Response to discussion on the treatment of structural FX under Article 352(2) of the CRR
Go back
- Definitions. We believe the EBA should not only look at the word ‘structural’ from article 352.2 CRR but should look at the concept ‘of non-trading or structural nature’. The Risk Weighting of FX positions under chapter 3 of Title IV of Part three CRR (“own funds requirements for foreign exchange risk”) is applicable to both banking and trading book positions, where only positions that are of a non-trading or structural nature can be excluded.
- Scope. We believe that when an institution hedges its ratio, the open currency position that fully hedges the ratio, amounts to the Risk Weighted Exposures in a particular currency multiplied with the ratio the institution wishes to hedge (i.e. the CET 1 ratio, Tier 1 ratio or total ratio). However, this open currency position could comprise trading and non-trading as well as structural and non-structural exposures. Therefore, this open currency position should be seen as the maximum amount of open currency position that hedges the ratio.
- Institution specific. An institution should demonstrate to the competent authority, what positions it wishes to exclude for risk weighting because they are of a non-trading and structural nature. What kind of positions to exclude in the risk weighting under the Standardised or Internal model approach should be consistent to an institutions hedge policy that is effective given their size, international presence, legal structure and internal organisation.
- Long position. This range can be long positions but could potentially also be a short positions, dependent on the FX volatility and RWA in the particular currencies. In this context we do not agree that only FX long positions could potentially be excluded.
- Deliberately unhedged. Leaving the position open is in this context an effective hedge strategy. Hence, the wording should not only incorporate active positions taken, but also positions deliberately left unhedged for purpose of hedging the capital ratios of the bank.
- Accounting. We wish to stress that this answer is based on applying an IFRS accounting framework. In the case of using a particular local GAAP accounting framework that deviates from IFRS, this answer could be different. For example, in some local GAAP, unrealised gains are not taken into account in contrast to IFRS.
- Double counting. Furthermore we wish to emphasise that the current text of article 351 of the CRR requires to calculate regulatory capital under the standardised approach for the sum of an institution's overall net foreign-exchange position and its net gold position (i.e. for banking and trading book positions). In the case an institution has received permission to use internal models for their trading desks, this results in the double counting of FX positions. In our view, not excluding FX positions from the standardised approach that are already risk weighted under internal models is an error in the CRR article 351.1 text.
We consider it the mandate of the ALCO or a comparable decision making body within a bank to decide upon an hedge effectiveness policy as also stated in answering question 3.
The consolidated ratio is the consolidated CET 1 (Tier 1 or total) capital divided by the consolidated Risk Weighted Exposure (RWE). In determining the consolidated RWE an institution should not make a distinction between the contribution to the consolidated RWE by a subsidiary and a branch.
We are of the view that an institution can only hedge the consolidated ratio due to the nature of individual reporting. At the individual entity level an institution runs translation risk that equals the translation risk at the consolidated level. However the balance sheet at the level of the individual institution does not present the same currency exposure as the consolidated balance sheet. This is due to the fact that the individual balance sheet only comprises the assets and liabilities directly taken at the individual entity level. The assets and liabilities in a foreign currency (if any) are only the gross long and short positions of a trading and non-trading as well as a structural and non-structural nature directly taken by the individual entity, like current accounts, loans, deposits taken and given, capital instruments, derivatives and the net investments in branches/subsidiaries, participations and other equity investments. The indirect currency exposure that is included in the net asset value of subsidiaries owned directly by the individual entity and that have the same functional currency as the individual entity, is not presented in gross long and short foreign currency positions in the individual entity balance sheet. Nevertheless, these indirect exposures can generate translation risk that is included in the EUR net asset value of the direct participations and subsequently in CET 1 capital of the individual entity.
In other words, the balance sheet of the individual entity comprises the assets and liabilities of the individual entity. Taking this approach, only the direct currency positions entered into by the individual entity should therefore be taken into account, which can be significantly different than the currency positions at the consolidated level. This is for example the case in the following structure.
