of the members of this committee are chosen based on the transactions being analyzed. It reviews and decides on those financial programs and operations that lie within its powers and debates those that fall under the Risk Committee. If appropriate, it passes on a favorable opinion to the Risk Committee.
The Assets and Liabilities Committee (ALCO): The committee is responsible for actively managing structural interest-rate and foreign-exchange risk positions, global liquidity and the Bank’s capital resources.
The Technology and Methodologies Committee: This committee decides on the coverage needs of models and infrastructures in the business areas within the framework of the GRM model of operation.
The New Business and Product Committees: Their functions are to study and, if appropriate, to grant technical approval and implement the new businesses, products and services before they are put on the market; to undertake subsequent control and monitoring for newly authorized products; and to foster business in an orderly way to enable it to develop in a controlled environment.
The Global Corporate Assurance Committee: Its main task is to undertake a review at the Bank level and of each of its units, of the control environment and the running of the internal control and operational risk models, and likewise to monitor and locate the main operational risks the Bank is exposed to, including those of a cross-cutting nature. This committee is therefore the highest operational risk management body in BBVA.

Risk appetite framework

The Group’s risk policy aims to achieve a moderate risk profile through prudent management; a model of universal banking, diversified by geographical areas and types of assets, portfolios and customers; a high international presence, both in emerging and developed countries, while maintaining a medium/low risk profile in each; and sustainable growth over time.

A series of basic metrics have been established which characterize the bank’s objective behavior and are applied across the organization, essentially related to solvency, liquidity and recurrent earnings. They determine the Group’s risk management according to each case and enable the desired objectives to be achieved. The levels of tolerance for the basic metrics are approved by the Executive Committee, acting on a proposal by GRM, and delimit the risks that the Group is willing to take. They define the Group’s risk appetite framework and are therefore permanent and structural in nature, with some exceptions.

On an annual basis, the Executive Committee, acting on a proposal by GRM and subject to a favorable report by the Risk Committee, sets limits for the main types of risks facing the Group, including credit, liquidity and funding, and market risk, whose compliance is monitoried during the year by these committees through regular reports prepared by that Area. For credit risk, the limits are defined at portfolio and/or sector level and for each Business Area. They constitute the maximum exposure thresholds for the BBVA Group’s lending activity over a period of one year.

The aim of the Group is not to eliminate all risks, but to assume a prudent level of risk that enables it to generate returns while maintaining adequate capital and fund levels in order to generate recurrent earnings.

1.4.4. Scope and nature of the risk measurement and reporting systems

Depending on their type, risks fall into the following categories:

Credit risk.
Market risk.
Operational risk.
Structural risks.

There follows a description of the risk measurement systems and tools for each kind of risk.

Credit risk

Credit risk arises from the probability that one party to a financial instrument will fail to meet its contractual obligations for reasons of insolvency or inability to pay and cause a financial loss for the other party. This includes management of counterparty risk, issuer credit risk, liquidation risk and country risk.

BBVA quantifies its credit risk using two main metrics: expected loss (EL) and economic capital (EC). The expected loss reflects the average value of the losses. It is considered a cost of the business. Economic capital is the amount of capital considered necessary to cover unexpected losses if actual losses are greater than expected losses.

These risk metrics are combined with information on profitability in value-based management, thus building the risk-return trade-off into decision-making, from the definition of business strategy to approval of individual loans, price setting, assessment of non-performing portfolios, incentives to areas in the Group, etc.

There are three essential parameters in the process of calculating the EL and EC measurements: the probability of default (PD), loss given default (LGD) and exposure at default (EAD). These are generally estimated using historical information available in the systems. They are assigned to operations and customers according to their characteristics. In this context, the credit rating tools (ratings and scorings) assess the risk in each transaction/customer according to their credit quality by assigning them a score, which is used in assigning risk metrics together with other additional information: transaction seasoning, loan to value ratio, customer segment, etc.

Point 4.5.1. of this document details the definitions, methods and data used by the Group to estimate and validate the parameters of probability of default (PD), loss given default (LGD) and exposure at default (EAD).

