Response to discussion Paper on Technical Advice on possible treatments of unrealised gains measured at fair value
Go back
However, the intention to realise gains (marg. no. 25 et seq.) should not play a role in the determination of whether or not unrealised gains can be taken into account for the regulatory capital. Especially in a restructuring case, the sale of items, e.g., is a possible course of action which usually even is stated in the restructuring plans. Moreover, a mixed business model is often applied to fixed-interest securities. In addition to receiving interest payments, these securities are basically available if additional liquid funds need to be provided. Therefore, these securities are liquid and usually can be sold at any time.
We cannot understand the concern or the statement that unrealised gains may disappear" (inter alia marg. nos. 16 and 28). The main drivers of changes in the value of fair value items in the banking book are changed assessments of an item's probability to become bad debt or be lost and a changed level of the expected yield on the market (interest rate level). Both risks are already covered by capital requirements (interest rate risk in pillar II and in discussion in pillar I). In so far, the assessment in column 3, line 1, in marg. no. 40 is not appropriate.
The argument of column 1 in line 4 (values above the nominal amount melt away as the maturity date approaches) is likewise not reasonable. Higher market values (than the nominal value) result from general interest rate level, interest rate of the bond and risk of the bond. Reductions of the market value until the maturity date correspond to received (cash) interest paid on the bond. In so far, the unrealised gains are, to the contrary, gradually realised as time passes.
Finally, it is stated in the discussion paper (marg. no. 40) that consideration of the unrealised gains results in increased volatility of the capital and there is a danger of pro-cyclicality. However, this applies in equal measure to the unrealised losses. Moreover, non-consideration of the unrealised gains may even (e.g. in case of increased volatility of the markets) result in an increased volatility of the own funds because the balancing effect of the unrealised gains would be missing in that case. In our opinion, a prudential filter would hence not contribute to stabilising the banking sector but rather increase uncertainty."
categories (2):
(1) Many institutions hold substantial volumes of hedging derivatives in the banking book. These derivatives are used primarily for economic hedge relationships which are not intended for the hedge accounting within the meaning of IAS 39 because they do not meet the strict requirements of IAS 39 and hence cannot be included in the hedge accounting. According to IAS 39, they have to be assigned to the held for trading" category as stand-alone derivatives although they have an economic hedge relationship because according to IFRS all derivatives (banking and trading book) are classified as held for trading.
Furthermore, embedded derivatives that must be separated consisting of hybrid financial instruments are always classified as held for trading. In the case of a non-trading book institution, these derivatives typically account for the major part of the held for trading category. Other considerable trading assets or liabilities must on a regular basis not exist at non-trading book institutions. This fact is not sufficiently accounted for in the discussion paper.
The valuation of underlying transactions in the context of a fair value control and hedges (derivatives) in economic hedge relationships acts in opposite direction and basically evens out, as in the case of hedge accounting transactions in accordance with IAS 39.
If prudential filters were applied based on the accounting categories of instruments, we would assume that unrealised gains can be set off against unrealised losses at the level of the respective accounting category at the most. Since economic hedge derivatives are assigned to the hft category and the associated underlying transactions to the afs category or the fair value option, there would be no possibility to set off compensating unrealised valuation yields stemming from economic hedges and underlying transactions.
(2) If a prudential differentiation in the trading and the banking book (as proposed by the EBA) were made and prudential filters applied to banking book items, there would be other problems. The EBA proposes to apply the prudential filter on the basis of the banking supervision categories, i.e. banking book and trading book. This would result in more and more diverging prudential and accounting depictions of exposures. Problems stemming from this are already discussed above (see I.) and have been seen by regulators when developing the CEBS-guidelines on prudential filters. What is more, further changes to the prudential framework will be needed once IFRS 9 is endorsed. There are even more problems resulting from the different treatment of unrealised gains and losses based on a balance sheet and a supervisory view. For example, profits and losses affecting net income (held for trading category) are each calculated and recorded on the profit and loss account as of the effective date ("year to date"). The result of this may be that the amount of the (regulatory law) deduction item (“life to date”) is higher than the actual unrealised gain reported on the effective date. The case is different for financial instruments that are valued without effect on net income because the respective revaluation reserve is carried forward from effective date to effective date ("life to date"). From a concept point of view, it must, therefore, be rejected that unrealised gains from financial instruments affecting net income are discussed as part of a deduction item.
The application of hedge accounting already mentioned in marg. no. 54 and the use of the fair value option for portfolios of the regulatory banking book will in practice lead to considerable unrealised gains and losses which in total have not led to a change of capital but the gross amounts of which partly may be higher than the entire regulatory capital.
