Response to consultation on Technical standards on the new Business Indicator framework for operational risk
Question 1: What are your views with regards to the proposal for the ILDC component? Please explain and provide arguments for your answer.
As a general comment on the calculation of the BI, we would like to emphasize that the mapping with Finrep elements proposed by the EBA should only be indicative and not compulsory. This mapping should be viewed as a way to lead institutions in their own mapping to the BI. This will allow institutions to better ensure consistency on the one hand with the prudential trading and non-trading books boundary, and on the other hand with other elements that are not mapped as indicated by the EBA (e.g. example given by the EBA on lease expenses).
To ensure consistency of the items of each component of the Business Indicator with the prudential classification of the trading book and the banking book, the items falling under ILDC should be consistent with the FRTB regulatory framework and the definition of the boundary between the trading book and the non-trading book according to CRR3.
We have found the following discrepancies:
- As the interest income / expenses from financial assets held for trading (art. 1 a) – art 2 b)) are not reported in the MNI but in the revenues of the trading book, we believe the item should be included in the financial component.
- Interplay between ILDC, FC and “clean price”:
Regarding the determination of the ILDC component and the Financial Component, it appears that institutions using the so called “clean price” to produce the Finrep reporting might be penalized compared to institutions using the “dirty price” approach.
As a reminder the clean and dirty price approaches are detailed in Instructions for Finrep reporting (Annex 5) as detailed bellow:
“Interest income and interest expense from financial instruments measured at fair value through profit or loss and from hedging derivatives classified in the category ‘hedge accounting’ shall be reported either separately from other gains and losses under items interest income’ and ‘interest expense’ (‘clean price’) or as part of gains or losses from these categories of instruments (‘dirty price’) (...)
‘Interest income. Financial assets held for trading’ and ‘Interest expenses. Financial liabilities held for trading’ shall include, where the clean price is used, the amounts related to those derivatives classified in the category ‘held for trading’ which are hedging instruments from an economic but not accounting point of view to present correct interest income and expenses from the financial instruments that are hedged (...)
Dividend income on equity instruments measured at fair value through profit or loss shall be reported either as ‘dividend income’ separately from other gains and losses from those classes of instruments where the clean price is used, or as part of gains or losses from those classes of instruments where the dirty price is used”.
Institutions using the clean price approach reclassify interest income & expenses and dividend incomes from gains and losses from instruments held for trading or instruments designated at fair value through profit or loss to interest incomes & expenses and dividend income within F02.00. This does not constitute an accounting choice or method but a reporting reclassification. These reclassifications are made for Finrep reporting purpose only.
However, in a situation where the P&L of the trading book of an institution would be negative, this reclassification would result to: i) deepen the loss of the P&L of the trading book and ii) increase the amounts of dividend incomes (as for example dividend revenues stemming from equity instruments measured at FV in Trading book would be reclassified in dividend income).
That will mean that an institution using clean price approach for Finrep would be penalized compared to an institution using the dirty price approach as, considering the same P&L profile, in case of negative P&L of the trading book, one institution using clean price would see its FC (based on absolute value) increased by the amounts related to dividend revenues or net interest and its ILDC increased by the same amount, where another one using dirty price would not suffer from this effect.
We consider that institutions using clean price approach should not be penalized by the application of the clean or dirty price approach and ask EBA to allow institutions to neutralize the negative impact of the reclassification made for Finrep purposes (with the same reclassification mechanism that the one used for AA to PBA approach but allowing reclassification of dividend revenue and interest incomes/expenses from ILDC to FC).
Question 2: What are your views with regards to the proposal for the Services component? Please explain and provide arguments for your answer.
Other operating expenses.
Operating expenses due to operational risk events (art 6 - d)) will be difficult to report because their breakdown is based on cost accounting and cannot be read directly in Finrep. By way of illustration, we can mention the examples of:
- overtime paid to employees following an operational risk event;
- the use of temporary workers who could be allocated within overhead costs.
No mapping to FINREP is proposed in the draft RTS. Moreover, the question arises as to which methodology or distribution keys to use to allocate the operating expenses.
These items are reported at a detailed level in the templates C17.01 and C17.02 on operational losses for supervisory reporting purposes and in the template OR1 on operational risk losses for pillar 3 disclosures.
