Area: 2006/48/EC, Article 4 (22) and Annex X, Part 3. Mapping of operational risk losses

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1 EUROPEAN COMMISSION Internal Market DG FINANCIAL INSTITUTIONS Banking and Financial Conglomerates Area: 2006/48/EC, Article 4(19) Definition of financial holding company Question number: 66 Date of question: 7 April 2006 Publication of answer: 7 July 2006 How should the statement exclusively or mainly be defined and calculated in the financial holding company definition? The criteria used to assess whether subsidiary undertakings are exclusively or mainly credit institutions or financial institutions may vary across Member States. It may also depend on the group s structure and accordingly be assessed on a case by case basis. Nevertheless, based on current supervisory practices, some criteria for defining whether subsidiaries are exclusively or mainly credit institutions or financial institutions include: the total assets/returns of the subsidiaries with the status of credit or financial institutions compared to the total assets/returns of the group; the number of these subsidiary undertakings; and the weight of participations in institutions carrying out activities that are typical of credit institutions or investment firms in the portfolio of permanent financial investment in capital. Area: 2006/48/EC, Article 4 (22) and Annex X, Part 3 Question number: 216 Mapping of operational risk losses Date of question: 15 February 2007 Publication of answer: 16 April 2007 The question is about mapping of losses from crystallisation of project losses. Project risks are not directly mentioned in Table 3 of Annex X, Part 5, therefore the questions related are a) Are the losses that stem from project management and scheduling failures to be recorded in the loss database? b) We think disputes with external project consultancy firms may fit the loss event type 1

2 classification of "execution, delivery and process management" of CRD. Is this interpretation in line with CRD? c.) Or is the "clients, products, and business practices" category is more suitable? We also recognise that "clients, products, and business practices" definition also calls for losses arising from the nature or design of a product. May this definition be extended to include project design and deliverance? Losses resulting from project management and scheduling failures shall be included in the loss database in so far as they fall within the definition of operational risk in Article 4(22). The loss should be traceable to internal inadequacies or failures or to an external event such as fraud by the employees of the consultant. The right loss event type depends on the actual loss event. 'Execution, Delivery and Process Management' loss event types referred to in Table 3 of Annex X would often be the appropriate classification. "Clients, products, and business practices" would only be applicable in cases where the credit institution fails to meet obligations to its own clients. Area: 2006/48/EC, Article 4(28) Question number: 12 Date of question: 9 December 2005 Publication of answer: 12 April 2006 Capital requirement for conversion factors Why does the definition include unadvised limits? This is an inconsistency to Basel. The CRD text is not inconsistent with the Basel text. Paragraph 474 of the Basel text which defines the specific requirements for EAD estimation under the AIRB approach refers to the " gross exposure of the facility upon default of the obligor". When estimating both conversion factors and exposure values, institutions should take into account the full extent of the potential exposure to a customer. That is the amount that the customer could draw without the need for a further credit decision, which may be the higher of the advised limit (known to the customer) and the unadvised limit (approved internally by the credit institution). As regards the definition of default, by relating to the advised limit, both the CRD text and the Basel text (paragraph 452, last bullet point) make the "past due" concept more transparent to the borrower and ensure that both institution and borrower have the same information about the borrower s default or non-default status. Furthermore, even if the definition of default kicks in before if the unadvised limit is higher (and the relevant probability of default may tend to increase), the ultimate effect on capital requirements will depend on the relevant credit institution's cure 2

3 rate. Area: 2006/48/EC, Article 4(22) Question number: 210 Operational risk strategic risk Date of question: 5 February 2007 Publication of answer: 26 February 2007 In Article 4 (22), operational risk is defined as "22) operational risk means the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, and includes legal risk". CEBS gives a definition of strategic risk in CP03 and counts it among Pillar II risks: "Strategic risk: the current or prospective risk to earnings and capital arising from changes in the business environment and from adverse business decisions, improper implementation of decisions or lack of responsiveness to changes in the business environment." We find it very interesting that CRD never mentions strategic risk although Basel II text paragraph 644 says "operational risk...but excludes strategic and reputational risk". a.) Is there a rationale for that? b.) How should the credit institutions evaluate whether a loss that is claimed to be stemming from a strategic decision should be: b.1) recorded in the operational risk loss database b.2.) and/or counted towards operational risk regulatory capital? c.) Can a differentiation be made between very senior executive level strategic decisions (like Board of Directors) and senior level tactical decisions (departments)? Can the loss amount of the event created by strategic risk be important while deciding and categorising a loss event as strategic risk? (between a very profound effect to earnings and a minor-effect event). d.) If there are provisions set against probable strategic risk losses, we can ignore them in the AMA modelling and calculation. Is this interpretation correct and in line with the Directive? e.) The relevant indicator calculation in the operational risk standard approaches does not leave strategic risk out. Is this interpretation in line with the Directive? Strategic risk does not fall under the definition of operational risk in Article 4 (22). Therefore, losses from strategic risk are neither required to be recorded in operational risk loss databases nor to be modelled in AMAs for capital requirement purposes. The relevant indicator of the simpler approaches was likewise not calibrated to reflect strategic risk. 3

