Response to discussion on the treatment of structural FX under Article 352(2) of the CRR
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2. All items (monetary as well as non-monetary) considered for the purposes of Article 352 (2) CRR are reflected using the last FX rate.
3. The structural FX position is managed on group level and not on single unit level, taking netting effects (CET1 versus risk-weighted assets) into account. All FX non-monetary items (and monetary items) and Risk Weighted Assets are converted to EUR with closing EUR/FCY exchange rates at the respective reporting date. A capital ratio hedge is applied on consolidated / group level taking into consideration net open capital positions in each currency. The Group’s capital ratios are affected by two dimensions: the change in the local regulatory capital (i.e. IFRS Equity position adjusted by regulatory deductions) and the change in the Risk Weighted Assets). Net open capital positions (either positive or negative) are managed by entering into hedging transaction.
We support the treatment as outlined in Paragraph 22 of the DP (“alternative view” ) that historic cost instruments should not be included in the overall net foreign exchange position.
In this case no regulatory exemption is required for such instruments. If a bank intends to hedge capital ratios instead of capital amounts the exemption should be granted to the positions that are taken as a hedge.
Investments in non-monetary items at historic costs are generally funded in the functional currency (EUR) and therefore there is no offsetting FX liability. They do not create any P/L volatility from FX movements and therefore do not impact the amount of own funds (held in functional currency) due to FX movements.
The Basel framework clearly states (in 718(xxxix), Basel II Accord) that no capital charge is needed to be applied for long-term participations. Although the paragraph mentions the relation to structural positions in the last sentence this is not applicable in context to the CRR text. The CRR text relates to structural positions explicitely considered in the context of capital ratio protection. As stated above the reason for funding historic cost items is to protect capital amounts (by avoiding adverse effects in case of FX rate volatility) but not capital ratios.
In the consolidated treatment, these instruments give rise to translation risk: all assets and liabilities of the subsidiary are translated into EUR on the consolidated financial statement using the exchange rate at the closing date of the period. This leads to volatility in the consolidated equity denominated in EUR but does not influence the P/L statement. The equity position denominated in foreign currency consists of paid-in capital, retained earnings and net-income of the current year. The paid-in capital and the retained earnings from previous year are translated into EUR by using the historical exchange rate (i.e. the rate when the capital was paid in or historical yearly average exchange rate for retained earnings). Any difference between the historic/average rates and the current exchange rate at the date of consolidation is shown under the line “currency translation” in the consolidated total equity statement.
The effects on consolidated equity are covered in the Pillar 2 risk calculation.
For model banks, the interaction with back-testing for the determination of overshootings is not clear. It is unclear if and how structural FX positions should be included into the (economic/actual) back-testing framework for the determination of the number of overshootings in the model. Inconsistencies between theoretical and actual Backtesting created by the inclusion or exclusion of hypothetical positions need to be addressed.
Additionally it must be mentioned that the effect on own funds requirement can be very different depending on the approach. For banks with internal models for banking book FX exposure this exposure might be dominant and will distort the diversification benefits with other risk types in the trading book.
A single/dominant exposure in the internal model will be subject for significantly higher capital requirments due to the inclusion of VaR + SVaR , 10-day scaling, model multiplier.
Example:
• FX Internal Model for CZK Position = 24.7% [=(VaR10d+SVaR10d)*multiplier 3]
• FX Standardized Approach = 8%
Our view is that structural FX positions can be long or short depending on the asset / liability structure, thus we see that hedging shall be allowed for both sides (both sides shall be subject to potential exclusion).
Please note that the statement above is based on the following way of calculating the net FX position: For determining the net position, the available capital is compared with the capital required per currency.
Considering the symmetrical effects of hedging, positions from instruments without optionality features seem appropriate (on the other hand this will reduce the firm value if FX rates behave favourably / diminish positive effects on the ratio).
We define “non deliberately” taken FX risks as positions coming out of banking or other operations where the strategy of the position is not primarily the taking of FX risk, e.g. if we operate a subsidiary in a different country with different domestic currency FX risk between the home currency of the Heas Office and the domestic currency of the subsidiary is implicitly generated and not deliberately taken.
In contrast to this, we understand the deliberate taking of an FX risk where the primary target is to benefit from the FX movement (FX spot, FX forward transactions, etc.) and the runtime is clearly defined (foreign assets with a maturity date).
• We deem a structural FX treatment on position level to be more appropriate, as positions can result from various monetary and non-monetary items and managing the net position therefore is more efficient in our view.
• Hedging a net position means reducing the structural FX position. This can also mean negative P&L results of the hedging instrument. In addition asymmetrical hedging instruments may not be available in all markets or economically attractive due to different market liquidity, hedging instrument availability and implied hedging costs. Therefore, we consider it acceptable to renounce potential gains in order to protect the ratio from potential losses.
• We consider both sides of hedging acceptable from an economic perspective. However, hedging instruments required for “only if the movement produces losses” situations may not be available for all markets or economically attractive.
• Hedging FX risks means reducing the volatility of the capital ratio against FX movements. These movements may create positive or negative P&L results of the hedging instruments. This approach must be available under Article 352 CRR. If a bank uses the alternative approach for certain well developed markets, we deem this to be a subset of the basic symmetric hedging approach.