We see operational problems in particular in the case of transactions which in the accounting are assigned to the held for trading category but not to the trading book. For these items, as for the entire trading portfolio (cf. questions 9 and 18), the portion of the unrealised gains will usually be impossible or difficult to be determined."
Banks control their market risk positions in the banking book at the macro-level and for this purpose conclude derivatives deals, among other deals, in the banking book. Since it is not in line with a bank's risk management to hedge its market risks — in particular the interest rate risks — at the individual transaction level, just part of the transactions are suitable for being designated as an IFRS hedge relationship. For this reason, banks designate just part of the derivatives concluded in the banking book for an IFRS hedge relationship.
Due to the partly long terms and great volumes, high unrealised gains may result from the economic hedging derivatives (looked at on an instrument-by-instrument basis) which are opposed by high unrealised losses from opposed positions. Without consideration of the hedge relationship at the macro-level, serious effects on the prudential capital and a high capital volatility would result depending on the approach chosen.
Differences result for example from the portfolios which in terms of regulation have been redesignated from trading book to banking book, for instruments for which an assignment to the regulatory trading book is not possible due to regulatory provisions and from the trading portfolio of non-trading book institutions.
We believe there is an important interaction between prudential regulatory requirements and accounting standards that must be factored into the regulators’ consideration before making any final decision on this topic. IFRS 9, the future accounting standard on financial instruments classification and measurement, is not yet final, but based on the current exposure drafts and IASB discussions, IFRS 9 is expected to narrow the definition of financial instruments that can be held at amortized cost, and therefore, increase in the classification of financial instruments at fair value through OCI (FVOCI") and fair value through profit and loss ("FVPL"). Additionally, under IFRS 9, many instruments that are held for the purpose of collecting cash flows may be classified at FVOCI or FVPL because of terms that result in cash flows that are not solely payments of principle and interest. It’s possible that this rule could increase the number of instruments classified as banking book for regulatory purposes, but held at fair value through profit and loss or FVOCI for accounting purposes.
In any case, due to the interdependency between IFRS 9 (that increases the scope of fair value classification) and solvency regulation we strongly urge the EBA to wait for the final issuance of IFRS 9 and to conduct an impact assessment with the industry before any decision regarding an asymmetric prudential filter is taken."
All interest bearing instruments (securities, receivable, liabilities, derivatives) are usually included in the control irrespective of their IFRS category. Due to the asymmetrical valuation that results from the classification rules in accordance with the IFRS, the hedge relationship that results from the entirety of the items is initially not reflected in the IFRS result (irrespective of P&L or OCI reporting).
In order to make hedge relationships transparent in the IFRS statement, the IFRS, on the one hand, provide for the possibility of designating hedge relationships and, on the other, the fair value option, stating either accounting mismatch or control of a portfolio on a fair value basis as the reason. Irrespective of whether the hedge relationships are designated as IFRS hedge relationships, whether they are reflected as economic hedge relationships based on the fair value option or whether, e.g., available for sale items are secured economically by means of derivatives in the banking book, high-volume long and short positions are opposing each other
in items valued at full fair value or hedged fair value the unrealised results of which develop in different directions when the interest rate changes. This means that there is a direct connection between positive and negative value developments of interest bearing instruments which must necessarily be taken account of in the examination.
This would be ensured only by a portfolio-related application. In the context of an individual-transaction-related application, the economic hedge relationship would, in contrast, not be accounted for. The prudential capital would be substantially reduced and subjected to major fluctuation. Accordingly, the institutions would be compelled to sell on a regular basis items with unrealised gains and, partly, also items with losses in case of market fluctuations to eliminate uncontrollable capital fluctuation. In the case of severe market fluctuations, serious effects on the entire market might result because all banks would try to sell their positions.
We, therefore, urgently speak in favour of a set-off of unrealised gains and losses at the highest portfolio level.
The unrealised gains and losses for items of the trading portfolio cannot be reasonably calculated. In practice, the systems relevant to valuation do not carry the original acquisition costs because they are not required for the subsequent valuation.
However, the statements made here cannot replace a decided impact study by the EBA. The effects of the mechanisms proposed require an in-depth examination beforehand which must be made unbiased as to the results and sufficiently early before any planned implementation.
We feel that the cumulative application of a haircut considered by the EBA and the restriction of the unrealised gains recognised in the prudential capital to a certain percentage is clearly too conservative. For reasons of consistency with the treatment of unrealised losses, we argue in favour of full recognition in the common equity tier 1.