4 Area: Directive 2006/48/EC, Article 4(28) Question number: 84 Date of question: 30 May 2006 Calculation of conversion factors Publication of answer: 12 October 2006 Is it possible to have and to use for RWA estimation purpose CCF greater then 100%? The question is related to changing credit limits. Suppose that at the moment of default EAD is equal to 110 and credit limit is year before default when CCF is being estimated on-balance exposure was 60 and credit limit was only 100. If one estimates CCF using limit of 100 one year before default, he or she will get CCF of (110-60)/(100-60) or 125%. If one uses limit at the moment at default then CCF is (110-60)/(120-60) or 83%. This raises such questions: 1) Which of the two CCFs is the right one, 125% or 83%? 2) If it is 125%, should we use this 125% CCF also for nondefaulted exposures for EAD estimation purposes and by doing so to account for possible future increase in credit limit? Or maybe we should set condition that the final realised CCF estimate is equal to Max(0;MIN(100%, CCF))? 3) If the answer to the second question is YES, then is the intention of Basel II to account for possible future increases in credit limits? 4) If the answer to the third question is YES, then shouldn't we account for possible future increases in exposures which have only an on-balance part, for example corporate borrower increases long-term loan amount? 5) What is the correct way to proceed in the example above? Regarding questions 1) and 2), it is not possible to estimate the conversion factor from the described observations. It appears important that a credit institution, in estimating conversion factors, applies a consistent treatment of observed exposures at default and utilises relevant available information in terms of different credit limits and drawn amounts prior to default in doing so. Comparing both the limit and the drawn amount at the time of default only (the "83% observation" in the correspondent's example) does not meet the Directive requirement of estimating the currently undrawn amount that will be drawn at default, i.e., the term currently referring to a moment in time prior to default. Note furthermore that Annex VII, Part 4, point 89 requires credit institutions to reflect in the conversion factor the possibility of additional drawings up to and after default, in principle regardless whether within or beyond the credit limit. 4

5 Regarding questions 3) and 4), please note that the requirement is to reflect additional drawings and not future lending decisions (i.e., increases in credit lines). Furthermore, future drawings need only be reflected in the context of conversion factor estimation for undrawn commitments. Area: 2006/48/EC, Article 4(28) Question number: 185 Date of question: 11 December 2006 Publication of answer: 15 January 2007 Estimation of credit conversion factors By reading some papers found over the Internet (a "History- Dependent" model of Credit Conversion Factor), CCF may be estimated according to the following formula: CCF = [Utilisation(default)-Utilisation(a year ago since default)] / [1 - Utilisation(a year ago since default)] and Utilisation = Amount drawn / Credit Line Is it right? Credit institutions are required to estimate the ratio of the currently undrawn amount of a commitment that will be drawn and outstanding at default to the currently undrawn amount of the commitment. A calculation as described may form one element of the estimation process that may be considered along with other elements in order to arrive at valid estimates. Note, however, that the above calculation assumes that the amount of the credit line does not change over time. If that was not the case, the calculation would not yield results in line with the definition in Article 4(28). Regarding guidance for the overall estimation process, please refer to Q12, Q84 and CEBS GL 10. Area: 2006/48/EC, Article 4(36) and Article 96(2) Question number: 274 Date of question: 25 September 2007 Publication of answer: 11 December 2008 Transactions with SPV definition of a securitisation position Article 96(2) of Directive 2006/48/EC states;.the providers of credit protection to securitisation positions must be considered to hold positions in the securitisation. Securitisation positions shall include exposures to a securitisation arising from interest rate or currency derivative transactions. From this, we would assume 5

6 that if a bank transacts an interest rate or currency derivative position with an SPV (that has completed a securitisation) or sells a CDS to an SPV, the banks must treat these transactions according to the securitisation requirements. However, Article 4, Section 36 states: securitisation means a transaction or scheme, whereby the credit risk associated with an exposure or pool of exposures is tranched, having the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or pool of exposures; and (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme" While it could be argued that in our example, payments depend on the underlying credit performance of the collateral pool, as the CDS premium paid to the Bank selling protection is dependent on the assets of the SPV, we are unclear as to how the tranching and subordination elements fit the example and thus, whether our example would indeed fall under the scope of the securitisation rules. In the case of any derivative transactions, it is important to distinguish the counterparty credit risk from the risk driven by the underlying of the derivative. Exposures to a securitisation arising from interest rate or currency derivative transactions All types of over-the-counter derivative (e.g. interest-rate or currency swaps, and credit derivatives) attract counterparty credit risk. If the counterparty of a derivative is a securitisation SPE (SSPE), the counterparty credit risk will be treated as a securitisation position according to where the claim on the SSPE counterparty would rank in the tranching of the securitisation positions. Providers of credit protection to securitisation positions When it comes to credit derivatives entered into with an SSPE, a securitisation position can arise not through counterparty credit risk, but through credit risk assumed through the derivative. The protection provider will have a securitisation position if either: the underlying names of the credit derivative are securitisation positions; or the underlying assets are not securitisation positions, but the credit protection covers only a tranche of the underlying portfolio, thus creating a synthetic securitisation. This meets the definition of a securitisation because protection payments due from the protection provider to the protection buyer are based on the performance of the underlying assets. If the protection provider gives protection to the originator on one or more of the exposures in the securitised portfolio (but without tranching) and its position has been transferred with the securitisation to the SPV, it does not have a securitisation position 6