The credit risk for the BBVA Group’s global portfolio is measured through a Portfolio Model that includes the effects of concentration and diversification. The aim is to study the loan book as a whole, and to analyze and capture the effect of the interrelations between the different portfolios.

In addition to enabling a more comprehensive calculation of capital needs, this model is a key tool for credit risk management, as it establishes loan limits based on the contribution of each unit to total risk in a global, diversified setting.

The Portfolio Model considers that risk comes from various sources (it is a multi-factor model). This feature implies that economic capital is sensitive to geographic diversification, a crucial aspect in a global entity like BBVA. These effects have been made more apparent against the current backdrop in which, despite the stress undergone by some economies, the BBVA Group’s presence in different geographical areas, subject to different shocks and different moments in the cycle, have contributed to bolster the bank’s solvency. In addition, the tool is sensitive to concentration in certain credit exposures of the entity’s large clients. Lastly, the results of the Portfolio Model are integrated into management within the framework of the Asset Allocation project, where business concentrations are analyzed in order to establish the entity’s risk profile.

The analysis of the entity’s RWA structure shows that 85% corresponds to Credit Risk.

(See Chapter 4 “Credit risk”).

Market risk

Market risk is due to the possibility of losses in the value of positions held as a result of changing market prices of financial instruments. It includes three types of risk:

Interest-rate risk: This is the risk resulting from variations in market interest rates.
Currency risk: This is the risk resulting from variations in foreign-currency exchange rates.
Price risk: This is the risk resulting from variations in market prices, either due to factors specific to the instrument itself, or alternatively due to factors which affect all the instruments traded on a specific market.

In addition, for certain positions, other market risks also need to be considered: credit spread risk, basis risk, volatility and correlation risk.

The analysis of the entity’s RWA structure shows that only 3% corresponds to Market Risk.

(See Chapter 5 “Market risk in trading book activities”).

Operational risk

It arises from the probability of human error, inadequate or faulty internal processes, system failures or external events. This definition includes legal risk, but excludes strategic and/or business risk and reputational risk.

The analysis of the entity’s RWA structure shows that 9% corresponds to Operational Risk.

(See Chapter 6 “Operational Risk”).

Structural risks

Below is a description of the different types of structural risk:

Structural interest-rate risk.

The aim of managing balance-sheet interest rate risk is to maintain the BBVA Group’s exposure to variations in interest rates at levels in line with its strategy and target risk profile. Movements in interest rates lead to changes in a bank’s net interest income and book value, and constitute a key source of asset and liability interest-rate risk. The extent of these impacts will depend on the bank’s exposure to changes in interest rates. This exposure is mainly the result of the time difference between the different maturity and repricing terms of the assets and liabilities on the banking book and the off-balance-sheet positions.

A financial institution’s exposure to adverse changes in market rates is a risk inherent in the banking business, while at the same time representing an opportunity to generate value. That is why the structural interest rate should be managed effectively and have a reasonable relation both to the bank’s capital base and the expected economic result. This function is handled by the Balance- Sheet Management unit, within the Financial Management area. Through the Asset and Liability Committee (ALCO) it is in charge of maximizing the Bank’s economic value, preserving the net interest income and guaranteeing the generation of recurrent earnings. In pursuance of this, the ALCO develops strategies based on its market expectations, within the risk profile defined by the BBVA Group’s management bodies and balance the expected results and the level of risk assumed. BBVA has a transfer pricing system that centralizes its interest-rate risk on ALCO’s books and helps to ensure that balance-sheet risk is being properly managed.

The corporate GRM area is responsible for controlling and monitoring structural interest-rate risk, acting as an independent unit to guarantee that the risk management and control functions are properly segregated. This policy is in line with the Basel Committee on Banking Supervision recommendations. It constructs the asset and liability interest-rate risk measurements used by the Group’s management, as well as designing models and measurement systems and developing monitoring, information and control systems. At the same time, the Global Risk Management Committee (GRMC) carries out the function of risk control and analysis reporting to the main governing bodies, such as the Executive Committee and the Board of Director’s Risk Committee.