Shares in funds are a special case and are not examined by the EBA in the discussion paper.
These items basically are equity instruments. Where funds are consolidated on the balance sheet, they are deconsolidated for regulatory purposes and not reported with their individual assets but with their shares. Hence, the unrealised gain would have to be determined at the level of the fund, i.e. based on the fund's historical costs in comparison with its current fund price.
The question is how unrealised results for shares in special funds are to be determined which are transparent to the bank and for which sufficient information is available from the accounting to choose a more appropriate method. From our point of view, it would not be appropriate to determine unrealised gains on the basis of the historical costs of the fund shares in comparison with their current repurchase price. During the time a fund is held, which may be a considerable period, the securities contained in it are usually sold several times and associated unrealised results are realised. Accordingly, part of the value development of a fund is based on already realised value developments of the individual investments of the fund.
We, therefore, suggest to determine unrealised results on the basis of the unrealised results of the individual investments to determine the unrealised gains from shares in funds held in the banking book for which a look-through is possible. The interest rate risk from the individual investments of a special fund is in many cases not hedged within the fund but in the banking book of the bank that holds the special fund. Control then is at the level of the interest book across all items. Where the interest bearing individual investments of special funds are controlled together with the direct investments of a bank, it should be possible to balance
the resulting unrealised results together with the unrealised results from the other interest rate risk positions of the banking book.
In practice, a considerable portion of the items assigned to the regulatory banking book is also controlled on a fair value basis and the fair value option is used for this. These items are usually assigned to the banking book because it is not intended to sell them with a profit in the short term.
However, an economic hedge relationship also exists if interest bearing assets and liabilities are designated for the fair value option together with derivatives because they are part of the portfolio which the bank administers on a fair value basis. Here as well, the management approach is to control interest rate risks in the portfolio on a net basis. The assets and liabilities items designated in this way and the interest derivatives concluded for this form a net interest rate risk position and react in different directions to changes of the interest rate level.
Another essential case of the application of the fair value option are financial instruments with embedded derivatives. It would be consistent to treat these embedded derivatives analogous to the stand-alone or separated derivatives of the regulatory trading book of the held for trading category.
Irrespective of whether a position is a closed or a just partly closed interest rate risk position — as assumed for accounting mismatch in the discussion paper —, the value developments of the opposing long and short positions compensate each other at least to some extent. Since opposing positions have value developments that compensate each other, the compensated portion of the value development may be regarded as having been realised even if the positions have not yet been sold. If the interest rate risk position is not closed, this is reflected in a positive or negative unrealised result.
A bank's interest rate risks are controlled at the level of one or several interest books, usually independent of the relevant balance sheet category. For this reason, it should likewise be possible to balance unrealised gains and losses from interest instruments measured at fair value independent of the balance sheet category (in IFRS available for sale, fair value option, held for trading, hedge accounting) at the level of the interest books.
However, the statements made here cannot substitute a decided impact study by the EBA. The effects of the mechanisms proposed require an in-depth examination beforehand which must be made unbiased as to the results and sufficiently early before any planned implementation.
This is justified in so far as it is assumed in the context of the provisions regarding prudent valuation that the items of the trading book can be balanced quickly at the prudent value. For this, an additional valuation adjustment (AVA) is already deducted directly from the common equity tier 1. To make another deduction from the capital because gains may reduce while an item is held would contradict the prudent value approach. Moreover, the market risk of trading book items is to be hedged by means of capital.
However, the EBA would like to enable the supervisory authorities to limit the recognition of unrealised gains from financial instruments of the trading book to a certain percentage if they are concerned about the amount of the unrealised gains in the trading book (marg. no. 100). We definitely reject this scope of discretion for reasons of a level playing field.
We reject a filter or the limitation (e.g. in the form of a cap) of recognition of unrealised gains in the CET1. It is of special importance to us that in addition to the unrealised results from the trading portfolio all results from other forms of economic hedging, in particular all forms of hedge accounting (macro and micro hedge accounting) and the fair value option, are not subjected to a filter and also not to a limitation by a cap. We also see a fundamental conflict of goals with good risk management if the economically reasonable hedging of risks would have negative consequences for the regulatory capital.
The provisions regarding prudent valuation are based on the assumption that items can as a rule be sold within a short time. One of the reasons the present discussion paper on unrealised gains gives to justify the deduction of unrealised gains is that the institutions precisely do not wish to, or cannot, sell their items and the gains from them vanish over time. Accordingly, the EBA assumes that the items are held. These two assumptions contradict each other. We, therefore, believe it is not appropriate to make a double deduction of capital, one with the assumption of a sale of the items at short notice and one with the reason that gains vanish over time.