Ad 2) It should not be limited by the minimum capital ratio. The bank should be able to partially or fully protect its current overall capital requirement ratio. The strategy of the bank should be assessed by the competent authority in the decision-making process of the application.
Investments in subsidiaries held at historic cost should not be included into the determination of FX exposure.
The treatment does not differ for branches but, in comparison to subsidiaries, these do not hold any FCY denominated equity.
• according to 325c 1(a) (ii) “the exclusion is made for at least six month” whereas
• according to 325c 2 it shall “remain in place for the life of the assets”.
The bank should be able to define the time horizon for the application (floored by e.g. 6 month to support the non-trading nature). The bank’s policy should be assessed by the competent authority in the decision-making process of the application.
The application for structural hedges should not be restricted to affiliated entities and consolidated subsidiaries. Banks with significant RWAs from non-domestic currency assets on the solo level should be allowed to exclude structural hedges as the nature of FX-risk to capital ratio is the same as for investments in affiliated or consolidated entities and subsidiaries.
As we do not currently apply the structural FX provision, there is no immediate impact on hedging strategies.
• Treatment of participation (with a home currency different from head office) in the consolidated financials
• The case of a short structural FX position (as mentioned above)
The example related to Historic cost (2.1.6) is not realistic. In the examples it is assumend that FX assets at HC are funded in foreign currency. In practice the FX Assets at HC are funded in domestic currency to protect capital amounts by avoiding P/L fluctuations from open FX.
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?
1. Major Austrian banks do not include FX non-monetary items (i.e. equity in participation holdings and real estate) in the overall net FX position (Art. 352 (1) CRR). These positions are included in the net foreign exchange position pursuant to Article 352 (2) CRR (structural FX position).2. All items (monetary as well as non-monetary) considered for the purposes of Article 352 (2) CRR are reflected using the last FX rate.
3. The structural FX position is managed on group level and not on single unit level, taking netting effects (CET1 versus risk-weighted assets) into account. All FX non-monetary items (and monetary items) and Risk Weighted Assets are converted to EUR with closing EUR/FCY exchange rates at the respective reporting date. A capital ratio hedge is applied on consolidated / group level taking into consideration net open capital positions in each currency. The Group’s capital ratios are affected by two dimensions: the change in the local regulatory capital (i.e. IFRS Equity position adjusted by regulatory deductions) and the change in the Risk Weighted Assets). Net open capital positions (either positive or negative) are managed by entering into hedging transaction.
We support the treatment as outlined in Paragraph 22 of the DP (“alternative view” ) that historic cost instruments should not be included in the overall net foreign exchange position.
In this case no regulatory exemption is required for such instruments. If a bank intends to hedge capital ratios instead of capital amounts the exemption should be granted to the positions that are taken as a hedge.
Investments in non-monetary items at historic costs are generally funded in the functional currency (EUR) and therefore there is no offsetting FX liability. They do not create any P/L volatility from FX movements and therefore do not impact the amount of own funds (held in functional currency) due to FX movements.
The Basel framework clearly states (in 718(xxxix), Basel II Accord) that no capital charge is needed to be applied for long-term participations. Although the paragraph mentions the relation to structural positions in the last sentence this is not applicable in context to the CRR text. The CRR text relates to structural positions explicitely considered in the context of capital ratio protection. As stated above the reason for funding historic cost items is to protect capital amounts (by avoiding adverse effects in case of FX rate volatility) but not capital ratios.
In the consolidated treatment, these instruments give rise to translation risk: all assets and liabilities of the subsidiary are translated into EUR on the consolidated financial statement using the exchange rate at the closing date of the period. This leads to volatility in the consolidated equity denominated in EUR but does not influence the P/L statement. The equity position denominated in foreign currency consists of paid-in capital, retained earnings and net-income of the current year. The paid-in capital and the retained earnings from previous year are translated into EUR by using the historical exchange rate (i.e. the rate when the capital was paid in or historical yearly average exchange rate for retained earnings). Any difference between the historic/average rates and the current exchange rate at the date of consolidation is shown under the line “currency translation” in the consolidated total equity statement.
The effects on consolidated equity are covered in the Pillar 2 risk calculation.
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?
In principle we share the view that in general the FX-exposure determination should follow the same rules for standardized approach and internal model.For model banks, the interaction with back-testing for the determination of overshootings is not clear. It is unclear if and how structural FX positions should be included into the (economic/actual) back-testing framework for the determination of the number of overshootings in the model. Inconsistencies between theoretical and actual Backtesting created by the inclusion or exclusion of hypothetical positions need to be addressed.
Additionally it must be mentioned that the effect on own funds requirement can be very different depending on the approach. For banks with internal models for banking book FX exposure this exposure might be dominant and will distort the diversification benefits with other risk types in the trading book.
A single/dominant exposure in the internal model will be subject for significantly higher capital requirments due to the inclusion of VaR + SVaR , 10-day scaling, model multiplier.
Example:
• FX Internal Model for CZK Position = 24.7% [=(VaR10d+SVaR10d)*multiplier 3]
• FX Standardized Approach = 8%
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.
