Implementation of EC Own Funds and Solvency Ratio
Directives for Credit Institutions Incorporated in Ireland
Introduction
1. A notice was issued to all Credit Institutions under Central Bank supervision on 16 July 1991, setting out the basis on which the Bank will implement the EC Own Funds and Solvency Ratio Directives with effect from 1 January 1993. The notice was reproduced in the Bank's Quarterly Bulletin, Autumn 1991. A further EC Directive (91/633/EEC)' was adopted on 3 December 1991 to amend certain aspects of the Own Funds Directive (89/299/EEC)
2. This notice is being issued to comply with the implementation requirements of Directive 91/633/EEC.3
Implementation
3. Directive 91/633/EEC clarifies the calculation of the Own Funds of Credit Institutions with regard to the treatment of the Fund for General Banking Risks. It specifies that the fund is to be included as part of Tier 1 Capital ("Original own Funds").
4. The creation of a Fund for General Banking Risks arises from the practice of under-valuation of specified banking assets, as defined in Directive 86/635/EEC, Article 37(2) 4 . As indicated at point 8 of the Bank's notice of 16 July 1991, this concept is not relevant in the Irish context. Accordingly, the implementation of Directive 91/633/EEC will not require any amendment of the basis of computation of the Own Funds of Irish Credit Institutions.
Reference Notes
1 91/633/EEC, 3 December 1991 (O.J. No. L339, 11.12.1991 p. 33/4)
2 89/299/EEC, 17 April 1989 (O.J. No. L124, 05.05.1989 p. 16-20)
3 Reference Note 5 of the Bank's notice of 16 July 1991 outlines the statutory provisions regarding the collection by the Bank of information and the application of specified ratios. These provisions provide the legislative basis for the implementation of Directive 91/633/EEC.
4 86/635/EEC, 8 December 1986 (O.J. No. L372, 31.12.1986 p. 1-17) Council Directive on the annual accounts and consolidated accounts of banks and other financial institutions.
Implementation of EC Own Funds and Solvency Ratio
Directives for Credit Institutions Incorporated in Ireland
The following is the text of a notice issued by the Bank to Credit Institutions on 16 luly 1991.
Introduction
1. A Credit Institutionl under Central Bank supervision shall maintain a level of Own Funds which the Bank considers adequate in relation to its business, ownership, structure and standing.
2. Certain adjustments to the Bank's current capital adequacy requirements2 are necessary to comply with the terms of the EC Own Funds Directive (89/299/EEC)3 and Solvency Ratio Directive (89/ 647/EEC)4. The basis on which the Bank is implementing these Directives is defined below.
Implementation
3. In accordance with the Bank's statutory powers5 regarding
(i) collection of information and
(ii) the maintenance of specified ratios by institutions under Bank supervision,
the Bank will require compliance with the minimum solvency provisions of
the Directives not later than 1 January 1993. The Bank will advance the
technical amendments necessary in reporting formats, which will be introduced
at an appropriate time before that date.
4. In the intervening period, current capital adequacy requirements will continue to apply. These would be suMcient to exceed the minimum requirements of Article 11 of the Solvency Ratio Directive. Under this Article, a Credit Institution may not allow its solvency ratio, as defined in theDirective,to fall below its current level where that is at or below 8percent. Where the current ratio is higher than this figure, it must continue to be maintained at or above 8 percent. In addition to requiring continued compliance with existing minimum ratio requirements, compliance with this requirement will also be monitored by the Bank. Where a fall in the ratio is foreseen, the necessary remedial steps should be agreed with the Bank without delay.
5. The Directives provide for a minimum standard. Member States are, however, free to apply stricter criteria. In exercising this discretion, the Bank will determine the minimum solvency' ratio requirement appropriate to each Credit Institution. While, generally, this is not expected at this time to involve a departure from current ratio requirements(8%to12%),minimum ratio requirements will continue to be subject to review. There will be, however, some technical adjustments in the method of computing the ratio.
6. In accordance with 89/647/EEC, Article 3, the Bank will apply solvency requirements on a consolidated basis to each incorporated Credit Institution under Bank supervision. In addition, however, minimum ratio requirements will continue to be applied below the level of full group consolidation in order to achieve an appropriate distribution of capital throughout a banking group. This does not represent any departure from current policy.