BBVA’s structural interest-rate risk management procedure has a sophisticated set of metrics and tools that enable its risk profile to be monitored precisely. This model is based on a carefully studied set of hypotheses which aim to characterize the behavior of the balance sheet exactly. The measurement of interest-rate risk includes probabilistic metrics, as well as a calculation of sensitivity to a parallel movement of x/- 100 basis points in the market curves. There is regular measurement of the Bank’s earnings at risk (EaR) and economic capital, defined as the maximum adverse deviations in net interest income and economic value, respectively, for a particular confidence level and time horizon. The deviations are obtained by applying a method for simulating interest-rate curves that takes into account other sources of risk in addition to changes in direction, such as changes in the slope and curvature, as well as considering the diversification between currencies and business units. The model is subject to regular internal validation, which includes backtesting.

The risk measurement model is supplemented by analysis of specific scenarios and stress tests. Stress tests have taken on particular importance in recent years. Stress testing has become particularly important in recent years, so a greater emphasis has been placed on the analysis of extreme scenarios in a possible breakthrough in both current interest-rate levels and historical correlations and volatility. At the same time, the evaluation of scenarios forecast by the Economic Research Department has been maintained.

Structural exchange rate risk

This risk is basically caused by exposure to variations in currency exchange rates that arise in the BBVA Group’s foreign subsidiaries and the provision of funds to foreign branches financed in a different currency to that of the investment. The BBVA Group’s structural exchange-rate risk management aims to minimize the potential negative impact from fluctuations in exchange rates on the solvency ratios and on the contribution to earnings of international investments maintained on a permanent basis by the Group.

The Balance Sheet Management unit, through ALCO, designs and executes the hedging strategies with the main purpose of minimizing the effect of exchange-rate fluctuations on capital ratios, as well as assuring the equivalent value in euros of the foreign-currency earnings of the Group’s subsidiaries, adjusting transactions according to market expectations and hedging costs. The Balance Sheet Management area carries out this work by ensuring that the Group’s risk profile is at all times adapted to the framework defined by the limits structure authorized by the Executive Committee. To do so, it uses risk metrics obtained according to the corporate model designed by the Global Risk Management area.

The corporate measurement model uses an exchange rate scenario simulation which, based on historical changes, quantifies possible changes in value for a given confidence interval and a pre-established time horizon, assessing the impacts in three management areas: on capital ratio, equity and the Group’s income statement. The calculation of risk estimates takes into account the risk mitigation measures aimed at reducing the exchange-rate risk exposure. The diversification resulting from investments in different geographical areas is also considered. In addition, in order to supplement the metrics in the three management areas, risk measurements are complemented with scenario, stress and backtesting analyses to obtain a more complete overview of the Group’s exposure.

In addition to monitoring in terms of exposure and sensitivity to the different currencies, risk control and management are based on probabilistic metrics that estimate maximum impacts for different confidence levels in each area, for which limits and alerts are set according to the tolerance levels established by the Group. Structural exchange-rate risk control is completed with the analysis of marginal contributions to currency risk, the diversification effects, the effectiveness of hedges and scenario and stress analysis. This provides a complete overview of the Group’s exposure to this risk.

The analysis of the entity’s RWA structure shows that 3% corresponds to Credit Risk.

Structural risk in the equity portfolio

The BBVA Group’s exposure to structural risk in the equity portfolio basically results from the holdings in industrial and financial companies, with medium/long-term investment horizons. It includes the holdings consolidated in the Group, although their variations in value have no immediate effect on equity in this case. This exposure is mitigated through net short positions held in derivatives of their underlying assets, which are used to limit portfolio sensitivity to potential falls in prices.