We believe that structural FX risk only exists in the non-trading area and shall only be measured in the banking book. In contrast to this, in the trading book, all FX risks are managed on a daily basis and are therefore of no structural nature.Our view is that structural FX positions can be long or short depending on the asset / liability structure, thus we see that hedging shall be allowed for both sides (both sides shall be subject to potential exclusion).
Please note that the statement above is based on the following way of calculating the net FX position: For determining the net position, the available capital is compared with the capital required per currency.
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?
We propose to look at any (rather long-term) positions which shift the currency mis-match of “structural” positions like equity, loans/RWA in order to minimize the impact of FX movements on the capital ratios / reduce the ratios’ sensitivity to such movements.Considering the symmetrical effects of hedging, positions from instruments without optionality features seem appropriate (on the other hand this will reduce the firm value if FX rates behave favourably / diminish positive effects on the ratio).
We define “non deliberately” taken FX risks as positions coming out of banking or other operations where the strategy of the position is not primarily the taking of FX risk, e.g. if we operate a subsidiary in a different country with different domestic currency FX risk between the home currency of the Heas Office and the domestic currency of the subsidiary is implicitly generated and not deliberately taken.
In contrast to this, we understand the deliberate taking of an FX risk where the primary target is to benefit from the FX movement (FX spot, FX forward transactions, etc.) and the runtime is clearly defined (foreign assets with a maturity date).
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?
There should be no differentiation between positions or specific instruments as the effects on capital and ratios are similar. Hedging should be understood of reducing sensitivity to both directions. Hedging instruments should be mainly simple/plain vanilla instruments like FX-Spot. Other instruments like options show time dependency effects (e.g. Delta) and would have to be constantly adjusted or renewed.• We deem a structural FX treatment on position level to be more appropriate, as positions can result from various monetary and non-monetary items and managing the net position therefore is more efficient in our view.
• Hedging a net position means reducing the structural FX position. This can also mean negative P&L results of the hedging instrument. In addition asymmetrical hedging instruments may not be available in all markets or economically attractive due to different market liquidity, hedging instrument availability and implied hedging costs. Therefore, we consider it acceptable to renounce potential gains in order to protect the ratio from potential losses.
• We consider both sides of hedging acceptable from an economic perspective. However, hedging instruments required for “only if the movement produces losses” situations may not be available for all markets or economically attractive.
• Hedging FX risks means reducing the volatility of the capital ratio against FX movements. These movements may create positive or negative P&L results of the hedging instruments. This approach must be available under Article 352 CRR. If a bank uses the alternative approach for certain well developed markets, we deem this to be a subset of the basic symmetric hedging approach.
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.)?
Under the current regime we define the structural FX position as the net position (capital available – capital required) of the RWA held in a specific currency and the capital available in the respective currency. It is calculated on group level with the latest available CET1 and RWA per currency and group CET1 ratio. As structural hedge we conclude FX Forward and Spot transactions in focus currencies where the influence of currency movements has a material impact on the group capital ratio. Therefore, currencies with internationally developed FX markets are in the focus.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?
Ad 1) we agree that the max FX position should be set at the level which would ideally neutralise the sensitivityAd 2) It should not be limited by the minimum capital ratio. The bank should be able to partially or fully protect its current overall capital requirement ratio. The strategy of the bank should be assessed by the competent authority in the decision-making process of the application.
Question 8: How do you assess the consolidated ratio? How does your treatment differ between subsidiaries and branches?
The Head Office only assesses the structural FX position on group / consolidated level. On group / consolidated level the amount of equity (more specifically, CET1) which is available per currency is compared to the amount of risk-weighted assets (expressed as a capital requirement based on the current consolidated capital ratio) to obtain a net position for each currency.Investments in subsidiaries held at historic cost should not be included into the determination of FX exposure.
The treatment does not differ for branches but, in comparison to subsidiaries, these do not hold any FCY denominated equity.
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 wording is ambiguous as• according to 325c 1(a) (ii) “the exclusion is made for at least six month” whereas
• according to 325c 2 it shall “remain in place for the life of the assets”.
The bank should be able to define the time horizon for the application (floored by e.g. 6 month to support the non-trading nature). The bank’s policy should be assessed by the competent authority in the decision-making process of the application.
The application for structural hedges should not be restricted to affiliated entities and consolidated subsidiaries. Banks with significant RWAs from non-domestic currency assets on the solo level should be allowed to exclude structural hedges as the nature of FX-risk to capital ratio is the same as for investments in affiliated or consolidated entities and subsidiaries.
As we do not currently apply the structural FX provision, there is no immediate impact on hedging strategies.
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 general the examples provided are hard to understand and do not cover all relevant aspects of this topic. This includes:• Treatment of participation (with a home currency different from head office) in the consolidated financials
• The case of a short structural FX position (as mentioned above)
The example related to Historic cost (2.1.6) is not realistic. In the examples it is assumend that FX assets at HC are funded in foreign currency. In practice the FX Assets at HC are funded in domestic currency to protect capital amounts by avoiding P/L fluctuations from open FX.