Assuming that currency positions are only kept at the GBP, USD and CHF subsidiary directly owned by the sub-holding with the sub-holding having EUR as the functional currency, the top holding doesn’t have (on an individual entity basis) any direct currency exposure. In the individual balance sheet of the top holding only assets (including the net asset value of the EUR sub-holding) and liabilities in EUR will be reported.
On the other hand, the top holding individual entity will be exposed to translation risk. This is due to the fact that currency fluctuations at the level of the GBP, USD and CHF subsidiary directly owned by the sub-holding will change the EUR net asset value of that sub-holding and equally the amount of CET of the top holding.
The text and concept that is used to draw up Chapter 3, Title V, Part Three of the CRR is derived from the 1996 Basel Committee on Banking Supervision Amendment to the capital accord . The concept that BCBS expressed there is based on the consolidated reporting. They state in paragraph 8 that all national authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision , but the BCBS does not give guidance how .
Because the European Commission did not incorporate this guidance either when proposing the text for the CRR in 2013, we consider not giving this guidance is an omission for including Chapter 3, Title V, Part Three of the CRR in the scope of Article 6 CRR (General principles).
In our view the text was not written from a point of view where the accounting framework is the basis for COREP reporting. For example, the amount of investments in consolidated subsidiaries denominated in foreign currency as written in article 325c (1a-ii), is only relevant when reporting at the individual level. When reporting the consolidated positions this amount is not relevant as it’s solely the assets and the liabilities in the foreign currency held by the parent company, its branches and its subsidiaries that matters. In addition, when article 325c (1a-ii) would become effective, how would this apply for a bank which has foreign denominated assets on its consolidated balance sheet and not necessarily via a subsidiary or an affiliated entity?
We do not understand why the exclusion from the calculation should be made for at least six months as stated in article 325c (1b) because the amount of exclusion depends on both the RWA’s and own funds. The restriction of article 325c (1b) would result in sub-optimal hedging of the ratio against the adverse effect of the foreign exchange rates. We consider that the institution should demonstrate to their competent authority what positions are of non-trading and structural nature.
Furthermore, we do believe that article 325c (2) and (3) is not written taking into account the concept of hedging of the ratio against the adverse effect of the foreign exchange rates that EBA and the EU banking sector is now trying to substantiate with a well thought of concept in mind. We strongly wonder how we should read ‘remain in place for the life for the asset or other item’ and how the Legislator envisions that each change by an institution to the amounts that it excludes should be approved. Especially when one knows that changes in RWA and own funds should drive the hedge ratio. Therefore, these restrictions will result in sub-optimal hedging strategies, which in our view is probably an unintended consequence of the proposed amendments.
Furthermore we do not agree with the CRR article 352.2 that in case a position in a foreign currency is deducted from CET 1, a bank should require permission from the competent authority not to include these positions in their currency reporting (i.e. C22 reporting). In case the bank would include them in the C22 reporting, the currency risk will be double counted in regulatory capital (i.e. on the one hand by the deduction from CET and on the other hand by the risk weighting of the open currency position for market risk).
Question 1: What is your current practice regarding the treatment of FX non-monetary items held at the historic FX? In particular, do you include these items in the overall net foreign exchange position pursuant to Article 352 CRR? If you include them, what value (i.e. historic or last FX rate) do you use for the purpose of computing them? How do you manage such positions from an FX point of view?
This is institution specific and therefore the Dutch Banking Association (NVB) is unable to respond.Question 2: Do you share the EBA’s view that there is no clear risk justification for making the determination of the net FX position as well as of the structural FX exclusion dependent on the approach for the calculation of FX own funds requirements?
We agree. Hedging the solvency ratio for FX risk should be based on economic reasoning, regardless of whether the Standardised Approach or Internal Model Approach is applied for calculating own funds requirements for FX risk.Question 3: Do you consider that the ‘structural nature’ wording in the CRR would limit the application of the structural FX provision to those items held in the banking book? Do you agree with the EBA’s view that the potential exclusion should be acceptable only for long FX positions? If you consider that it should be allowed for short positions please provide rationale and examples.