7 but an exposure on the names for which credit protection has been provided. Consequently, it shall apply the credit risk framework. Area: Directive 2006/48/EC, Article 4(37) Question number: 343 Date of question: 2 July 2008 Publication of answer: 12 September 2008 Definition of a securitisation - issuance of securities Article 4 (37) of Directive 2006/48/EC: traditional securitisation means a securitisation involving the economic transfer of the exposures being securitised to a securitisation special purpose entity which issues securities. This shall be accomplished by the transfer of ownership of the securitised exposures from the originator credit institution or through sub-participation. The securities issued do not represent payment obligations of the originator credit institution; Our questions: - Is it essential for a special purpose entity to issue securities in order to be considered as a securitisation? - Do the securities being issued by a special purpose entity in a securitisation have to be fungible securities? The claims on the securitisation special purpose entity can take forms other than that of securities with the definition of a traditional securitisation still being met. Area: 2006/48/EC, Article 4 (38), Annex IX, Part 2, point 2 Question number: 257 Date of question: 25 July 2007 Publication of answer: 14 November 2007 Synthetic securitisation/credit protection with tranches 1) Definitions of synthetic securitisation. The definition of synthetic securitisation introduced in Article 4 (38) indicates the credit derivatives or the guarantees as the means used in order to transfer credit risk. In Annex IX, Part 2, point 2, when describing the minimum requirements for recognition of significant credit risk transfer in a synthetic securitisation, the Directive 2006/48/EC says credit risk transferred to third parties either through funded or unfunded credit protection. If bank A has an exposure partially collateralized by a pledge on government bonds provided by bank B and this credit protection creates a tranching, then does the (synthetic) securitization treatment applies? If the securitisation framework shall not be applied, it is hard to understand what is included in the securitisation definition (which is based on the tranching 7

8 concept, whatever the legal form is). On the other hand, it must be noted that the abovementioned definition (Article 4, point 38) of synthetic securitisation does not explicitly refer to collateral. 2) Investor s treatment If the securitisation framework applies, let s suppose that bank B is an SA bank. We envisage the following consequence: Bank B holds the first loss protection (by providing the collateral), but because it is an investor no cap will apply to the first loss exposure of bank B (the Standardized Approach does not allow for a cap for banks which are neither originator nor sponsor). Therefore, we might come up with a very odd situation: if bank B fully collateralized the exposure, it could be charged a capital requirement lower than the one applied in case it partially collateralized the exposure. An example might help: - bank A has exposures equal to 100 weighted 100% which are securitised; the capital requirement applied to these exposures is equal to 8 (100 x 100% x 8%); - if bank B provides full credit protection via collateral (CCF 100%), it is charged with a capital requirement of 8 (i.e. 100 x 100% x 100% x 8%); - if bank B provides partial credit protection that covers the first loss for 10 (CCF 100%), the capital requirement amounts to 10, as no cap applies. 1) Yes, the (synthetic) securitisation treatment applies 2) No, the outcome of the above example does not represent an odd situation. The higher capital requirement reflects one of the key assumptions underpinning the securitisation framework, i.e. junior unrated losses broadly represents a proxy of expected losses associated with the underlying portfolio and, as such, should attract the highest capital charge. The absence of a cap to capital requirements for investors' securitisation positions reflects the outcome of the legislative process at the EU level. Area: Directive 2006/48/EC, Article 4(44) Question number: 110 Date of question: 28 June 2006 Publication of answer: 28 November 2006 Synthetic securitisations: status of SSPE An unclear issue for us is the status of the SSPE in the synthetic securitisation. Is the consolidation of the SSPE to the originator an important issue when a synthetic securitisation transaction is in question? 8