The GRM corporate area acts as an independent unit that is responsible for monitoring and analyzing risks, standardizing risk management metrics and providing tools that can anticipate potential deviations from targets. It also monitors the level of compliance with the limits set, according to the appetite for risk and as authorized by the Executive Committee. It reports on these levels regularly to the Risk Management Committee (RMC), the Board’s Risk Committee and the Executive Committee, particularly in the case of significant levels of risk assumed, in line with the current corporate policy. The mechanisms of risk control and limitation hinge on the key aspects of exposure, earnings and economic capital. The structural equity risk management metrics designed by GRM according to the corporate model contribute to effective risk monitoring by estimating the sensitivity figures and the capital necessary to cover possible unexpected losses due to the variations in the value of the companies making up the Group’s equity portfolio, at a confidence level that corresponds to the institution’s target rating, and taking into account the liquidity of the positions and the statistical performance of the assets under consideration. To carry out a more in-depth analysis, stress tests and sensitivity analyses are carried out from time to time against different simulated scenarios, using both past crisis situations and forecasts by BBVA Research as the base. On a monthly basis, backtesting is carried out on the risk measurement model used.

Liquidity risk

Liquidity and funding risk management aims to ensure in the short term that a bank does not have any difficulties in duly meeting its payment commitments, and that it does not have to resort to funding under difficult conditions which may harm the bank’s image or reputation. In the medium term the aim is to ensure that the Group’s financing structure is ideal and that it is moving in the right direction with respect to the economic situation, the markets and regulatory changes. The management of structural funding and short-term liquidity in BBVA Group is decentralized to prevent possible contagion from a crisis affecting only one or a few geographical areas.

The aim of liquidity risk management, tracking and control is to ensure, in the short term, that the payment commitments of the BBVA Group entities can be duly met without having to resort to borrowing funds under burdensome terms, or damaging the image and reputation of the entities. In the medium term the aim is to ensure that the Group’s financing structure is ideal and that it is moving in the right direction with respect to the economic situation, the markets and regulatory changes.

Management of structural funding and liquidity within the BBVA Group is based on the principle of financial autonomy of the entities that make it up. This approach helps prevent and limit liquidity risk by reducing the Group’s vulnerability during periods of high risk. This decentralized management prevents possible contagion from a crisis affecting only one or a few BBVA Group entities, which must act independently to meet their liquidity requirements in the markets where they operate. As regards liquidity and funding management, the BBVA Group is organized around eleven Liquidity Management Units (UGL) made up of the parent company and the banking subsidiaries in each geographical area, plus their dependent branches, even when these branches raise funding in different currencies.

One of the objectives of the BBVA Group’s principle of financial independence of liquidity management in the subsidiaries is to ensure that price formation reflects the cost of liquidity correctly. For this reason, each entity maintains explicit assets available for managing liquidity at the individual level: Banco Bilbao Vizcaya Argentaria S.A. and its subsidiaries, including BBVA Compass, BBVA Bancomer and the Latin American subsidiaries. The only exception to this principle is Banco Bilbao Vizcaya Argentaria (Portugal), S.A., which is financed by Banco Bilbao Vizcaya Argentaria, S.A. Banco Bilbao Vizcaya Argentaria (Portugal), S.A. represented 0.91% of total consolidated assets and 0.56% of total consolidated liabilities as of December 31, 2013.

The BBVA Group’s policy for managing liquidity and funding risk is also the basis of the model’s robustness in terms of planning and integration of risk management into the budgeting process of each UGL, according to the appetite for funding risk it decides to assume in its business. In order to implement this principle of anticipation, limits are set on an annual basis for the main management metrics that form part of the budgeting process for the liquidity balance. This framework of limits contributes to the planning of the joint evolutionary performance of:

The loan-book, considering the types of assets and their degree of liquidity, a well as their validity as collateral in collateralized funding.
Stable customer funds, based on the application of a methodology for establishing which segments and customer balances are considered to be stable or volatile funds based on the principle of sustainability and recurrence of these funds.
The credit gap projection, in order to require a degree of self-funding that is defined in terms of the difference between the loan-book and stable customer funds.
Incorporating the planning of securities portfolios into the banking book, which include both fixed-interest and equity securities, and are classified as available-for-sale or held-to-maturity portfolios, and additionally on trading portfolios.
The structural gap projection, as a result of assessing the funding needs generated both from the credit gap and by the securities portfolio in the banking book, together with the rest of on-balance-sheet wholesale funding needs, excluding trading portfolios. This gap therefore needs to be funded with customer funds that are not considered stable or on wholesale markets.