With regard to question number three, we have the following remarks:- Definitions. We believe the EBA should not only look at the word ‘structural’ from article 352.2 CRR but should look at the concept ‘of non-trading or structural nature’. The Risk Weighting of FX positions under chapter 3 of Title IV of Part three CRR (“own funds requirements for foreign exchange risk”) is applicable to both banking and trading book positions, where only positions that are of a non-trading or structural nature can be excluded.
- Scope. We believe that when an institution hedges its ratio, the open currency position that fully hedges the ratio, amounts to the Risk Weighted Exposures in a particular currency multiplied with the ratio the institution wishes to hedge (i.e. the CET 1 ratio, Tier 1 ratio or total ratio). However, this open currency position could comprise trading and non-trading as well as structural and non-structural exposures. Therefore, this open currency position should be seen as the maximum amount of open currency position that hedges the ratio.
- Institution specific. An institution should demonstrate to the competent authority, what positions it wishes to exclude for risk weighting because they are of a non-trading and structural nature. What kind of positions to exclude in the risk weighting under the Standardised or Internal model approach should be consistent to an institutions hedge policy that is effective given their size, international presence, legal structure and internal organisation.
- Long position. This range can be long positions but could potentially also be a short positions, dependent on the FX volatility and RWA in the particular currencies. In this context we do not agree that only FX long positions could potentially be excluded.
- Deliberately unhedged. Leaving the position open is in this context an effective hedge strategy. Hence, the wording should not only incorporate active positions taken, but also positions deliberately left unhedged for purpose of hedging the capital ratios of the bank.
- Accounting. We wish to stress that this answer is based on applying an IFRS accounting framework. In the case of using a particular local GAAP accounting framework that deviates from IFRS, this answer could be different. For example, in some local GAAP, unrealised gains are not taken into account in contrast to IFRS.
- Double counting. Furthermore we wish to emphasise that the current text of article 351 of the CRR requires to calculate regulatory capital under the standardised approach for the sum of an institution's overall net foreign-exchange position and its net gold position (i.e. for banking and trading book positions). In the case an institution has received permission to use internal models for their trading desks, this results in the double counting of FX positions. In our view, not excluding FX positions from the standardised approach that are already risk weighted under internal models is an error in the CRR article 351.1 text.
Question 4: How should firms/regulators identify positions that are deliberately taken in order to hedge the capital ratio? What types of positions would this include? Do you consider that foreign exchange positions stemming from subsidiaries with a different reporting currency can be seen (on a consolidated level) as ‘deliberately taken to hedge against the adverse effect of FX movements’? If yes, how do you argue that this is the case?
As stated in our response to question three, we believe that when an institution hedges its ratio, the open currency position that fully hedges the ratio amounts to the Risk Weighted Exposures in a particular currency multiplied with the ratio the institution wishes to hedge (i.e. the CET 1 ratio, Tier 1 ratio or total ratio). However this open currency position comprises trading and non-trading as well as structural as non-structural exposures. In case the consolidated ratio is hedged, these positions stem from the parent company as well as its branches and subsidiaries. Therefore, this open currency position should be seen as the maximum amount of open currency position that hedges the ratio. In addition an institution should demonstrate to the competent authority, what positions it wishes to exclude because they are of a non-trading and structural nature. What kind of positions to exclude in the risk weighting under the Standardised or Internal model approach should be consistent with an institutions hedge policy that is effective given their size, international presence, legal structure and internal organisation. This range can be long positions but could potentially also be a short positions, dependent on the FX volatility and RWA in the particular currencies. Leaving the position stemming from subsidiaries/branches with a different reporting currency open is in this context an effective hedge strategy.We consider it the mandate of the ALCO or a comparable decision making body within a bank to decide upon an hedge effectiveness policy as also stated in answering question 3.
Question 5: Do you consider that the structural FX treatment could be applied to specific instruments instead of being understood as being applicable for ‘positions’? Taking into account the risk rationale of hedging the capital ratio, do you consider that it is acceptable to renounce to potential gains in order to protect the ratio from potential losses? Do you consider that both types of hedging (i.e. reducing the sensitivity of the ratio to movements of FX in both directions, or only if the movement produces losses) are acceptable from an economic perspective? If so, do you consider that both approaches would be acceptable under Article 352?