9 As the originator can carry out the risk transfer without the SSPE it would seem logical that even if the SSPE were consolidated into the originator, the transaction would still be considered to be eligible for Basel II securitisation framework. Also, based on the following definitions of SPEs, SPVs and SSPEs we would like to raise the question, when the assets and liabilities of the mentioned entities may or may not be required to be consolidated to the entity that created them. FSI tutorials: A special purpose entity (SPE), sometimes referred to as a special purpose vehicle (SPV), can be any corporation, trust or other such entity established for a specific purpose (including a physical or synthetic securitisation). The SPE must have a structure that makes it completely independent from its originator or seller in terms of their credit risk exposures. A special purpose vehicle (SPV) is the entity that purchases the assets from the originator in a securitisation. The SPV is typically a wholly-owned subsidiary of the originator and is a "bankruptcy remote entity". Directive 2000/12/EC Securitisation special purpose entity (SSPE) means a corporation trust or other entity, other than a credit institution, organised for carrying on a securitisation or securitisations, the activities of which are limited to those appropriate to accomplishing that objective, the structure of which is intended to isolate the obligations of the SSPE from those of the originator credit institution, and the holders of the beneficial interests in which have the right to pledge or exchange these interests without restriction. Article 95 states that credit institutions may apply the securitisation framework as set out in Annex IX where significant credit risk associated with the securitised exposures has been transferred in accordance with the terms of Annex IX, Part 2. This is the only test that must be met when determining whether the approaches in Annex IX should be applied to a synthetic securitisation. It follows from this that accounting derecognition of the securitised credit risk exposures is neither a prerequisite for, nor evidence of, the effectiveness or significance of credit risk transfer for prudential purposes(see also CEBS GL10). Area: Question number: 352 Directive 2006/48/EC, Article 4 (45)(a) Group of connected clients Date of question: 13 August 2008 Publication of answer: 7 October 2008 Article 4(45)(a) defines the group of connected clients based on the criterion of control as follows: group of connected clients 9

10 means: (a) two or more natural or legal persons who, unless it is shown otherwise, constitute a single risk because one of them, directly or indirectly, has control over the other or others Does this definition mean that the control mechanism has to be limited to the clients of a bank (that is to say to persons with whom the credit institution is in a contractual relationship) or can it be applied to whatever member of a group of companies even though there is no contractual relationship between the bank and the controlling entity? If the word "client" is supposed to have a sense there must be a direct or indirect control of one client company on another client company. This is not the case between two sister companies (controlled by the same entity that is in no contractual relationship with the bank) or a sister and the daughter of her sister. If the word "client" has no sense, as soon as a bank has a contractual relationship with two or more entities of the same group, they are treated as a "group of connected clients" although none of the entities has a direct or indirect control over the others. The definition of a 'group of connected clients' in Article 4(45) is risk-oriented and includes all natural and legal persons contributing to the risk of the concerned exposure no matter whether there is more than one contractual relationship with the institution, and whether this or these relationships refer to the controlling entity. Area: 2006/48/EC, Articles 57/67 Question number: 9 Date of question: 9 December 2005 Publication of answer: 9 March 2006 Accounting framework used for own funds calculation Does the Directive leave it open which accounting framework for the purpose of the calculation of own funds requirements according to Articles 57 to 67 can be used? The CRD contains a number of provisions relating to which accounting framework may be used: Article 57 makes a number of references to Directive 86/635/EEC for the specification of own funds items; Article 64(4) prevents the inclusion in own funds of certain items that can arise for credit institutions that use IAS/IFRS; Article 74(1) specifies how assets and off balance sheet items should be valued, namely in accordance with the statutory accounting framework (but does not refer to the accounting framework for liabilities, the accounting classification of most 10

11 Own Funds constituents). As well as these binding provisions, Recital 30 indicates that the calculation of own funds should "take account of" the accounting framework to which, under national law, the credit institution is subject. The CRD does not legally compel credit institutions, investment firms or supervisory authorities to use the same accounting framework for the calculation of Own Funds as that which applies for statutory reporting. However, clearly the logic underlying the CRD text is that credit institutions should use either Directive 86/635/EEC or IAS/IFRS for both sides of the balance sheet. For each credit institution, this will depend on and take account of the choices and obligations at national level about the scope of application of IAS/IFRS for statutory reporting. Area: 2006/48/EC, Article 57 Question number: 10 ISA/IFRS own funds components Date of question: 9 December 2005 Publication of answer: 9 March 2006 Yes (See Question 9) Is it allowed to use IAS/IFRS-standards as own fund components in Article 57 of Directive 2006/48/EC? Background: Regulation 1606/2002 allows IAS/IFRS standards for the purpose of harmonising financial information, but does not lay down the objective of harmonising the calculation of own funds requirements. In its relation to Directive 86/635/EEC it is not clear, whether the value of assets, calculated for accounting purposes on the basis of IFRS-standards, can also be used for the purpose of the calculation the capital requirement. Directive 2006/48/EC does not lay down this objective, but includes some prudential filters and the reference on Regulation 1606/2002 in Article 74 of Directive 2006/48/EC. Area: Question number: 130 Date of question: 26 July /48/EC, Article 57(a) Publication of answer: 26 October 2006 Definition of "value adjustments" In the CRD the term ' value adjustment' is used in various places. Given that in previous CRD drafts the term write-offs was used and subsequently replaced by value adjustments, we originally 11

