The preparation of the Group’s consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities at the reporting date and the reported amount of income and expenses during the period ended. Management evaluates its estimates and judgments on an ongoing basis. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The following estimates and judgments are considered important to the portrayal of the Group’s financial condition:
Allowance for impairment losses of loans and receivables
The Group regularly reviews its loans and receivables to assess for impairment. The Group’s loan impairment provisions are established to recognize incurred impairment losses in its portfolio of loans and receivables. The Group considers accounting estimates related to allowance for impairment of loans and receivables a key source of estimation uncertainty because (i) they are highly susceptible to change from period to period as the assumptions about future default rates and valuation of potential losses relating to impaired loans and receivables are based on recent performance
experience, and (ii) any significant difference between the Group’s estimated losses and actual losses would require the Group to record provisions which could have a material impact on its financial statements in future periods.
The Group uses management’s judgment to estimate the amount of any impairment loss in cases where a borrower has financial difficulties and there are few available sources of historical data relating to similar borrowers. Similarly, the Group estimates changes in future cash flows based on past performance, past customer behavior, observable data indicating an adverse change in the payment status of borrowers in a group, and national or local economic conditions that correlate with defaults on assets in the group. Management uses estimates based on historical loss experience for assets with credit risk characteristics and objective evidence of impairment similar to those in the group of loans and receivables. The Group uses management’s judgment to adjust observable data for a group of loans or receivables to reflect current circumstances not reflected in historical data.
The most significant judgment is applied in assessing impairment levels in real estate loans and construction financing. Current economic and market conditions make historical statistical loss levels less relevant in determining the inherent loss levels in the loan portfolio. Instead, management is required to use recent empirical evidence of impairment or employ analytical tools to estimate future economic value of collateral secured under loans or the expected cash generating ability of borrowers’ business. This area of judgment bears significant sensitivity to various risk factors, such as general economic growth, central government involvement, support of local authorities, trends in the housing and commercial real estate markets, and changes in the regulatory environment. The assumptions underlying this judgment are highly subjective.
The level of loan loss provisions for this loan category at the reporting date is supported by following factors:
• The economic value assessment of collateral under real estate loans. In some cases management used certain assumptions to determine the inherent value of collateral, such as land, based on highest and best use, current observable lease rates and sale prices for commercial and residential real estate. Moreover, the assessment sometimes depends on expectations that local municipal government will continue funding capital expenditure costs for infrastructure development in and around any given real estate project. In certain cases, the requirement for additional financing as well as investment is factored into determining the value.
• The Bank has formulated a work-out strategy for construction loans, which is currently being implemented, most significantly in Almaty and Astana. In many cases the approach taken by the Bank necessitates close partnership with local municipal authorities, construction subcontractors, suppliers of construction materials, and the availability of construction materials, specialized equipment and labor.
• Incomplete construction projects are more likely to result in past due construction loans. Therefore, the Bank encourages additional investments in incomplete construction projects, which in turn increase an opportunity to generate more cash flows for existing borrowers of the Bank that are involved in ancillary services to the construction sector, such as equipment leasing, construction materials, site management, labor outsourcing, transportation, security, and other services.
Fair value changes in the above factors and assumptions may result in significant adjustment to loan loss provisions and the carrying value of loans to customers. Management seeks to regularly update assumptions and the approach it has taken toward individual borrowers.
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The allowances for impairment losses of financial assets in the consolidated financial statements have been determined on the basis of existing economic and political conditions. The Group is not in a position to predict what changes in these conditions will take place in Kazakhstan and what effect such changes might have on the adequacy of the allowances for impairment of financial assets in future periods.
The impairment of a loan is identified within credit monitoring, which includes monitoring of payments of the customer and preparation of regular monitoring reports on the customer and his loans every 6 or 12 months, depending on the solvency of the customer. In addition, on a regular basis the credit managers monitor the quality of the loan, financial position and business of the customer, and observe the terms of the loan agreements. For the purpose of provisioning, an assessment of impairment losses for corporate loans is performed on an individual basis.