A structural FX position cannot be treated as a specific instrument. For example, a net investment in a foreign subsidiarity is not an instrument, but is a (monetary) FX exposure that can be hedged by applying an open FX position. In our view both gains and losses should be taken into account when an institution wants to hedge the ratio. As stated in our answer under question 3 and 4, we believe that to hedge against the adverse effect of the exchange rate on the ratios, the potential maximum hedged amount should be determined per currency. In order to determine this amount, the risk weighted exposure amount per currency as well as the ratio to be hedged are required. Certain currencies appreciate and other depreciate against the functional currency of the reporting entity. This revaluation and devaluation of the different currencies is reflected in the risk weighted exposures amounts as well in the ratio that is being hedged. The objective of article 352.2 is to exclude certain exposures from risk weighting. Therefore in order to be consistent with determining the maximum hedged amount, one should be consistent to include gains and losses.Question 6: If ‘structural FX’ is used conceptually internally within your organisation (e.g. in risk policies, capital policies, risk appetite frameworks, etc.), how do you define the notion of ‘structural FX position’ and ‘structural hedge’? Please describe how any ratio-hedging strategies are mandated within your organisation. Are ratio-hedging strategies prescribed in risk policies approved by the board? How do you communicate structural FX risk and position taking to your external stakeholders (e.g. in Pillar 3 reports, or reporting to regulators, investors, etc.)?
This is institution specific and therefore the Dutch Banking Association (NVB) is unable to respond.Question 7: Do you share the EBA’s view that the maximum FX position that could be considered structural should be the position that would ideally neutralise the sensitivity of the capital ratio to FX movements? Alternatively, in the light of the reference to Article 92(1), do you consider that the size of the structural position should be limited by the minimum capital ratio levels? If this is the case, which one of the three levels established in Article 92(1) do you apply?
We do not read the reference in article 352 to article 92(1) in relation to the size of the structural position nor limiting the structural position by the minimum capital ratio levels. We believe that only by hedging the current ratio, a bank will hedge itself against the adverse effect of the exchange rate on its ratios. When an institution would hedge itself again a required pillar I minimum ratio as set in article 92.1 CRR it would under hedge itself, making the hedge strategy of the institution less effective to hedge itself against an adverse effect of the exchange rate to its ratios.Question 8: How do you assess the consolidated ratio? How does your treatment differ between subsidiaries and branches?
This question is not applicable to institutions that do not have subsidiaries and branches. These institutions will report on an individual basis. For institutions that have only branches, legally they do not have to report on consolidated basis as a branch is not a legal separate entity. Legally its part of the parent company. However, certain local authorities require that branches are treated as subsidiaries, making it in particular situations for banks difficult to follow a strict legal framework. For institutions that have subsidiaries, the CRR requires them to report the consolidated ratio and the individual ratio.The consolidated ratio is the consolidated CET 1 (Tier 1 or total) capital divided by the consolidated Risk Weighted Exposure (RWE). In determining the consolidated RWE an institution should not make a distinction between the contribution to the consolidated RWE by a subsidiary and a branch.
We are of the view that an institution can only hedge the consolidated ratio due to the nature of individual reporting. At the individual entity level an institution runs translation risk that equals the translation risk at the consolidated level. However the balance sheet at the level of the individual institution does not present the same currency exposure as the consolidated balance sheet. This is due to the fact that the individual balance sheet only comprises the assets and liabilities directly taken at the individual entity level. The assets and liabilities in a foreign currency (if any) are only the gross long and short positions of a trading and non-trading as well as a structural and non-structural nature directly taken by the individual entity, like current accounts, loans, deposits taken and given, capital instruments, derivatives and the net investments in branches/subsidiaries, participations and other equity investments. The indirect currency exposure that is included in the net asset value of subsidiaries owned directly by the individual entity and that have the same functional currency as the individual entity, is not presented in gross long and short foreign currency positions in the individual entity balance sheet. Nevertheless, these indirect exposures can generate translation risk that is included in the EUR net asset value of the direct participations and subsequently in CET 1 capital of the individual entity.