Inconsistencies may likewise occur in those cases in which the prudent valuation method assumes the holding of the position. For example, AVAs are determined for the evening-up costs from derivative books at the portfolio level and thus on the basis of a net position. For the assumed holding of the underlying net position, an AVA for administrative costs incurred for this in the future needs to be applied. Therefore, determination of unrealised gains from derivatives in the banking book on an individual-transaction-related basis would be inconsistent.
Should, nevertheless, a prudential filter for unrealised gains be introduced in addition to prudent valuation, the amount of unrealised gains of the banking book remaining after set-off with the unrealised losses should be reduced by the AVAs assigned to them. A prudential filter should then be applied only to this positive difference. This would avoid double deductions. Otherwise, a profit would be deducted which has not occurred at all according to the EBA's calculation method.
Do you agree with the description of the different criteria provided on this section in order to assess the possible treatments of unrealised gains? If not, please state why. Do you think there are other criteria that should be considered?
The criteria used for the analysis of the possible treatments of unrealised gains are basically comprehensible. Due to the existing interdependencies with other regulations, it is from our point of view important in particular to take account of the interactions with the prudential capital resources requirements and the capital deduction for the prudent valuation of items measured at fair value.However, the intention to realise gains (marg. no. 25 et seq.) should not play a role in the determination of whether or not unrealised gains can be taken into account for the regulatory capital. Especially in a restructuring case, the sale of items, e.g., is a possible course of action which usually even is stated in the restructuring plans. Moreover, a mixed business model is often applied to fixed-interest securities. In addition to receiving interest payments, these securities are basically available if additional liquid funds need to be provided. Therefore, these securities are liquid and usually can be sold at any time.
We cannot understand the concern or the statement that unrealised gains may disappear" (inter alia marg. nos. 16 and 28). The main drivers of changes in the value of fair value items in the banking book are changed assessments of an item's probability to become bad debt or be lost and a changed level of the expected yield on the market (interest rate level). Both risks are already covered by capital requirements (interest rate risk in pillar II and in discussion in pillar I). In so far, the assessment in column 3, line 1, in marg. no. 40 is not appropriate.
The argument of column 1 in line 4 (values above the nominal amount melt away as the maturity date approaches) is likewise not reasonable. Higher market values (than the nominal value) result from general interest rate level, interest rate of the bond and risk of the bond. Reductions of the market value until the maturity date correspond to received (cash) interest paid on the bond. In so far, the unrealised gains are, to the contrary, gradually realised as time passes.
Finally, it is stated in the discussion paper (marg. no. 40) that consideration of the unrealised gains results in increased volatility of the capital and there is a danger of pro-cyclicality. However, this applies in equal measure to the unrealised losses. Moreover, non-consideration of the unrealised gains may even (e.g. in case of increased volatility of the markets) result in an increased volatility of the own funds because the balancing effect of the unrealised gains would be missing in that case. In our opinion, a prudential filter would hence not contribute to stabilising the banking sector but rather increase uncertainty."
Do you agree with the proposed approach based on the prudential classification (distinction between the trading and banking book) to analyse the different policy options? If not, please state why. Do you envisage any operational issue if the prudential approach is followed?
In our opinion, a restriction of the analyses to one point of view (the banking supervisory view) is not sufficient. This leaves a number of problem areas out of consideration because in general the application of asymmetrical prudential filters causes substantial problems in respect of both their application to balance sheet categories (1) and their application to prudentialcategories (2):
(1) Many institutions hold substantial volumes of hedging derivatives in the banking book. These derivatives are used primarily for economic hedge relationships which are not intended for the hedge accounting within the meaning of IAS 39 because they do not meet the strict requirements of IAS 39 and hence cannot be included in the hedge accounting. According to IAS 39, they have to be assigned to the held for trading" category as stand-alone derivatives although they have an economic hedge relationship because according to IFRS all derivatives (banking and trading book) are classified as held for trading.
Furthermore, embedded derivatives that must be separated consisting of hybrid financial instruments are always classified as held for trading. In the case of a non-trading book institution, these derivatives typically account for the major part of the held for trading category. Other considerable trading assets or liabilities must on a regular basis not exist at non-trading book institutions. This fact is not sufficiently accounted for in the discussion paper.
The valuation of underlying transactions in the context of a fair value control and hedges (derivatives) in economic hedge relationships acts in opposite direction and basically evens out, as in the case of hedge accounting transactions in accordance with IAS 39.