12 assumed that it was a mere name change (without widening the scope). We noted that in almost all cases, the term value adjustments was used in conjunction with provisions. Later on we discovered that various stakeholders (peer banks, regulators) had different interpretations of the term ' value adjustments' and we changed our view looking at the impact of IFRS. In Article 57(e) there is a reference to Article 37(2) of Directive 86/635/EEC which unfortunately did not bring us any further. Could you please clarify which of the following items are covered in the term ' value adjustments': 1 write-offs 2 fair value adjustments (revaluations of assets, changes in market value or book value) 3 general provisions (as opposed to specific provisions) 4 any other items? Our interpretation is that only the items under 1 and 2 above are captured under ' value adjustments'. We would be very grateful if you could confirm this assumption. Broadly speaking, a reference to a 'value net of value adjustments' does mean that the exposure value is the fair value or the historic cost less specific provisions/write-offs. However, the term 'value adjustments' as referred to in the CRD does not lend itself to a precise and comprehensive definition, in part because of the different accounting conventions in use (IFRS vs. national GAAPs) and also because of the different contexts in which the term is used. For example, as referenced under the Own Funds rules (2006/48/EC, Article 57 (e)), the term value adjustments is as it was in Directive 2000/12/EC, and as such is not a new term. For details on how this provision has been applied or interpreted, you may refer to the CEBS publication 'Current Rules on Own Funds and Market Trends in New Capital Instruments.' In terms of what items are covered under this provision, it should be noted that in accordance with Article 61, the use of the Own Funds constituents in Article 57, "shall be left to the discretion of the Member States." For past due items under the Standardised approach, (Annex VI, Part 1, point 61) the reference to value adjustments refers to specific provisions and write-offs. In a different reference, Annex VII, Part 4, point 36 states that the EL amounts shall be subtracted from the sum of value adjustments and provisions related to those exposures, but the text is also explicit that in this case discounts on balance sheet exposures purchased when in default should also be treated as value adjustments. These examples should serve to illustrate that a general listing of the makeup of 'value adjustments' that applies in all instances in 12

13 the CRD is not appropriate. Area: Question number: /48/EC, Article 57 (o) Date of question: 7 January 2008 Publication of answer: 3 April 2008 Deduction of short term investment in insurance undertaking The bank has short-term investment in insurance undertaking (comprising 100 % of insurance undertaking s capital) for resale purposes. Does this bank have to deduct such an investment from its capital in accordance with item (o), Article 57 of the Directive 2006/48/EC? This participation exceeds 20% of the capital of the insurance undertaking and thus falls within the scope of Article 57(o) pursuant to Article 4(10). Wherever booked (trading or banking book), a short term investment in insurance undertaking within the meaning of Article 4(10) shall be deducted, unless otherwise provided for (Article 58, 59 and 60). Area: 2006/48/EC, Article 72(3) Question number: 59 Disclosure requirements Date of question: 30 March 2006 Publication of answer: 7 July 2006 The competent authorities responsible for exercising supervision on a consolidated basis may decide not to apply paragraph 1 and 2 to credit institutions which are included within comparable disclosures provided on a consolidated basis by a parent undertaking established in a third country. 1) If the competent authority decides not to apply in full paragraphs 1 and 2 to the credit institutions which are included within comparable disclosures provided on a consolidated basis by a parent undertaking established in a third country: a) are significant subsidiaries in that case exempted from disclosing information on an individual basis? (Article 72 [1 and 2])? b) Is the EU parent credit institution (Article 72(1)) or the credit institution controlled by an EU parent holding company (Article 72(2)) in that case exempted from disclosing information on an individual basis? 2) If the competent authority decides not to apply in part 13

14 paragraphs 1 and 2, does this mean that significant subsidiaries do not have to disclose information or does this mean that EU parent credit institutions or credit institutions controlled by an EU parent financial holding company, do not have to disclose information on a consolidated basis? Or does this mean that the competent authority may choose between the two? EU parent credit institutions, or credit institutions controlled by an EU parent financial holding company, are required to make disclosure on a consolidated basis under Article 72(1) or (2) respectively. There is no requirement for them to make disclosures on an individual basis (unless, in the case of credit institutions controlled by a FHC, they are also significant subsidiaries). The consolidating supervisor can exercise the discretion in Article 72(3) in full or in part. The consequence of the exercise of the discretion is that either no disclosures on a consolidated basis, or partial disclosures on a consolidated basis, will be required. 1a) The significant subsidiary may still have to make disclosures if it is located in a different Member State than the one where the competent authority makes the decision under 72(3). The competent authorities in that different Member State may feel that, regardless of the disclosures by the third country parent, disclosures are still required from the significant subsidiary in their jurisdiction. 1b) EU parent credit institutions are in any case not required to disclose information on an individual basis. For credit institutions controlled by an EU parent FHC, the only disclosures they may have to make on an individual basis are those required of significant subsidiaries. 2) For significant subsidiaries the same argument as in 1a) applies: disclosure may still be required by the competent authority responsible for supervision of the significant subsidiary (where different to the competent authority exercising the discretion in 72(3)). If the discretion in 72(3) is exercised in part, then partial disclosures on a consolidated basis will be required by the EU parent credit institution, or by credit institutions controlled by an EU parent FHC. It is for the competent authority to decide on the extent of these partial disclosures. Area: 2006/48/EC, Article 73(2) Question number: 313 Scope of application Date of question: 21 January 2008 Publication of answer: 14 May 2008 Article 73(2) of Directive 2006/48/EC provides that if the parent undertaking of a subsidiary credit institution is a financial holding 14