In other words, the balance sheet of the individual entity comprises the assets and liabilities of the individual entity. Taking this approach, only the direct currency positions entered into by the individual entity should therefore be taken into account, which can be significantly different than the currency positions at the consolidated level. This is for example the case in the following structure.
Assuming that currency positions are only kept at the GBP, USD and CHF subsidiary directly owned by the sub-holding with the sub-holding having EUR as the functional currency, the top holding doesn’t have (on an individual entity basis) any direct currency exposure. In the individual balance sheet of the top holding only assets (including the net asset value of the EUR sub-holding) and liabilities in EUR will be reported.
On the other hand, the top holding individual entity will be exposed to translation risk. This is due to the fact that currency fluctuations at the level of the GBP, USD and CHF subsidiary directly owned by the sub-holding will change the EUR net asset value of that sub-holding and equally the amount of CET of the top holding.
The text and concept that is used to draw up Chapter 3, Title V, Part Three of the CRR is derived from the 1996 Basel Committee on Banking Supervision Amendment to the capital accord . The concept that BCBS expressed there is based on the consolidated reporting. They state in paragraph 8 that all national authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision , but the BCBS does not give guidance how .
Because the European Commission did not incorporate this guidance either when proposing the text for the CRR in 2013, we consider not giving this guidance is an omission for including Chapter 3, Title V, Part Three of the CRR in the scope of Article 6 CRR (General principles).
Question 9: What are your views on the CRR2 text of the structural FX article? What significant impacts might this have on your current hedging strategies?
The text is too strict. The issues identified by EBA should be re-written.In our view the text was not written from a point of view where the accounting framework is the basis for COREP reporting. For example, the amount of investments in consolidated subsidiaries denominated in foreign currency as written in article 325c (1a-ii), is only relevant when reporting at the individual level. When reporting the consolidated positions this amount is not relevant as it’s solely the assets and the liabilities in the foreign currency held by the parent company, its branches and its subsidiaries that matters. In addition, when article 325c (1a-ii) would become effective, how would this apply for a bank which has foreign denominated assets on its consolidated balance sheet and not necessarily via a subsidiary or an affiliated entity?
We do not understand why the exclusion from the calculation should be made for at least six months as stated in article 325c (1b) because the amount of exclusion depends on both the RWA’s and own funds. The restriction of article 325c (1b) would result in sub-optimal hedging of the ratio against the adverse effect of the foreign exchange rates. We consider that the institution should demonstrate to their competent authority what positions are of non-trading and structural nature.
Furthermore, we do believe that article 325c (2) and (3) is not written taking into account the concept of hedging of the ratio against the adverse effect of the foreign exchange rates that EBA and the EU banking sector is now trying to substantiate with a well thought of concept in mind. We strongly wonder how we should read ‘remain in place for the life for the asset or other item’ and how the Legislator envisions that each change by an institution to the amounts that it excludes should be approved. Especially when one knows that changes in RWA and own funds should drive the hedge ratio. Therefore, these restrictions will result in sub-optimal hedging strategies, which in our view is probably an unintended consequence of the proposed amendments.
Question 10: Do you agree with the analysis in the simplified assessment, from both an individual and a consolidated perspective, of the various elements discussed in this Annex of the DP or do you have any comments? In particular, do you have comments regarding the analysis of: o the actual level of the capital ratio o the effect of items deducted from capital / subject to a 1.250% RWA / subject to a 0% RWA o the effect of items held at the historical FX rate? Are there any additional elements, not included in the simplified examples, which should be considered in the analysis, both from an individual and a consolidated perspective? Please provide simple examples to illustrate them.
In our view conceptually one cannot hedge the consolidated and the individual ratio as the currency exposures and the RWE per currency, as implied by the CRR, will differ.Furthermore we do not agree with the CRR article 352.2 that in case a position in a foreign currency is deducted from CET 1, a bank should require permission from the competent authority not to include these positions in their currency reporting (i.e. C22 reporting). In case the bank would include them in the C22 reporting, the currency risk will be double counted in regulatory capital (i.e. on the one hand by the deduction from CET and on the other hand by the risk weighting of the open currency position for market risk).