If prudential filters were applied based on the accounting categories of instruments, we would assume that unrealised gains can be set off against unrealised losses at the level of the respective accounting category at the most. Since economic hedge derivatives are assigned to the hft category and the associated underlying transactions to the afs category or the fair value option, there would be no possibility to set off compensating unrealised valuation yields stemming from economic hedges and underlying transactions.
(2) If a prudential differentiation in the trading and the banking book (as proposed by the EBA) were made and prudential filters applied to banking book items, there would be other problems. The EBA proposes to apply the prudential filter on the basis of the banking supervision categories, i.e. banking book and trading book. This would result in more and more diverging prudential and accounting depictions of exposures. Problems stemming from this are already discussed above (see I.) and have been seen by regulators when developing the CEBS-guidelines on prudential filters. What is more, further changes to the prudential framework will be needed once IFRS 9 is endorsed. There are even more problems resulting from the different treatment of unrealised gains and losses based on a balance sheet and a supervisory view. For example, profits and losses affecting net income (held for trading category) are each calculated and recorded on the profit and loss account as of the effective date ("year to date"). The result of this may be that the amount of the (regulatory law) deduction item (“life to date”) is higher than the actual unrealised gain reported on the effective date. The case is different for financial instruments that are valued without effect on net income because the respective revaluation reserve is carried forward from effective date to effective date ("life to date"). From a concept point of view, it must, therefore, be rejected that unrealised gains from financial instruments affecting net income are discussed as part of a deduction item.
The application of hedge accounting already mentioned in marg. no. 54 and the use of the fair value option for portfolios of the regulatory banking book will in practice lead to considerable unrealised gains and losses which in total have not led to a change of capital but the gross amounts of which partly may be higher than the entire regulatory capital.
We see operational problems in particular in the case of transactions which in the accounting are assigned to the held for trading category but not to the trading book. For these items, as for the entire trading portfolio (cf. questions 9 and 18), the portion of the unrealised gains will usually be impossible or difficult to be determined."
Do you have instruments that are classified as held for trading for accounting purposes included in the (regulatory) banking book or available for sale instruments classified as a position of the (regulatory) trading book? Could you quantify the relevance of these situations?
According to the IFRS, all derivatives are assigned to the held for trading category, irrespective of whether they are assigned to the regulatory trading or banking book, and hence valued with an effect on net income. Derivatives may to a major extent be assigned to the banking book without being intended for hedge accounting. Accordingly, the assumption made in the discussion paper that derivatives are usually assigned to the trading book and only in exceptional cases (e.g. in the context of hedge accounting) to the banking book (cf. marg. no. 57) is not correct (see also our comments on question 3).Banks control their market risk positions in the banking book at the macro-level and for this purpose conclude derivatives deals, among other deals, in the banking book. Since it is not in line with a bank's risk management to hedge its market risks — in particular the interest rate risks — at the individual transaction level, just part of the transactions are suitable for being designated as an IFRS hedge relationship. For this reason, banks designate just part of the derivatives concluded in the banking book for an IFRS hedge relationship.
Due to the partly long terms and great volumes, high unrealised gains may result from the economic hedging derivatives (looked at on an instrument-by-instrument basis) which are opposed by high unrealised losses from opposed positions. Without consideration of the hedge relationship at the macro-level, serious effects on the prudential capital and a high capital volatility would result depending on the approach chosen.
Differences result for example from the portfolios which in terms of regulation have been redesignated from trading book to banking book, for instruments for which an assignment to the regulatory trading book is not possible due to regulatory provisions and from the trading portfolio of non-trading book institutions.
Do you see any differences in the analysis that should be taken into account with the requirements in the forthcoming IFRS 9?
The facts stated in respect of question 4 will probably not change based on the already published rules regarding the general hedge relationships (primarily micro-hedge accounting). Although at the moment it is considered to allow macro-hedge accounting, the regulations regarding this have not yet been issued.We believe there is an important interaction between prudential regulatory requirements and accounting standards that must be factored into the regulators’ consideration before making any final decision on this topic. IFRS 9, the future accounting standard on financial instruments classification and measurement, is not yet final, but based on the current exposure drafts and IASB discussions, IFRS 9 is expected to narrow the definition of financial instruments that can be held at amortized cost, and therefore, increase in the classification of financial instruments at fair value through OCI (FVOCI") and fair value through profit and loss ("FVPL"). Additionally, under IFRS 9, many instruments that are held for the purpose of collecting cash flows may be classified at FVOCI or FVPL because of terms that result in cash flows that are not solely payments of principle and interest. It’s possible that this rule could increase the number of instruments classified as banking book for regulatory purposes, but held at fair value through profit and loss or FVOCI for accounting purposes.