Calculation of Own Funds
7. The solvency ratio is calculated by expressing Own Funds as a proportion of Risk Assets (including off-balance-sheet items). Own Funds consists of two tiers, as follows:
Tier 1 ("Original Own Funds")
(i) (a) Equity Capital, defined for the purposes of this birective (89/299/EEC, Article 2(1)(1)) to include paid-up ordinary share capital and perpetual non-cumulative preference shares/ preferred stock. With the approval of the Bank, building society deferred shares may also be included subiectto Section 17 of the Building Societies Act, 1989;
(b) Minority interests in subsidiaries where the underlying investment meets the above definition of Equity Capital (relevant in calculations on consolidated basis);
(ii) Share Premium Account,
(iii) Disclosed revenue and capital reserves but excluding revaluation reserves;
(iv) Interim declaredprofits,net of foreseeable charge or dividend,may be included only where the amounts have been verified for extemal audit purposes and with the approval of the Bank.
Less: Deductions in calculating Tier 1
(i) Goodwill and other intangible assets.
(ii) Material losses of the current financial year.
(iii) Own shares at book value held by a Credit Institution.
Tier 2 ("Additional Own Funds")
(i) Perpetual subordinated loan capital6 and cumulative perpetual preference shares/preferred stock (89/299/EEC, Article 2(1)(6)); such capital may not be reimbursed without the prior approval of the Bank.
(ii) Tangible Fixed Asset Revaluation Reserves.
(iii) Financial Fixed Asset Revaluation Reserves7.
(iv) Other items which, in the opinion of the Bank, are freely available to cover nommal banking risks, disclosed in internal accounting records and verified by audit (89/299/EEC, Article 2(1)(6)). Insofar as these conditions are met, general provisions may be included under this heading up to the current limit of 1.25% of Risk Assets.
(v) Current year profits other than those detailed at (iv) of Tier l which have been verified for audit purposes and with the approval of the Bank. (For the purposes of verification, intemal auditing may be considered to meet the requirements of the Directive).
(vi) Fixed-term and other redeemable cumulative preference shares/ preferred stock with an original maturity of at least 5 years or redeemable only with the prior consent of the Bank.
(vii) Subordinated loan capital with an original maturity of at least 5 years and subject to the other conditions of 89/299/EEC, Article 4(3)8.
Less. Deductions in arriving at Own Funds As defined earlier, certain items should be deducted at Tier 1 level. The following further items fall for deduction in the calculation of Own Funds (Tier 1 plus Tier 2):
i. The amount of any Investment in Other Credit and Financial9 Institutions which exceeds 10 per cent. of the capital of those institutions and
ii. the amount of any Investment in Other Credit and Financial9 Institutions (other than those at (i) above) which exceeds 10 per cent. of the reporting institution's Own Funds (as measured before these deductions from Own Funds).
Limits
i. The total of Tier 2 items which may be counted as part of Own Funds is limited to the Tier 1 total (net of deductions).
ii. The aggregate of Subordinated loan capital and redeemable preference shares which may be included in Tier 2 is limited to 50 per cent. of the Tier 1 total (net of deductions).
Own Funds is defined, therefore, as the aggregate of Tier 1 (net of deductions) and Tier 2 items, less the further deductions specified above and subject to the preceding limits.
Certain National Discretions
8. The Bank is not adopting the following provisions:
i) Fund for general banking risks and value adjustments (89/299/EEC, Article 2(1)(4) and 2(1)(5)) will not form part of Own Funds as they are not relevant in the Irish context;
ii) the commitments of the members of Credit Institutions set up as cooperative societies and the jointand several commitments ofthe borrowers of certain institutions organised as funds (89/299/EEC, Article 2(1)(7)) will not form part of Own Funds as these are not relevant in the Irish context;
iii) as at present in the calculabon of unconsolidated Own Funds of a parent institution, its investment in other Credit Institutions within the group will continue to be deducted. The Bank is not, therefore, adopting the option contained in 89/299/EEC, Article 2(1). The amount to be deducted will be calculated subject to the amendments under the heading "Deductions in arriving at Own Funds" detailed above.