Consumer loans are classified as non-performing or impaired if there is a default on payments of the principal or accrued interest for 60 days or more. For the purpose of provisioning, assessment of impairment losses is made on a collective or portfolio basis.
According to the Group’s credit portfolio management policy, if at least one loan of a customer is recognized as impaired based on the above mentioned criteria, the total debt of such a customer is considered impaired, i.e. other performing loans of such customer are also recognized as impaired.
For certain performing loans which are not overdue, the Group classifies them as homogenous and individually assessed watch assets. Homogenous assets are not individually impaired, because there is not enough objective evidence to recognize them as impaired. At the same time, the Group assesses these assets for credit risk and impairment on a collective basis taking into account the general macroeconomic environment as well as industry specific developments. The individually assessed watch assets consist of loans not past due, but there is a possibility that the credit losses may arise in the future due to a possible negative trend in the borrower’s financial position or evidence of some unsatisfactory financial results which affect the ability of a borrower to repay. The financial standing of such clients is evidenced and monitored, based on business results, repayment discipline and cash flows.
The Group creates an allowance for impairment losses in order to cover credit losses, including losses where the asset is not specifically identified. At least monthly, the provision for impairment losses on interest bearing assets is reviewed by the Chairman of the Board, the Head of Risk Management Department №1, the Chief Financial Officer, and the Chief Accountant. At least quarterly, the provision for impairment losses and overall credit quality is reviewed by the Board of Directors. The amount of provision is reviewed relative to the credit portfolio and current economic conditions. The amount of provision is determined by individual and portfolio-based approaches. As at 31 December 2012, 2011 and 2010, management deemed the provision for impairment losses to be appropriate and sufficient to absorb losses that are inherent to the Group’s loan portfolio.
The carrying amount of the allowance for impairment of loans to customers as at 31 December 2012 is KZT 923,287 million (2011: KZT 658,108 million, 2010: KZT 572,450 million).
In December 2012 amendments to the Tax Code of RK came into force, in accordance with which starting from 2013 Kazakhstani banks will have a right to deduct provisioning charges under IFRS and dynamic provisioning charges incurred under the requirements of the NBRK. Regulatory specific provisioning based on the requirements of the FMSC is to be cancelled in 2013. Additionally in 2013 phase-in of capital adequacy ratios in accordance with Basel III is expected to start in Kazakhstan. Regulations of NBRK covering these
amendments have not yet been approved in the manner prescribed by the legislation, thus creating uncertainty of the regulatory environment.
Valuation of financial instruments
Financial instruments that are classified at fair value through profit or loss or available-for- sale, and all derivatives, are stated at fair value. The fair value of such financial instruments is the estimated amount at which the instrument could be exchanged between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value is calculated based on the market price at the close of business on the reporting date. When valuation parameters are not observable in the market or cannot be derived from observable market prices, the fair value is derived through analysis of other observable market data and the use of discounted cash flow pricing models. Where market-based valuation parameters are not directly observable, management will make a judgment as to its best estimate of that parameter in order to determine a reasonable reflection of how the market would be expected to price the instrument. In exercising this judgment, a variety of tools are used including proxy observable data, historical data, and extrapolation techniques. The best evidence of fair value of a financial instrument at initial recognition is the transaction price unless the fair value of that instrument is evidenced by comparison with other observable current market transactions in the same instrument or based on a valuation technique whose variables include only data from observable markets. Any difference between the transaction price and the value based on a valuation technique is not recognized in the consolidated income statement on initial recognition. Subsequent gains or losses are only recognized to the extent that it arises from a change in a factor that market participants would consider in setting a price.