Items related to operational risk may be recorded under general costs (e.g. temporary staff called in to ensure continuity of service, recorded under staff costs and not under Service Component items, etc.) or under the interest margin, depending on the type of operational risk. From an accounting standpoint, concentrating these items in the SC makes little sense.
Moreover, as mentioned above, the correspondence between an operational risk event financial impact and the corresponding accounting aggregate is not straightforward, and maintaining such correspondence as the RTS requires, with comprehensive information on where the impacts of operational risk events are accounted for in the PnL statement will be very complex if not impossible to achieve. It requires to duplicate any accounting entry between the ones linked to operational risk and those that are not. Furthermore, such requirement is not included in the Level 1 text which only requires to measure the operational risk losses (art 315(3)). It seems from the industry’s perspective that such requirement is not proportionate to the aim the level 1 text intends to achieve.
SC calculation for asset management activities.
We would like to highlight the unwarranted consequences of SC calculation for asset management activities.
Indeed, inducement on fees and commissions for investment and ancillary services – as defined in MiFID 2014/65/EU art. 23 & 24 - are perceived by a “receiving party” (e.g. an institution providing advice) from a “paying party” (e.g. a fund/asset management company), in relation to a service provided to the end client (e.g. investment advice). The paying party “retrocedes” a portion of the fees and commissions it collected from the end client, as agreed with the receiving party and as displayed to the end client. The inducement is actually “flowing through” the paying party. This is very different from outsourcing services.
Therefore, to avoid the double counting of such inducements, we believe that EBA should consider that :
- The party receiving inducements should report them given that they are commissions and fees remunerating its advisory service to the end client.
- Conversely, the party paying inducements out of the fees and commissions revenues perceived from the end client should report its fee and commission income net of the relevant inducements, and not consider such inducements paid as a gross expense.
This is confirmed by the Basel reform. In its “Annex: Definition of Business Indicators Components”, the fee and commission from asset management are solely included in the “fee and commission income”. There is no mention of expenses from asset management, which confirms inducements paid by asset managers are netted against their revenues from asset management to calculate the relevant fee and commission income component.
Question 3: What are your views with regards to the proposal for the Financial component? To which extent are you carrying out operations or making accounting choices as referred to under paragraph 2, point a) of Article 9 of this draft RTS? Are you carrying out operations or making accounting choices, other than those specified under paragraph 2, point a) of Article 9 of this draft RTS, that could justify the use of the PBA? Please explain and provide arguments for your answer.
Calculation of the Financial component.
According to Article 314.4 of the CRR, the trading book component (TC) of the financial component (FC) should be “defined as appropriate either in accordance with accounting standards or, in accordance with Part three, Title I, Chapter 3” (i.e., the prudential boundary criteria). This requirement is also explicit in the mandate of Article 314.6 which requires that EBA develops the list of typical sub-items of the business indicator by “taking into account international regulatory standards and, where appropriate, the prudential boundary defined in Part three, Title I, Chapter 3”.
The draft RTS in the consultation does indeed provide the two required approaches to calculate the financial component in the proposed accounting approach (AA) and prudential boundary approach (PBA). There are, however, several issues with the requirements envisaged by EBA.
First and foremost, the AA has been made the default approach while the PBA can only be used by way of derogation after meeting some conditions. This requirement goes beyond that of the CRR which does not favour one approach over another but, rather, requires that the PBA be available where and as appropriate. An institution should therefore be able to choose the PBA on a permanent basis if it considers such approach as appropriate. It should be noted that the CRR already imposes very strict requirements for the management of the trading book including for the inclusion of positions (Articles 102, 103 and 104), and equally strict rules to reclassify a trading book position (Article 104a) which contributes to the robustness of the PBA approach. However, to avoid continuous changes from one approach to another, it appears reasonable that when an institution has made the decision to apply the PBA, it would only be permitted to revert to the AA (or the other way round) if such change is triggered by material evolutions of its activity, environment or risk management (for example a change of business model) and after approval from the competent authority only. This would provide the consistency required for having a sound framework for the PBA and would ensure that no regulatory arbitrage is possible which, as previously mentioned, is already prevented by trading book framework of the CRR. Consequently, neither the 3-year freeze nor the automatic reversal to the accounting approach should be imposed.