As a result of these funding needs, the BBVA Group plans in each UGL the target wholesale funding structure according to the tolerance set. Thus, once the structural gap has been identified and after resorting to wholesale markets, the amount and composition of wholesale structural funding is established in subsequent years, in order to maintain a diversified funding mix and guarantee that there is not a high reliance on short-term funding (short-term wholesale funding plus volatile customer funds).

In practice, the execution of the principles of planning and self-funding at the different UGLs results in the Group’s main source of funding being customer deposits, which consist mainly of demand deposits, savings deposits and time deposits. As sources of funding, customer deposits are complemented by access to the interbank market and the domestic and international capital markets in order to address additional liquidity requirements, implementing domestic and international programs for the issuance of commercial paper and medium and long-term debt.

(See Chapter 9 “Liquidity and funding risk”).

1.4.5. Internal control system

The Group’s internal control system is based on the best practices developed in “Enterprise Risk Management – Integrated Framework” by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) as well as in “Framework for Internal Control Systems in Banking Organizations” by the Bank for International Settlements (BIS).

The Group’s internal control system extends to all the organization and has been designed to identify and manage the risks facing the Group’s entities so that the corporate objectives established are achieved.

The control model has a system with three lines of defense:

The first line is made up of the Group’s business units, which are responsible for control within their area and for executing any measures established by higher management levels.
The second line consists of the specialized control units (Legal Compliance, Global Accounting & Informational Management/Internal Financial Control, Internal Risk Control, IT Risk, Fraud & Security, Operations Control and the Production Divisions of the support units, such as Human Resources, Legal Services, etc.). This line supervises the control of the various units within their cross-cutting field of expertise, defines the necessary improvement and mitigating measures, and promotes their proper implementation. The Corporate Operational Risk Management unit also forms part of this line, providing a methodology and common tools for management.
The third line is the Internal Audit unit, which conducts an independent review of the model, verifying the effectiveness and compliance with corporate policies and providing independent information on the control model.

Among the principles underpinning the Internal Control system are the following:

Its core element is the “process”.
The form in which the risks are identified, valued and mitigated must be unique for each process; and the systems, tools and information flows that support the internal control and operational risk activities must be unique, or at least be administered fully by a single unit.
The responsibility for internal control lies with the Group’s business units, and at a lower level, with each of the entities that make them up. Each business unit’s Operational Risk Management unit is responsible for implementing the system of control within its scope of responsibility and managing the existing risk by proposing any improvements to processes it considers appropriate.
Given that some business units have a global scope of responsibility, there are cross-cutting control functions which supplement the control mechanisms mentioned above. The Operational Risk Management Committee in each business unit is responsible for approving suitable mitigation plans for each existing risk or shortfall. This committee hierarchy culminates at the Group’s Global Corporate Assurance Committee.

Within the GRM area, the Group has set up an Internal Risk Control and Internal Validation unit independent of the units that develop the models, manage the processes and execute the controls, which has been allocated expert resources for managing the different types of risks. Its objectives are:

To ensure that a policy, a process and measures defined for each risk relevant to the Group are in place.
To guarantee that they are applied and executed as they were defined.
To control and report any deficiencies identified in order to establish objectives for improvement.
Internal validation of the models, independent of their development.

Both units report on their activities and communicate their work plans to the Board’s Risk Committee.

This Internal Risk Control area is integrated into the second line of defense. Its scope of action is global from the point of view of geographical area and type of risk, extending to all the types managed by the Corporate Risk Area. The unit has a structure of teams at both corporate level and in the most relevant geographical areas in which the Group operates. As in the case of the Corporate Area, local units are independent of the business areas that execute the processes, and of the units that execute the controls, and report functionally to the Internal Risk Control unit. This Unit’s lines of action are established at Group level, and it is responsible for their adaptation and execution locally, as well as for reporting the most relevant aspects.

Internal Corporate Validation is in charge of ensuring that the internal risk models of the BBVA Group are adequate for their use in management. There are local Internal Validation areas in different geographical areas which are in charge of giving an opinion on the internal models within their scope of responsibility. In Spain, the Internal Corporate Validation unit also acts as a local unit in the business units of Spain and Portugal and in CIB.