The Bank would consider on a case-by-case basis requests by Credit Institutions for the application of a zero weighting to claims on local authorities or regional governments of other Member States where such a weighting is applied domestically in those Member States (8916471 EEC, Article 7(2))
Calculation of Risk Assets
9. The total of Risk Assets (including off-balance-sheet items) forms the denominator in the solvency ratio calculation. The basis of riskadjustment is very similarto that currently employed by the Bank. Each Risk Asset is weighted at 100 per cent. unless it comes within one of the lower-risk categories as described below.
10. For the purpose of this notice, Zone A countries shall comprise all EC MemberStates, all full membersoftheOECDandanycountrywhich has concluded a special lending arrangement with the IMF associated with the General Arrangements to Borrow (GAB). Zone B shall comprise all other countries.
11. Multilateral development banks comprise the Intemational Bank for Reconstruction and Development, the Intemational Finance Corporation, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the Council of Europe Resettlement Fund, the Nordic Investment Bank, the Caribbean Development Bank and the European Bank for Reconstruction and Development.
12. The following risk weightings apply:
(a). Zero weighting
1. cash in hand and equivalent items;
2. asset items constituting claims on Zone A central governments and central banks;
3. asset items constituting claims on the European Communities;
4. asset items constituting claims carrying the explicit guarantees of Zone A central governments and central banks;
5. asset items constituting claims on Zone B central governments and central banks, denominated and funded in the national currencies of the borrowers;
6. asset items constituting claims carrying the explicit guarantees of Zone B central governments and central banks, denominated and funded in the national currency common to the guarantor and the borrower;
7. asset items secured by collateral in the form of Zone A central government or central bank securities, or securities issued by the European Communities, or by cash deposits placed with the lending institution or by certificates of deposit or similar instruments issued by and lodged with the latter;
(b) 20% weighting
1. asset items constituting claims on the European Investment Bank (EIB);
2. asset items constituting claims on multilateral development banks;
3. asset items constituting claims carrying the explicit guarantee of the European Investment Bank (EIB);
4. asset items constituting claims carrying the explicit guarantees of multilateral development banks;
5. asset items constituting claims on Zone A regional governments and local authorities 10;
6. asset items constituting claims carrying the explicit guarantees of Zone A regional govemments or local authorities l0;
7. asset items constituting claims on Zone A Credit Institutions;
8. asset items constituting claims, with a maturity of one year or less, on Zone B Credit Institutions;
9. asset items carrying the explicit guarantees of Zone A Credit Institutions;
10. asset items constituting claims with a maturity of one year or less, carrying the explicit guarantees of Zone B Credit Institutions;
11. asset items secured bycollateral in the form of securities issued by the EIB or by multilateral development banks;
12. cash items in the process of collection;
(c) 50% weighting
loans fully and completely secured by first-charge mortgages on residential property which is or will be occupied by or which is let by the borrower; mortgages fully or partly secured on nonresidential property will not qualify for the 50% weighting.
(d) 100% weighting
1. asset items constituting claims on Zone B central governments and central hnks except where denominated and funded in the national currency of the borrower;
2. asset items constituting claims on Zone B regional governments or local authorities, unless otherwise agreed with the Bank;
3. asset items constituting claims with a maturity of more than one year on Zone B Credit Institutions;
4. tangible assets;
5. all other assets (except where deducted from Own Funds). Prepayments and accrued income not otherwise included should continue to form part of this category.
13. The aggregate net short Foreign Exchange open position will continue to be weighted at 100%.
Off-Balance-Sheet Items
14. The current treatment of off-balance-sheet items is being retained with the exception of the weighting of certain Documentary Credits, as follows:
(i) 20% weighting: Documentary Credits collateralised by the underlying
shipment.
(ii) 50% weighting: Documentary Credits issued and confirmed but not collateralised
by the underlying shipment.
(iii) 100% weighting: Standby letters of credit serving as financial guarantees.
As at present, in calculating off-balance-sheet risk, the weighting appropriate
to the counterparty is applied to the credit equivalent amount of the off-balance-sheet
item (having converted full-risk items at 100%, medium-risk items at 50%,
medium/low risk items at 20% and with low risk items set atzero). The risk
classification of off-balance-sheet items is included as Annex 1.