In any case, due to the interdependency between IFRS 9 (that increases the scope of fair value classification) and solvency regulation we strongly urge the EBA to wait for the final issuance of IFRS 9 and to conduct an impact assessment with the industry before any decision regarding an asymmetric prudential filter is taken."
Do you agree with the proposal to distinguish between different categories of instruments/items (interest bearing financial instruments, non-interest bearing financial instruments and tangible assets) in analysing the different policy options? If not, please state why
The EBA proposes to distinguish between interest bearing and non-interest bearing financial instruments and tangible assets. The assumption that these items will always be controlled separately is not always correct. To some extent, these items are controlled across boundaries, in particular because partly substantial dependencies of changes in value have shown. In so far, a differentiation by these categories appears to be inappropriate. Moreover, in the context of its analysis, the EBA assumes that derivatives are concluded in the trading book for purposes other than hedge accounting (marg. no. 57). This assumption is not correct. With regard to this, we refer to our comments regarding question 4.Do you agree with the arguments in favour of an item-by-item basis or a portfolio basis? Are there other arguments that should be considered for the decision to apply the policy options on an item-by-item or on a portfolio basis?
The EBA is at best considering a set-off of unrealised gains and losses within a category of instruments. However, bank control is at the overall bank portfolio level. In our opinion, therefore, set-off at the highest portfolio level is absolutely necessary. Moreover, we speak out in favour of consolidating the portfolios at the group level. Otherwise, the institutions risk situation would be clearly exaggerated.Do you consider that the application on an item-by-item or on a portfolio basis would be more justified for certain types of instruments/items than for others (for instance, debt securities, equity instruments, tangible assets)?
We urgently advocate a portfolio-related application at the highest level. This is absolutely necessary in particular for the interest bearing instruments. Banks in particular control their interest risks at the macro-level and to this end also conclude derivatives in the banking book, i.e., the interest rate risks are usually hedged by means of opposing transactions.All interest bearing instruments (securities, receivable, liabilities, derivatives) are usually included in the control irrespective of their IFRS category. Due to the asymmetrical valuation that results from the classification rules in accordance with the IFRS, the hedge relationship that results from the entirety of the items is initially not reflected in the IFRS result (irrespective of P&L or OCI reporting).
In order to make hedge relationships transparent in the IFRS statement, the IFRS, on the one hand, provide for the possibility of designating hedge relationships and, on the other, the fair value option, stating either accounting mismatch or control of a portfolio on a fair value basis as the reason. Irrespective of whether the hedge relationships are designated as IFRS hedge relationships, whether they are reflected as economic hedge relationships based on the fair value option or whether, e.g., available for sale items are secured economically by means of derivatives in the banking book, high-volume long and short positions are opposing each other
in items valued at full fair value or hedged fair value the unrealised results of which develop in different directions when the interest rate changes. This means that there is a direct connection between positive and negative value developments of interest bearing instruments which must necessarily be taken account of in the examination.
This would be ensured only by a portfolio-related application. In the context of an individual-transaction-related application, the economic hedge relationship would, in contrast, not be accounted for. The prudential capital would be substantially reduced and subjected to major fluctuation. Accordingly, the institutions would be compelled to sell on a regular basis items with unrealised gains and, partly, also items with losses in case of market fluctuations to eliminate uncontrollable capital fluctuation. In the case of severe market fluctuations, serious effects on the entire market might result because all banks would try to sell their positions.
We, therefore, urgently speak in favour of a set-off of unrealised gains and losses at the highest portfolio level.
Please provide quantitative information about the difference between applying a filter on a portfolio basis or on an item-by-item basis and the impact of this difference in your capital ratios.
Unrealised gains make up a substantial portion of the common equity tier 1. Surveys in the Member States have shown that almost the entire common equity tier 1 would be used up in case of an individual-transaction-related application.The unrealised gains and losses for items of the trading portfolio cannot be reasonably calculated. In practice, the systems relevant to valuation do not carry the original acquisition costs because they are not required for the subsequent valuation.
However, the statements made here cannot replace a decided impact study by the EBA. The effects of the mechanisms proposed require an in-depth examination beforehand which must be made unbiased as to the results and sufficiently early before any planned implementation.
Do you agree with the alternatives presented in this section? Do you have a preferred alternative? Please explain the reasons.
