Conversation with Hannan Mohammad, Deputy Head of the Funding and Markets Division, AFD

March 12, 2014

Description of AFD and its business activities

The Agence Française de Développement (French Agency for Development - AFD) is a public development finance institution that has been working to fight poverty and foster economic growth in developing countries and the French Overseas Provinces for seventy years. It executes the policy defined by the French Government. AFD is present on four continents where it has an international network of seventy agencies and representation offices. It finances and supports projects that improve people’s living conditions, promote economic growth and protect the planet, such as schooling for children, maternal health, support for farmers and small businesses, water supply, tropical forest preservation, and the fight against climate change.

In 2012, AFD approved €7 billion to finance activities in developing countries and France’s overseas provinces. The funds will help get 10 million children into primary school and 3 million into secondary school; they will also improve drinking water supply for 1.79 million people. Energy efficiency projects financed by AFD in 2012 will save nearly 3.6 million tons of CO2 emissions annually.

 

What are your views on the current market?

New banking regulations have been introduced in response to the credit crisis, together with new obligations that may turn into operational risks (and financial risk) if not managed properly within small-sized structures such as AFD. As an example, under EMIR, central clearing for certain classes of OTC derivatives requires AFD to daily compute, reconcile and process payments for margin calls (initial margin and variation margin) like any other “conventional” Investment Bank. Furthermore, it requires the application of risk mitigation techniques for non-centrally cleared OTC derivatives such as timely confirmation, portfolio reconciliation and compression, dispute resolution, marking-to-market and marking-to-model, exchange of collateral to cover the exposures arising from OTC derivatives, not cleared by a CCP, and reporting to trade repositories. In light of these new challenges, AFD on-boarded a clearing broker and new risk management (Quantifi) and reconciliation tools. Besides, due to its singular mission, AFD does not aim to generate profit like other conventional banks.

 


"The funds will help get 10 million children into primary school and 3 million into secondary school; they will also improve drinking water supply for 1.79 million people. Energy efficiency projects financed by AFD in 2012 will save nearly 3.6 million tons of CO2 emissions annually."


 

Therefore, any impacts generated by derivatives pricing or regulation constraints can become significant with regards to AFD’s P&L i.e. CVA requirement as part of Basel III (capital cost) but also IFRS 13 (P&L), OIS discounting, valuation of currency basis risks, CCP and clearing fees, DTCC and TriOptima fees, etc. Given the above, we consider the real challenge market participant, of a similar size  to  AFD, face (both in terms of staff resourcing and P&L levels) relates to anticipating and effectively managing these impacts, both financially (P&L) and organizationally (people and IT).

 

What key challenges and/or opportunities does the current environment bring to your business?

Given its role and mission, AFD benefits from dual status: as a specialised financial institution, regulated by the banking authority, and a French Public Entity (EPIC). Our peers in the development business are not constrained by the same banking regulation. For instance, some bilateral development agencies have gained exemption from EMIR and derivatives central clearing, as multilateral development banks explicitly have (e.g. IMF, World Banks, EIB…). Consequently, this increases the necessity to manage both revenue and risk more efficiently, in order to identify new opportunities for optimizing.

 

What is your approach to risk management?

As previously stated, AFD’s business is predominantly based on lending to sovereign and non-sovereign counterparties in emerging markets, where conventional banks are not able to offer an alternative. AFD faces inherent counterparty risk on top of interest rate and foreign exchange risk. Therefore, it’s necessary for AFD to hedge against all these risks. Exposure to credit risk includes balance sheet risk, notably exposure to loans, equity stakes, financial instruments and derivatives, as well as off-balance sheet exposures (financing commitments and guarantees given). AFD records items guaranteed by the French State on its balance sheet and off-balance sheet.

AFD hedges credit exposures to its non-sovereign customers by utilising different types of guarantees (letters of intention, liens on businesses, etc.). AFD does not execute credit derivative transactions, either on non-sovereign entities (which may not be available in the markets) nor derivatives banking counterparts.

AFD’s sole purpose of utilising OTC derivatives is to hedge against interest rate and FX risks. These transactions, when not centrally cleared, are ruled by CSA that mitigates credit risk. AFD subsequently computes CVA to capture the remaining credit risks to a given counterparty’s derivatives’ portfolio. This Counterparty risk on financial instruments is managed using a set of limits and management rules, of which principles and main characteristics are set by the Board of Directors.

As AFD’s funding principally relies on floating-rate resources, fixed-rate loans are covered by a micro-hedge that protects the net interest margin. Also, AFD’s general policy is to systematically hedge FX loans through cross-currency swaps. Given that AFD does not hold speculative positions, market risk is limited to FX risk, which is below the threshold set by CRBF Regulation 95-02 on capital adequacy with regard to the market.

 

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