In the case of interest-rate and foreign exchange related items, the Bank will continue to employ the mark-to-market basis, as outlined in Annex ll, in determining the appropriate credit equivalent amount.
15. The Directives provide for a procedure to allow technical amendment or updating of their provisions. Accordingly, the Bank reserves the right to amend the basis of the solvency ratio calculation where necessary or desirable in the light of future developments.
Reference Notes
1.The First Banking Directive (77/780/EECof 12 December 1977) defines
a Credit Institution as an undertaking whose business is to receive deposits
or other repayable funds from the public and to grant credits for its own
account. In the Irish context Credit Institutions comprise licensed banks,
building societies, trustee savings banks, the Agricultural Credit Corporation
plc' and the Industrial Credit Corporation plc'. Credit Unions and Friendly
Societies are excluded under Directive 86/524/EEC of 27 October 1986. Separate
own funds in the forrn of endowment capital are not required for bank licence
holders established on a branch basis and not incorporated in the State.
2. The Bank's capital adequacy requirements, as published in the Quarterly Bulletin for Autumn 1987, were last amended in January 1990 on the adoption by the Bank (for licensed banks, building societies and trustee savings banks) of the risk-weighted system of capital adequacy measurement devised by the Basle Committee on 8anking Regulation and Supervisory Practices. The implementation of this system in Ireland was described in the article entitled "Credit Institutions Incorporated in Ireland: Revised Capital Adequacy Requirements" published in the Quarterly Bulletin, Winter 1990.
3. 89/299/EEC, 17April 1989 (O.l. No.L 124, 05.05.1989 p. 16-20)
4. 89/647/EEC,18December1989(0.J. No.L386,30.12.1989p.14-22)
5. Legislative provisions in respect of the collection of information and application of specified ratios by the Bank:
Collection of Information
Section 18 of the Central Bank Act,1971, as amended by the substitution of Section 37 of the Central Bank Act, 1989.
Section 41 of the Building Societies Act, 1989.
Section 25 of the Trustee Savings Bank Act, 1989
.Application of Specified Ratios
Section 23 of the Central Bank Act ,1971, as amended by Section 40 of the Central Bank Act, 1989.
Section 23A of the Central Bank Act, 1971, as inserted by Section 41 of the Central Bank Act, 1989.
Section39 of the Building Societies Act, 1989.
Section 31 of the Trustee Savings Bank Act, 1989.
6. Conditions for inclusion in Tier 2 capibl of perpe tual subordinated loan capital:
a) it may not be reimbursed on the bearer's initiative or without the prior agreement of the Central Bank;
b) the debt agreement must provide for the Credit Institution to have the option of deferring the payment of interest on the debt,
c) the lender's claims on the Credit Institution must be wholly subordinated to those of all non-subordinated creditors;
----------
' The Department of Finance is the competent authority in respect of these State sponsored financial institutions.
d) the documents governing the issue of the securities must provide for debt and unpaid interest to be such as to absorb losses, whilst leaving the Credit Institution in a position to continue trading;
e) only fully paid-up amounts shall be taken into account.
The term "Financial fixed assets" relates to non-tangible items such as fixed asset investments (including investments in associates and nonconsolidated subsidiaries) held for the long term. The amount by which thevaluation ofthese itemsexceedstheircost isdefined in Directive 86/ 635/EEC ("Bank Accounts Directive") as a revaluation reserve and would, therefore, fall to be treated for capital adequacy purposes as a Tier 2 item. It is envisaged that this requirement will be applied only in the calculation of consolidated Own Funds.
8. Further conditions for inclusion in Tier 2 capital of subordinated loan capital and redeemable preference shares.
a) only fully paid-up funds may be taken into account.
b) the extent to which they rank as Own Funds will be reduced on a straight-line basis over the last five years before repayment date.
c) the loan agreement must not include any clause providing that in specified circumstances, other than the winding up of the Credit Institution, the debt will become repayable before the agreed repayment date.