15 company which has a credit institution or a financial institution or an asset management company as a subsidiary in a third country (or holds a participation in such an undertaking) the requirements laid down in Articles 75 and 123 on a sub-consolidated basis shall apply. 1. Is Article 73(2) applicable in the case where the parent undertaking is a financial holding company registered and operating in a third country? 2. If yes, what is the perimeter of the sub-consolidation regarding the subsidiary credit institution that operates in a member state and which methods can be implemented e.g. full consolidation, proportional consolidation etc. 3. Finally, if the subsidiary credit institution which operates in a member state was to sub-consolidate on the basis of the financial situation of the financial holding company, would this be performed by assessing the consolidated position of the financial holding company? For background information on how to implement Article 73(2), see answer to CRDTG question 8. This question does not relate to the implementation of Article 73(2) (which implies a 'subconsolidation') but refers to the way consolidation shall be performed where the 'parent' of a EU credit institution is a FHC in a third country. 1. Unless the financial holding company is subject to consolidated supervision by a third country which is deemed equivalent in accordance with Article 143 (i.e. the financial holding company in the third country consolidates the entity in a third country), the subsidiary credit institution may be subject to consolidation in accordance with Article 143(3) on the basis of the consolidated financial position of the financial holding company. 2. When applicable, consolidation shall be performed in accordance with the rules laid down in Article See answer to CRDTG question 8. Please note that a financial holding company in a third country is not regulated by EU Directives. Area: 2006/48/EC, Article 73(2) Question number: 324 Sub-consolidation Date of question: 26 February 2008 Publication of answer: 14 May 2008 In addition to CRDTG Question number 8, we have a question regarding sub-consolidation. As a result of the requirements of article 73(2) of the CRD, subsidiary credit institutions which are 15

16 not a parent credit institution in a Member state, but which do have a subsidiary credit institution, a financial institution or an asset management company outside the EU, are subject to consolidated supervision at their own level. This is referred to as sub-consolidated supervision. In the practical application, questions have been raised on the rationale behind the requirements for sub-consolidated supervision. This rationale is important, as sub-consolidated supervision can result in high administrative burden for credit institutions. Our question to the CRDTG is twofold : 1) Sub-consolidation is only required when there are subsidiary credit institutions outside the EU. When there are only subsidiary credit institutions inside the EU, sub-consolidation is not applicable according to the article. What is the rationale behind sub-consolidation in case of subsidiary credit institutions outside the EU? 2) Would this rationale be harmed when a Member State would assess the necessity of sub-consolidated supervision on a case by case basis, for example taking into account the materiality (in terms of risk) of the Non-EU subsidiary or by applying more or less the same waiver requirements as can be used to waive supervision on a solo basis? (notably: integrated risk management and transferability of capital within the group). 1. Article 73(2) implements Basel paragraph 22, requiring the framework to be applied 'at every tier within a banking group'. This is a specific requirement for 'internationally active subgroup'. Under the CRD, they are defined as institutions having a subsidiary credit institution, a financial institution or an asset management company outside the EU. 2. Application of this provision is mandatory. Area: 2006/48/EC, Article 73(2) Sub-consolidation of Financial Holding Companies Question number: 8 Date of question: 9 December 2005 Publication of answer: 12 April 2006 Article 73(2) (scope) requiring sub-consolidation notably in the calculation of own funds requirements when credit institutions have a subsidiary (or hold a participation) in a third country. We understand this provision perfectly well in the case of CI with a subsidiary in a third country, but what's the perimeter of the subconsolidation required for institutions whose mother FHC have subsidiaries in a third country? 16

17 This was discussed at length during the drafting of the proposal and during the Council and EP negotiations. The answer will depend on whether the Member State has chosen to supervise financial holding companies (FHCs) directly, or not. If the Member State does supervise the FHC directly, then the perimeter of consolidation is the FHC and the third country entity. If the Member State does not supervise FHCs directly, the only practical solution is to consolidate to the "nearest" credit institution in the group structure. The actual perimeter depends on the group structure. Some examples are shown in the diagrams attached. 17

18 THIRD COUNTRIES MEMBER STATE 1 MEMBER STATE 2 1A FHC 2A FHC EX 1B BANK 2B BANK 1. If the Member State does not directly supervise FHCs, then under Article 71(2), 1B consolidates at EU level on the basis of the financial situation of 1A. 2. Under Article 73(2), 2B sub-consolidates on the basis of the financial situation of 2A including the entity EX outside the EU. 3. However, if the Member State applies supervision directly to FHCs, then under Article 73(2) 2A 1 consolidates EX; and 4. Under Article 71(2) 1A consolidates all the other entities (which gives the same result as 2). 18

19 THIRD COUNTRIES MEMBER STATE 1 MEMBER STATE 2 1A FHC 2A FHC EX 1B BANK 1. If the Member State does not directly supervise FHCs, then under both Articles 71(2) and 73(2), 1B sub-consolidates on the basis of the financial situation of 1A including the non-eu entity EX. 2. However, if the Member State applies supervision directly to FHCs, then under Article 73(2) 2A consolidates EX; and 3. Under Article 71(2) 1A consolidates all the other entities. 2 19