The Group considers that the accounting estimate related to valuation of financial instruments where quoted market prices are not available is a key source of estimation uncertainty because: (i) it is highly susceptible to change from period to period because it requires management to make assumptions about interest rates, volatility, exchange rates, the credit rating of the counterparty, valuation adjustments and specific feature of the transactions and (ii) the impact that recognizing a change in the valuations would have on the assets reported on its consolidated statement of financial position as well as its profit/ (loss) could be material.
The Group classifies its financial instruments using a fair value hierarchy that reflects the significance of the inputs used in measuring the fair value of those instruments. The fair value hierarchy has the following levels:
Level 1 – quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 – inputs other than quoted prices included within Level 1 that are observable for
the asset or liability, either directly (i.e., as prices) or indirectly (i.e., derived from prices).
Level 3 – i nputs for the asset or liability that are not based on observable market data (unobservable inputs).
The Group uses quoted market prices from independent information sources, for all its financial assets and liabilities recorded at fair value, with the exception of certain debt securities, which are valued using internal models, and derivative financial instruments, which are valued using generally recognized valuation models based on market data.
The Group considers the credit risk of its counterparties when estimating the fair value of financial instruments, including derivatives. The Group attempts to mitigate credit risk to third parties by entering into netting and collateral arrangements. Net counterparty exposure (counterparty positions netted by offsetting transactions and both cash and
Chairman of the Board
of Directors
Analysis of the Bank’s financial statements
Corporate governance
Corporate social responsibility
Statements
the Bank’s assetsthe Bank’s liabilities the Bank’s income
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securities collateral) is then valued for counterparty creditworthiness and this resulting value is incorporated into the fair value of the respective instruments. The Group generally calculates the credit risk adjustment for derivatives on observable credit data.
Credit risk is measured using dynamic models that calculate the probability and potential future exposure given default. The main inputs used in these models are generally data relating to individual issuers in the portfolio and correlations thereto. The main inputs used in determining the underlying cost of credit for credit risk derivatives are quoted credit spreads and the correlation between individual issuers’ quoted credit derivatives. Historically, the Group did not adjust derivative liabilities for its own credit risk. As at 31 December 2012, 2011 and 2010, the impact of credit valuation adjustments in the derivatives portfolio was not material to the Group.
Had Management used different assumptions regarding the interest rates, volatility, exchange rates, the credit ratings of the counterparties, a larger or smaller change in the valuation of financial instruments where quoted market prices are not available could have had a material impact on the Group’s reported net (loss)/income.
The table below summarizes the Group’s financial assets and liabilities held at fair value by valuation methodology at 31 December 2012, 2011 and 2010, respectively:
Category as per the consolidated statement of financial position Quoted prices in active markets Internal models based on market prices Internal models (unobservable inputs) 31 December 2012 (Level 1)
(KZT million) (KZT million)(Level 2) (KZT million)(Level 3) (KZT million)Total
Assets:
Trading assets Debt securities 103,561 – 83 103,644
Equity investments 6,355 – – 6,355
Derivative financial
instruments Foreign exchange and interest rate
contracts – 8,823 – 8,823
Investments available-
for-sale Debt securities 13,965 – – 13,965
Equity securities 1,717 – – 1,717
TOTAL 125,598 8,823 83 134,504
Liabilities:
Derivative financial
instruments Foreign exchange and interest rate
contracts – 8,877 – 8,877
TOTAL – 8,877 – 8,877
Category as per the consolidated statement of financial position Quoted prices in active markets Internal models based on market prices Internal models (unobservable inputs) 31 December 2011 (Level 1)
(KZT million) (KZT million)(Level 2) (KZT million)(Level 3) (KZT million)Total
Assets:
Trading assets Debt securities 165,277 – 82 165,359
Equity investments 9,852 – – 9,852
Derivative financial
instruments Foreign exchange and interest rate
contracts – 13,102 – 13,102
Investments available-for-
sale Debt securities 11,312 – – 11,312
