Loans and advances to banks and customers are carried at amortised cost, including deferred interest. Premiums and discounts are shown under deferred items, in accordance with section 340e (2) of the HGB. Credit risks are accounted for by setting aside provisions in the amount of the expected loss, using prudent estimates.
Portfolio-based valuation allowances are recognised for risks which have already materialised, but which cannot be allocated to individual loans and advances due to lack of knowledge. For this purpose, groups of financial assets with comparable default risk profiles are combined in portfolios and reviewed for impairment. The valuation allowances are calculated using a formula-based procedure based on the following Basel II parameters used in the advanced IRB Approach: expected loss given default (LGD) and probability of default (PD). The transition of the one-year probability of default, which represents the basis for the concept of expected loss pursuant to the German Solvency Regulation (Solvabilitätsverordnung), to the concept of incurred loss is made using the LIP (Loss Identification Period) factor. The LIP factor is a correction factor to adjust the one-year probability of default to the estimated time period, from the date the loss is incurred up to the identification of the actual loss.
Securities
Bonds and other fixed-income securities, as well as equities and other non-fixed income securities, are measured strictly at the lower of cost or market value, as prescribed for current assets, taking into account hedging instruments. Where the reasons for the write-down no longer apply, write-ups are made in accordance with section 253 (5) of the HGB. Investment securities are valued at the lower of cost or market. Differences between cost and amounts repayable are amortised in income.
Participating interests, interests in affiliated companies, intangible assets and tangible assets
Participating interests, interests in affiliated companies and tangible assets as well as purchased intangible assets are stated at purchase or production costs, less depreciation/amortisation. Write-downs are required in the event of impairments in value deemed to be other than temporary.
Where the reasons for the write-down no longer apply, write-ups are recognised for participating interests, interests in affiliated companies, intangible assets and tangible assets in accordance with section 253 (5) of the HGB. Where land and buildings were acquired to salvage loans and have been in the possession of the bank for more than five years, these are reported under tangible fixed assets. Additions of low-value com- mercial goods ("geringwertige Wirtschaftsgüter") of not more than € 150 are fully written off in the year of acquisition, and accounted for as disposals. In addition, Aareal Bank AG made use of the simplification rule pursuant to section 6 (2a) of the German Income Tax Act (Einkommensteuergesetz – "EStG").
The option to disclose a net amount, pursuant to section 340c (2) of the HGB has been exercised. The relevant amount was reported in an expense or income line item.
Deferred taxes
If there are differences between the book value of assets, liabilities, deferred income and prepaid expenses and their related tax bases which are expected to be reversed in later financial years, any resulting net tax burden is recognised as a deferred tax liability and any resulting net tax benefit is recognised as a deferred tax asset, in accordance with section 274 of the HGB. Tax loss carryforwards are taken into account in the calcu- lation of deferred tax assets, based on the level of the potential losses to be offset within the next five years. Deferred taxes are measured using the company- and country-specific tax rates expected to apply at the time of the realisation of temporary differences and the offsetting of loss carryforwards. The bank discloses deferred taxes on a gross basis, in accordance with section 274 (1) sentence 3 of the HGB.
Liabilities
Liabilities are shown on the balance sheet at the settlement amount. The difference between the settlement amount and the initial book value of liabilities is recognised under deferred items, and amortised over the term of the liability.
Provisions
Provisions are recognised in the amount of the required settlement amount, as determined based on prudent commercial judgement. Pursuant to section 253 (2) sentence 1 of the HGB, provisions with a remaining term of more than one year have to be discounted using the average market interest rate of the past seven years applicable for their average remaining term.
Provisions for pensions have to be recognised at the settlement amount, taking into account future wage, salary and pension trends. The amount recognised has to be discounted pursuant to the provisions set out in section 253 (2) of the HGB. Provisions for pensions and similar obligations are determined in accordance with actuarial principles.
Provisions for taxes and other provisions have been set aside for existing legal or constructive obligations in the settlement amount, as required by prudent commercial judgement.
Currency translation
Currency translation complies with the principles set out in sections 256a and 340h of the HGB.
The bank has classified all foreign exchange transactions as “specific cover” and measured these using the middle spot rate (ECB reference middle rate) in accordance with section 340h of the HGB. Hence, income and expenses from currency translation were recognised in the income statement.
The bank decomposes foreign exchange forward transactions into an agreed spot base and the swap rate, recognising a deferred liability (reported under other liabilities) equivalent to the net aggregate difference between the spot base and the exchange rates prevailing on the reporting date. Forward premiums or discounts are amortised in net interest income over the term of the transaction.
Currency translation income and expenses are reported in net other operating income/expense. Trading portfolio
There were no financial instruments of the trading portfolio as at the balance sheet date. Hedging relationships
The bank establishes hedging relationships within the meaning of section 254 of the HGB. Accordingly, fixed- income securities of the liquidity reserve in the amount of € 4,782.14 million are hedged against changes in value attributable to interest rate risk, on the basis of so-called "micro hedges". In this context, the underlying transaction and the hedge generally are acquired within the framework of so-called "asset swap packages", i.e. they are so-called "perfect hedges" where all value-affecting factors between the hedged portion of the underlying transaction substantially correspond to the hedging portion of the hedge. The prospective effective-
ness of the hedging relationship, which refers to the period until the security's final maturity, is proven, based on the so-called "critical terms match method". Regression and correlation coefficients are used as criteria to measure retrospective effectiveness.
This is presented in the financial statements using the so-called "net hedge presentation method" (Einfrie- rungsmethode). Under this method, the cumulative changes in the value of the underlying transaction is determined on the basis of the hedged risk, and compared to the changes in the value of the hedge. The hedged risk amounts to € 658.4 million and corresponds to the cumulative increase of the fair value of assets since inception of the hedging relationship. This increase is not shown in the income statement on a net basis, after including hedge transactions. Any previously existing ineffectiveness based on the hedged risk is
reflected in a provision for hedging relationships. The changes in value attributable to the hedged risk are reflected on a portfolio basis, in the form of a write-down on the security concerned.
The bank continues to establish hedging relationships between repurchased own bonds in a nominal amount of € 1,411.27 million and the corresponding securitised liabilities.
Fair value measurement of interest rate instruments of the banking book
In addition, Aareal Bank AG recognises derivative financial instruments of the banking book (non-trading book) for the purpose of controlling various risks as part of overall management of the bank. In accordance with HGB, these instruments represent "pending transactions" which are not recognised in the balance sheet. They form a "hedging relationship", together with the recognised assets and liabilities. No provision for anticipated losses had been recognised as at the balance sheet date. The present value of the banking book is positive as at 31 December 2012.
Derivatives
Derivative financial instruments are considered pending transactions, and are therefore generally not recorded in the balance sheet.
Exchange-traded derivatives are included at their quoted market price. The market price of over-the-counter (OTC) derivatives is determined using standard valuation models commonly accepted in the financial industry, such as the present value technique and option pricing models. The fair value of foreign exchange forwards is generally based on current forward exchange rates.
Acquired as well as issued structured products are accounted for as groups of uniform assets and liabilities in accordance with IDW RS HFA 22.
Structured products subject to different types of risks or rewards are accounted for separately as individual receivables or liabilities.