20 THIRD COUNTRIES MEMBER STATE 1 MEMBER STATE 2 2A FHC EX 1B BANK 1. If the Member State does not directly supervise FHCs, then under Article 73(2), 1B consolidates on the basis of the financial situation of 2A. 2. However, if the Member State applies supervision directly to FHCs, then under Article 73(2), 2A consolidates EX. 3. In both cases, under Article 71(2), 1B consolidates on the basis of the financial situation of 2A (Article 125(2) applies). 3 20

21 THIRD COUNTRIES MEMBER STATE 1 MEMBER STATE 2 1A BANK 2A FHC MEMBER STATE 3 EX 3A BANK 1. If the Member State does not directly supervise FHCs, then under both Articles 71(2) and 73(2), either 1A or 3A consolidates on the basis of the financial situation of 2A. 2. However, if the Member State applies supervision directly to FHCs, then under Article 73(2) 2A consolidates EX; and 3. Under Article 71(2), either 1A or 3A consolidates on the basis of the financial situation of 2A. The choice between 1A and 3A is made based on Article 126(2). 4 21

22 Area: 2006/48/EC, Article 75 Question number: 322 Date of question: 25 February 2008 Publication of answer: 14 May 2008 Capital requirements for counterparty credit risk arising from both banking book and trading book positions Should capital requirements for counterparty credit risk arising from both banking book and trading book positions be included into capital requirements for credit risk or capital requirements for market risk? Or should one maybe differentiate based on whether it arises from a position in banking book or trading book (e.g. if an exposure is in the banking book, then the CCR capital charge is included in credit risk capital requirement and if an exposure is in the trading book, then the CCR capital charge is included in market risk capital requirement)? Capital requirements for counterparty credit risk are referred to in Article 75(a) while in respect of credit institution's trading book business, settlement and counterparty risk are calculated under Article 75(b). It must be noted that under Directive 2006/49/EC, Annex II, point 6, exposures values and risk-weighted exposures amounts for counterparty credit risk arising from positions in the trading book must be calculated in accordance with the relevant provisions of Directive 2006/48/EC. Although Directives 2006/48/EC and 2008/49/EC do not use the term "market risk" with respect to own funds requirements, the question could be understood as asking whether CCR exposures, at least in the trading book, could benefit from the alternative determination of own funds in Article 13(2) of Directive 2006/49/EC. This treatment is explicitly limited to Annexes I and III to VI of Directive 2006/49/EC, i.e. to position risk, foreign exchange risk and commodities risk. Since CCR is subject to Annex II of this Directive, the alternative determination of own funds is not available for this kind of risk. 22

23 Area: Directive 2006/48/EC, Article 77 Question number: 69 Definition of exposures Date of question: 28 April 2006 Publication of answer: 7 July 2006 In the course of the implementation work of the new Directive texts, we have noted a problem with the wording of Article 77. The Directive says 'exposure' for the purposes of this Section means an asset or off-balance sheet item. This, in our opinion, is not a complete description of what is intended to be covered. The problem is with derivatives contracts that have a negative market value. For the holder, they represent exposures, but having a negative current market value they will most likely be recorded in accounting terms on-balance as liabilities, not assets. We say most likely because there may be some national differences as the 1996 Accounting Directives leave this point open. In the past, it was often the case that derivatives were treated as off-balance sheets items for accounting purposes. However, that is no longer so today. Under IFRS the normal derivatives are always to be recorded on the balance sheet, as assets or liabilities depending on their current value. We believe that the same is true in many national accounting standards. We feel that the wording of Article 77 does not reflect current accounting practice and can bring doubts as to the status of the derivatives with negative current values. What are your views? The CRD does not legally compel credit institutions, investment firms or supervisory authorities to use a specific accounting framework. However, clearly the logic underlying the CRD text is that credit institutions should use the same accounting standard (e.g., Directive 86/635/EEC or IAS/IFRS) for both sides of the balance sheet. For each credit institution, this will depend on and take account of the choices and obligations at national level about the scope of application of IAS/IFRS for statutory reporting. However, the question describes a situation that may also be relevant for minimum own funds requirements for credit risk. A reading of Article 77 with respect to an accounting framework other than Directive 86/635/EEC could be interpreted as not including some risk positions which may determine a riskweighted exposure amount under the CRD provisions. The main purpose of Article 77 is to make clear that, for calculating minimum own funds requirements, each position exposed to credit risk is to be taken into account, independent of 23