Equity securities 4,107 – – 4,107
TOTAL 190,548 13,102 82 203,732
Liabilities:
Derivative financial
instruments Foreign exchange and interest rate
contracts – 37,771 – 37,771
TOTAL – 37,771 – 37,771
Category as per the consolidated statement of financial position Quoted prices in active markets Internal models based on market prices Internal models (unobservable inputs) 31 December 2010 (Level 1)
(KZT million) (KZT million)(Level 2) (KZT million)(Level 3) (KZT million)Total
Assets:
Trading assets Debt securities 197,068 - 120 197,188
Equity investments 4,519 - - 4,519
Derivative financial
instruments Foreign exchange and interest rate contracts - 21,524 - 21,524
Investments available-for-
sale Debt securities 11,876 - - 11,876
Equity securities 4,946 - - 4,946
TOTAL 218,409 21,524 120 240,053
Liabilities:
Derivative financial
instruments Foreign exchange and interest rate contracts - 36,047 - 36,047
TOTAL - 36,047 - 36,047
2012
(KZT million) (KZT million)2011 (KZT million)2010
Beginning of the year 82 120 599
Gain/(loss) recognized in the consolidated income
statement 1 (38) (479)
End of the year 83 82 120
Reconciliation from the beginning balances to the ending balances in Level 3 of fair value hierarchy for the years ended 31 December 2012, 2011 and 2010 was presented as follows:
Internal models used in estimation of fair value of certain debt instruments are based on discounted future cash flows with/or without consideration of restructuring plan depending on type of debt security. Discount factors are estimated using yield curve which in turn is formed by constructing risk-free curve for a given currency of debt instrument adding a risk premium. The risk premium value is measured in basis points and reflects an issuer’s credit risk determined using a robust scoring model. This internal model does not take directly into consideration available market information related to prices. However, on a regular basis its outcomes are compared with prices of similar instruments or quoted prices of certain debt instruments, which the Management does not consider reliable due to low trading volumes, thus, a minimal number of those values are used to determine fair value of the debt instrument. Reasonable possible changes in the key assumptions were used. Based on changing the key assumptions, Management determined that changing these assumptions did not cause the fair value of those debt instruments to change significantly.
Goodwill impairment
The review of goodwill for impairment reflects management’s best estimate of the future cash flows of the CGUs and the rates used to discount these cash flows, both of which are subject to uncertain factors as follows:
• the future cash flows of the CGUs are sensitive to the cash flows projected for the periods for which detailed forecasts are available and to assumptions regarding the long- term pattern of sustainable cash flows thereafter. Forecasts are compared with actual performance, and reflect management’s expectations of future business prospects at the time of the assessment; and
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• the rates used to discount future expected cash flows are based on the costs of capital assigned to individual CGUs and the rates can have a significant effect on their valuation. The cost of capital percentage is generally derived from a Capital Asset Pricing Model, which incorporates inputs reflecting a number of financial variables, which are subject to fluctuations in external market rates and economic conditions beyond our control. Impairment testing inherently involves a number of judgmental areas: the preparation of cash flow forecasts for periods that are beyond the normal requirements of management reporting; the assessment of the discount rate appropriate to the business; estimation of the fair value of cash-generating units; and the valuation of the separable assets of each business whose goodwill is being reviewed.
During 2012, 2011 and 2010 no impairment of goodwill was identified. The carrying amount of goodwill as at 31 December 2012 is KZT 2,405 million (2011: KZT 2,405 million, 2010: KZT 2,405 million).
Statutory reserve
The Statutory reserve which reflects the difference between provisions for impairment losses accrued under IFRS and provisions for impairment losses reported to the regulator in accordance with statutory requirements amounted to KZT 802 million as at 31 December 2012 (2011: KZT 172,009 million). The difference results mostly from methodological deviations in the calculation of the provision on loans to customers in accordance with statutory requirements and under IFRS. One of the differences is attributable to the impact that collateral has on the level of provisions. This reserve is required by legislation of the Republic of Kazakhstan and is created through an appropriation of retained earnings.