We urgently recommend to take account of unrealised gains in the regulatory capital. We cannot see a convincing reason why the capital from unrealised gains should be of a worse quality (see also our comments on question 2).We feel that the cumulative application of a haircut considered by the EBA and the restriction of the unrealised gains recognised in the prudential capital to a certain percentage is clearly too conservative. For reasons of consistency with the treatment of unrealised losses, we argue in favour of full recognition in the common equity tier 1.
Do you agree that the haircut may be different depending on whether it affects the different layers of capital and also on whether the adjustment is applied on a portfolio or an item-by-item basis? Do you have a view regarding the level of the haircut?
From our point of view, haircuts are not appropriate. Their introduction would result in overlappings with the provisions regarding prudent valuation and to a double burden.Regarding the second adjustment (the threshold): do you agree to establish a limit to the recognition of unrealised gains in own funds? Do you have a view regarding the level of the threshold?
From our point of view, a restriction of the unrealised gains recognised in the prudential capital to a certain percentage is not appropriate. The items are valued extremely cautiously already by means of prudent valuation.Do you think equity and debt securities should be subject to the same policy options / treatment? Do you agree with the reasons provided in this section about the difference between equity and debt?
From our point of view, equity and borrowed capital instruments should be treated equally.Shares in funds are a special case and are not examined by the EBA in the discussion paper.
These items basically are equity instruments. Where funds are consolidated on the balance sheet, they are deconsolidated for regulatory purposes and not reported with their individual assets but with their shares. Hence, the unrealised gain would have to be determined at the level of the fund, i.e. based on the fund's historical costs in comparison with its current fund price.
The question is how unrealised results for shares in special funds are to be determined which are transparent to the bank and for which sufficient information is available from the accounting to choose a more appropriate method. From our point of view, it would not be appropriate to determine unrealised gains on the basis of the historical costs of the fund shares in comparison with their current repurchase price. During the time a fund is held, which may be a considerable period, the securities contained in it are usually sold several times and associated unrealised results are realised. Accordingly, part of the value development of a fund is based on already realised value developments of the individual investments of the fund.
We, therefore, suggest to determine unrealised results on the basis of the unrealised results of the individual investments to determine the unrealised gains from shares in funds held in the banking book for which a look-through is possible. The interest rate risk from the individual investments of a special fund is in many cases not hedged within the fund but in the banking book of the bank that holds the special fund. Control then is at the level of the interest book across all items. Where the interest bearing individual investments of special funds are controlled together with the direct investments of a bank, it should be possible to balance
the resulting unrealised results together with the unrealised results from the other interest rate risk positions of the banking book.
Do you agree with the analysis for hedge accounting? Please provide quantitative information about the relevance of hedge ineffectiveness in hedge accounting
Some institutions primarily do fair value hedge accounting instead of the cash-flow hedge accounting discussed in the discussion paper. Therefore, this accounting method, or examples of it, should likewise be examined.Do you see any difference in this analysis under the forthcoming hedge accounting requirements that the IASB is expect to publish in the second half of 2013?
We need to wait for the new regulations of the IFRS 9.Do you agree with the analysis for fair value option accounting? Do you classify assets and liabilities managed on a fair value basis and financial instruments with embedded derivatives in the banking or the trading book? Please state the reasons for the classification
It is correct that in those cases in which the fair value option is applied due to accounting mismatch the items are items that represent an economic hedge.In practice, a considerable portion of the items assigned to the regulatory banking book is also controlled on a fair value basis and the fair value option is used for this. These items are usually assigned to the banking book because it is not intended to sell them with a profit in the short term.
However, an economic hedge relationship also exists if interest bearing assets and liabilities are designated for the fair value option together with derivatives because they are part of the portfolio which the bank administers on a fair value basis. Here as well, the management approach is to control interest rate risks in the portfolio on a net basis. The assets and liabilities items designated in this way and the interest derivatives concluded for this form a net interest rate risk position and react in different directions to changes of the interest rate level.
Another essential case of the application of the fair value option are financial instruments with embedded derivatives. It would be consistent to treat these embedded derivatives analogous to the stand-alone or separated derivatives of the regulatory trading book of the held for trading category.
Irrespective of whether a position is a closed or a just partly closed interest rate risk position — as assumed for accounting mismatch in the discussion paper —, the value developments of the opposing long and short positions compensate each other at least to some extent. Since opposing positions have value developments that compensate each other, the compensated portion of the value development may be regarded as having been realised even if the positions have not yet been sold. If the interest rate risk position is not closed, this is reflected in a positive or negative unrealised result.