9. Majority holdings in financial institutions do not require deduction insofaras they are consolidated within the solvency computations of the investor Credit Institution. The Second Banking Directive (89/646/EEC of 15 December 1989) defines a financial institution as an undertaking other than a Credit lnstitution the principal activity of which is to acquire holdings in or to carry on one of the following activities:
(i) Lending (including inter alia: consumer credit, mortgage credit, factoring with or without recourse and financing of commercial transactions including forfaiting).
(ii) Financial leasing.
(iii) Money transmission services.
(iv) Issuing and administering means of payment (e.g. credit cards, travellers' cheques and bankers' drafts).
(v) Guarantees and commitments.
(vi) Trading for own account or for account of cust omers in:
(a) money market instruments (cheques, bills, CDs, etc.);
(b) foreign exchange;
(c) financial futures and options;
(d) exchange and interest rate instruments;
(e) transferable securities.
(vii) Participation in share issues and the provision of services related to such issues.
(viii) Advice to undertakings on capital structure, industrial strategy and related questions and advice and services relating to mergers and the purchase of undertakings.
(ix) Money broking.
(x) Portfolio management and advice.
(xi) Safekeeping and administration of securities.
(xii) Credit reference services.
(xiii) Safe custody services.
10. In the Irish context, certain non-commercial public-sector entities are included in thls category. This does not represent any departure from current policy.
ANNEX I
CLASSIFICATION OF OFF-BALANCE-SHEET ITEMS
Full risk-100%
Guarantees,
Acceptances (if not already recorded on-balance-sheet),
Endorsements on bills not bearing the name of another credit institution,
Transactions with recourse,
Irrevocable standby letters of credit having the character of credit substitutes/serving as financial guarantees,
Asset sale and repurchase agreements (as defined in Articles 12(1) and (2) of Directive 86/635/EEC), if not already recorded on-balance-sheet,
Assets purchased under outright forward purchase agreements,
Forward forward deposits,
The unpaid portion of partly-paid shares and securities,
Other items also carrying full risk.
Medium risk-50%
Documentary credits issued and confirmed but not collateralised by the underlying shipment (see also medium/low risk),
Warranties and indemnities (including bidltender, performance, customs and tax bonds) and guarantees not having the character of credit substitutes (e.g. Intervention Guarantees),
Asset sale agreements with an option to repurchase (as defined in Article 12(3) and (5) of Directive 86/635/EEC),
Undrawn credit facilities (agreements to lend, purchase securitiei, provide guarantees or acceptance facilities) with an original maturity of more than one year,
Note issuance facilities (NlFs) and revolving underwriting facilities (RUFs),
Other items also carrying medium risk.
Medium / low risk-20%
Documentary credits in which the underlying shipment acts as collateral and other self-liquidating transactions,
Other items also carrying medium/low risk.
Low risk-0%
Undrawn credit facilities (agreements to lend, purchase securities, provide guarantees or acceptance facilities) with an original maturity of upto and including one year or which may be cancelled unconditionally at any time without notice,
Other items also carrying low risk.
ANNEX ll
THE TREATMENT OF OFF-BAIANCE-SHEET ITEMS
CONCERNING INTEREST AND FOREIGN-EXCHANGE RATES
The counterparty-risk calculation in respect of interest-rate and foreignexchange related items isto becomputed usingthe mark-to-marketapproach, as described below.
Step (a): by attaching current marketvalues to contracts (marking to market) the current replacement cost of all contracts with positive values is obtained.
Step (b): to obtain a figure for potential future credit exposure', the notional principal amounts or values underlying an institution's aggregate books are multiplied by the following percentages:
___________
Residual Maturiry/Interest-Rate Contract/Foreign-Exchange Contracts
One Year or Less / 0% / 1 %
More Than One Year / 0.5% / 5%
Step (c): the sum of current replacement cost and potential future credit exposure is multiplied by the risk weightings appropriate to the relevant counterparties.
For interest-rate and exchange-rate computations, a 50% weighting should be applied to counterparbes who would normally attract a 100% weighting.
Interest-rate and foreign-exchange contracts traded on recognised exchanges where they are subject to daily margin requirements and foreign-exchange contracts with an original maturity of 14 calendar days or less are excluded.
_______________
' Except in the case of single-currency floating / floating interest rate
swaps in which only the current replacement cost will be calculated.