Validations include methodological aspects of the model, the databases used, the model’s integration into management, the technological environment in which it is implemented and the adequacy of the controls established.

The validated internal models include those which are used, or are expected to be used in the short term, for estimating regulatory capital consumption. They include the credit, market, operational, equity portfolio and longevity risk models. This scope of validation is extended after conducting a Risk Assessment on the models used throughout the Group according to its greater coverage in terms of exposure, expected loss and consumed capital. This scope includes the structural risk models in different geographical areas, validation of the credit models in South American countries, the treasury credit risk in BBVA S.A., as well as other relevant tools used in the configuration of the Group’s economic capital (portfolio model, risk aggregation, etc.).

1.4.6. Risk protection and reduction policies. Supervision strategies and processes

In most cases, maximum exposure to credit risk is reduced by collateral, credit enhancements and other actions which mitigate the Group’s exposure. The Group applies a credit risk protection and mitigation policy deriving from its business model focused on relationship banking. On this basis, the provision of guarantees may be a necessary instrument but one that is not sufficient when taking risks; this is because for the Group to assume risks, it needs to verify the payment or resource generation capacity to comply with repayment of the risk incurred under the agreed conditions.

This is carried out through a prudent risk management policy which involves analyzing the financial risk in a transaction, based on the repayment or resource generation capacity of the credit receiver, the provision of guarantees –in any of the generally accepted ways (monetary, collateral or personal guarantees and hedging)– appropriate to the risk borne, and lastly on the valuation of the recovery risk (the asset’s liquidity) of the guarantees received.

The procedures for the management and valuation of collateral are set out in the Internal Manuals on Credit Risk Management Policies and Procedures (retail and wholesale), which establish the basic principles for credit risk management, including the management of collateral assigned in transactions with customers.

The methods used to value the collateral are in line with the best market practices and imply the use of appraisal of real-estate collateral, the market price in market securities, the trading price of shares in mutual funds, etc. All collateral assigned must be properly drawn up and entered in the corresponding register. They must also have the approval of the Group’s legal units.

The following is a description of the main types of collateral for each financial instrument class:

Trading book: The guarantees or credit enhancements obtained directly from the issuer or counterparty are implicit in the clauses of the instrument.
Trading and hedging derivatives: In derivatives, credit risk is minimized through contractual netting agreements, where positive- and negative-value derivatives with the same counterparty are offset for their net balance. There may likewise be other kinds of guarantees, depending on counterparty solvency and the nature of the transaction.

The BBVA Group has a broad range of derivatives. The Group uses credit derivatives to mitigate credit risk in its loan book and other cash positions and to cover risks assumed in market transactions with other clients and counterparties.

Derivatives may follow different payment and netting agreements, under the rules of the International Swaps and Derivatives Association (ISDA) ⁽¹⁾. The most common types of triggers to netting include the bankruptcy of the credit institution in question, swiftly accumulating indebtedness, default, restructuring or the winding up of the entity. Practically all the credit derivative portfolio is registered and matched against counterparties, as over 99% of credit derivative transactions are confirmed at the Depositary Trust & Cleaning Corporation (DTCC).

Other financial assets and liabilities designated at fair value through profit or loss and Available-for-sale financial assets: Guarantees or credit enhancements obtained directly from the issuer or counterparty are inherent in the structure of the instrument.
Loans and receivables:

1. Loans and advances to credit institutions: These usually only have the counterparty’s personal guarantee.

2. Loans and advances to customers: Most of these operations are backed by personal guarantees extended by the counterparty. There may also be collateral to secure loans and advances to customers (such as mortgages, cash guarantees, pledged securities and other collateral), or to obtain other credit enhancements (bonds, hedging, etc.).

3. Debt securities: Guarantees or credit enhancements obtained directly from the issuer or counterparty are inherent in the structure of the instrument.

Financial guarantees, other contingent risks and drawable by third parties: These have the counterparty’s personal guarantee.

(1) http://www.isda.org/

information of prudential relevance 2013