A bank's interest rate risks are controlled at the level of one or several interest books, usually independent of the relevant balance sheet category. For this reason, it should likewise be possible to balance unrealised gains and losses from interest instruments measured at fair value independent of the balance sheet category (in IFRS available for sale, fair value option, held for trading, hedge accounting) at the level of the interest books.
Please provide quantitative information about the use of the fair value option
In our opinion, the statement about the use of the fair value option in relation to the entire financial assets is not reasonable because they are measured partly at fair value (e.g. afs) and partly at acquisition costs. A meaningful statement might, in contrast, be made in relation to the relevant balance sheet items (e.g. share of fair value items in the receivables from banks or customers).However, the statements made here cannot substitute a decided impact study by the EBA. The effects of the mechanisms proposed require an in-depth examination beforehand which must be made unbiased as to the results and sufficiently early before any planned implementation.
Do you agree with the description provided in this section? Can you quantify the amount of unrealised gains included in the trading book?
We expressly welcome it that the EBA wishes to not apply a prudential filter to trading book items and, therefore, unrealised gains from financial instruments of the trading book can be fully considered in the common equity tier 1.This is justified in so far as it is assumed in the context of the provisions regarding prudent valuation that the items of the trading book can be balanced quickly at the prudent value. For this, an additional valuation adjustment (AVA) is already deducted directly from the common equity tier 1. To make another deduction from the capital because gains may reduce while an item is held would contradict the prudent value approach. Moreover, the market risk of trading book items is to be hedged by means of capital.
However, the EBA would like to enable the supervisory authorities to limit the recognition of unrealised gains from financial instruments of the trading book to a certain percentage if they are concerned about the amount of the unrealised gains in the trading book (marg. no. 100). We definitely reject this scope of discretion for reasons of a level playing field.
We reject a filter or the limitation (e.g. in the form of a cap) of recognition of unrealised gains in the CET1. It is of special importance to us that in addition to the unrealised results from the trading portfolio all results from other forms of economic hedging, in particular all forms of hedge accounting (macro and micro hedge accounting) and the fair value option, are not subjected to a filter and also not to a limitation by a cap. We also see a fundamental conflict of goals with good risk management if the economically reasonable hedging of risks would have negative consequences for the regulatory capital.
Do you think that there is a risk of double effect when applying a prudential filter and the requirements on prudent valuation?
The regulatory technical standards regarding prudent valuation are to take account of the prudential concerns that unrealised gains might vanish due to market price uncertainty of the underlying transaction. Therefore, this capital deduction item is to remedy the insufficient reliability of the fair value for banking supervision purposes, similar to the prudential filter for unrealised gains. In the simplified flat-rate approach, reference is even made explicitly to the unrealised gains. In so far, unrealised gains are neutralised already partly by means of the AVA. In our opinion, there is a danger of double deduction of unrealised gains of banking book items. From our point of view, a multiple burden in the form of higher deduction items for identical or similar banking supervision issues is not comprehensible.The provisions regarding prudent valuation are based on the assumption that items can as a rule be sold within a short time. One of the reasons the present discussion paper on unrealised gains gives to justify the deduction of unrealised gains is that the institutions precisely do not wish to, or cannot, sell their items and the gains from them vanish over time. Accordingly, the EBA assumes that the items are held. These two assumptions contradict each other. We, therefore, believe it is not appropriate to make a double deduction of capital, one with the assumption of a sale of the items at short notice and one with the reason that gains vanish over time.
Inconsistencies may likewise occur in those cases in which the prudent valuation method assumes the holding of the position. For example, AVAs are determined for the evening-up costs from derivative books at the portfolio level and thus on the basis of a net position. For the assumed holding of the underlying net position, an AVA for administrative costs incurred for this in the future needs to be applied. Therefore, determination of unrealised gains from derivatives in the banking book on an individual-transaction-related basis would be inconsistent.
Which are your views on the different issues described in point a) to d) of section 5.6.4? Please provide reasoning supporting your response
With regard to the unrealised gains for banking book items, there might be double deductions. We think this is not appropriate for the reasons stated at question 19.Should, nevertheless, a prudential filter for unrealised gains be introduced in addition to prudent valuation, the amount of unrealised gains of the banking book remaining after set-off with the unrealised losses should be reduced by the AVAs assigned to them. A prudential filter should then be applied only to this positive difference. This would avoid double deductions. Otherwise, a profit would be deducted which has not occurred at all according to the EBA's calculation method.
Upload files
Comments GBIC on EBA DP 2013-03.pdf
(123.09 KB)