24 whether this position is recorded in the balance sheet or is an offbalance sheet item. With respect to Directive 86/635/EEC this purpose is achieved by defining a (credit risk) exposure as an asset or off-balance sheet item. In case of using another accounting framework a credit institution should consequently read Article 77 with respect to this purpose, i.e., asset meaning all on-balance sheet items exposed to credit risk. For example, credit institutions holding a single derivative contract with a negative market value should calculate the relevant exposure value for CCR purposes according to Annex III of 2006/48/EC, which may result in a positive exposure value and, accordingly, a positive risk weighted exposure amount for purposes of calculating minimum own funds requirements for credit risk. The provisions included in the Annexes ensure a correct calculation of exposure values for purposes of minimum own funds requirements for credit risk for risk positions having negative market values (see for example Directive 2006/48/EC, Annex III, Part 5, point 1 and Part 6, points 5 to 15). Area: 2006/48/EC, Article 74 Question number: 319 Valuation of assets Date of question: 14 February 2008 Publication of answer: 3 April 2008 My question refer to how to treat "on balance sheet" investment holdings, by using a fair value or a combination of fair value plus a reasonable haircut pending the nature of the investment vehicle: Governamental & corporate bonds, USA equities (NYSE & NASDAQ), European equities (the Europe 15) Japanese Equities Emerging markets in general? Please see Article 74 of 2006/48/EC. The valuation of assets (including investment holding) shall be effected in accordance with the accounting framework to which the credit institution is subject. Trading book items shall be subject to valuation adjustments in accordance with Directive 2006/49/46, Annex VII, part B, points 8 to 15. Area: Directive 2006/48/EC, Article 74(1) Question number: 161 Calculation of exposure values under the Standardised and the IRB approach 24

25 Date of question: 24 October 2006 Publication of answer: 8 May 2007 We question if the exposure values under the Standardized Approach and the IRB approach could be calculated following: an IFRS book value; a local GAAP book value; the nominal value; and the contractual value; We also question if this is different on a consolidated level compared to a social level (institutions use IFRS on consolidated level and local GAAP on a social level)? For the calculation of the minimum capital requirements institutions must use the exposure values prescribed in the respective parts of Directive 2006/48/EC (the Directive). Article 74(1) says that save where otherwise provided, the valuation of assets and off-balance sheet items shall be effected with the accounting framework to which the credit institution is subject under Regulation (EC) No 1606/2002 and Directive 86/635/EEC. For the Standardised approach Article 78(1) provides that, subject to certain exceptions specified in paragraphs 2 and 3 ' the exposure value of an asset item shall be its balance-sheet value and thus implies the use of the carrying amount/book value (IFRS or local GAAP depending on the framework used in the prudential context). The text of the Basel Accord ( 52) provides that the balance-sheet value corresponds to the accounting value of the exposure, net of provisions. While this has not been made explicit in the Directive, the same concept is nevertheless implicitly introduced by Article 78, given that the balance sheet value is to be understood as net of impairment (i.e. net of specific provisions and partial write-off/collective impairment). The response is less straightforward in the case of the IRB approaches. According to Annex VII, Part 3, points 12 and 13, the exposure value for equity exposures and for other non-credit obligation assets shall be the value presented in the financial statement. For those exposure classes the same applies as said above for the Standardised approach. Unlike this, for exposures to institutions, corporates, central governments and central banks and retail exposures the following definition is provided in Annex VII, Part 3, point 1: Unless noted otherwise the exposure value of on-balance sheet exposures shall be measured gross of value adjustments. The directive goes on to say that This rule also applies to assets purchased at a price different than the amount owed. For purchased assets, the difference between the exposure and the net value recorded on the balance-sheet of the bank is denoted discount if the exposure is 25

26 larger, and premium if the exposure is smaller. Bearing in mind Article 74, this should be read to mean that for the computation of risk-weighted exposure and expected loss amounts, the exposure value of on-balance sheet exposures should, in principle, and unless otherwise prescribed in the directive, be based on the value presented in the financial statements, gross of value adjustments (i.e., impairment or partial write-offs). Consistent with the guidelines on prudential filters issued by CEBS and in order to mirror the effects of these guidelines on regulatory capital, supervisors may also decide that unrealised accounting gains or losses should only be taken into account in the exposure values (under standardised or IRB approaches) when they have been reflected in regulatory capital. In the same way, supervisors may decide that unrealised gains or losses should not be taken into account for the calculation of exposure values of hedged items, provided that the hedging relationship is properly documented for accounting purposes. The previous principles apply whether the calculation is being made at solo or at consolidated level. Area: Directive 2006/48/EC, Article 74(2) & Annex X, Part 1, point 3 and Part 2, point 2 Question number: 269 Date of question: 11 September 2007 Publication of answer: 14 November 2007 Reporting and calculation Basic Indicator Approach and Standardised Approach Article 74 (2) states that the calculations to verify the compliance of credit institutions with the obligation to hold own funds for, among others, operational risk, shall be carried out no less than twice each year. Also, credit institutions shall communicate the results and any component data required to the competent authorities. Under the Basic Indicator Approach and the Standardised Approach, the three year-average is calculated on the basis of the last twelve-monthly observations at the end of the financial year. For those Member States whose financial year ends on December 31, the three-year average determined during the first quarter of 2008 shall be calculated on the basis of the observations dated , and When verification of compliance under article 74 (2) is carried out four times each year, the three-year average determined after the end of the first quarter of 2008 shall be calculated still on the basis of observations dated , and (i.e. the observations at the and of the last three financial years), so as to ensure compliance with the two Annex X provisions already mentioned, or on the basis of the observations at the end of last 26