Second, in the approach proposed in the RTS the application of the PBA is conditional on several criteria including the presence of certain operations or accounting choices that result in an “unwarranted increase” of the FC when using the AA. Once again, this would limit the usage of PBA while CRR does not favor one approach over another nor intend to limit the usage of PBA. Furthermore, an unwarranted increase in the TC’s P&L over a certain period can be volatile by definition as it can be impacted by several market factors. An institution can therefore experience an unwarranted increase in a given reporting period and not experience any in a following reporting period while having similar operations and accounting choices. The application of the PBA should, therefore, not be based on an unwarranted P&L increase in the TC nor be subject to any limitation. In any case, the potentiality of such increase demonstrated ex ante shall be sufficient and would avoid volatility.
Finally, the notification process seems very cumbersome, especially as all the requirements (points (a) to (h) of Article 13.2 of the RTS) should be reviewed annually. All these requirements should only be required for the initial notification of the intention to use the PBA and the annual review should be limited to the independent review on the fulfilment of the conditions to use the PBA (point (h) of Article 13.2 of the RTS).
Accordingly, we suggest the following amendments to article 14:
“Article 14 Reversal to the accounting approach:
An institution shall use, consistently over time, the accounting approach or the prudential boundary approach. An institution shall notify the competent authority prior to switching from one approach to the other.
Scope of entities applying the prudential boundary approach (PBA)
According to the draft RTS on the components of the Business Indicator, the prudential boundary approach to be permitted shall apply to all entities of a same consolidation group.
However, for entities with little or no market activities, it would be operationally difficult to apply the prudential boundary approach due to the documentation to be provided and due to the policies and procedures constraints compared to the benefits expected, while using FINREP would be easier.
Therefore, we believe that institutions should be allowed to choose the appropriate approach in those specific cases, provided that the approach used is consistent from one financial year to the next and that the approach would change only under specific or rare circumstances. We ask to introduce proportionality principles[1] in that requirement permitting to ensure consistent application avoiding cherry picking at the group level without undue implementation costs. In fact, some entities in the prudential Group may have differences between their accounting and prudential perimeters but with limited unwarranted increase of the financial component. For those entities the cost of implementation largely overseed the benefit.
Notification process.
More specifically, we would like to highlight the 90 days timing constraint related to the intention to use the prudential boundary approach that institutions shall notify to the competent authorities before its implementation. We question how supervisors will be able to give prior authorisation to institutions so that institutions can apply the prudential boundary approach to calculate the financial component, when the finalisation of the draft technical standard and submission to the EC are only scheduled for the end of 2024. Indeed, institutions have 90 days before the implementation date to notify the supervisors of their intention and submit a documented file (P&L monitoring with the prudential boundary, impact of the choice of method, independent audit, etc.). However, based on an implementation date of end-2024, institutions should be submitting their documented files as early as September, even though the technical standard has not yet been published.
Finally, the notification process seems very cumbersome, especially as all the requirements (points (a) to (h) of Article 13.2 of the RTS) should be reviewed annually. All these requirements should only be required for the initial notification of the intention to use the PBA and the annual review should be limited to the independent review on the fulfilment of the conditions to use the PBA (point (h) of Article 13.2 of the RTS).
[1] For example : according to art. 325(4), an institution may use a combination of the simplified approach with other approaches at consolidated level standard to calculate the own funds requirements for market risk.
Question 4: What are your views with regards to the proposal for the specification of the items to be excluded from the BI? Please explain and provide arguments for your answer.
We have no specific comments.
Question 5: What are your views with regards to the proposed mapping of the BI items to the FINREP cells? Please explain and provide arguments for your answer.
F01.01_r0092_c0010 does not exist in the IFRS version of the FINREP 1.1
Some FINREP components cannot be separated within the FINREP items proposed for the
for the calculation of the Service component, in particular the operational risk items:
- F45.03 (not due to operational risk and not due to leases)
- F02.00 (due to operational risk)
- F02.00 (due to operational risk and not due to leases)
- F02.00 (due to operational risk and not due to leases or to outsourcing fees paid for the supply of financial services
Generally, the Finrep mapping should be considered indicative and not compulsory.
Question 6: What are your views with regards to consider the financial statements used for the final valuation as the only reference for the acquisition of activities under the baseline approach (i.e. full historical data)? Please explain and provide arguments for your answer.
In the perspective of updating the BI, we believe that a threshold should be defined for acquisitions and mergers as this would avoid high operational costs. Please refer to question 8.
To avoid a bottleneck at the time of the first application, we would like confirmation that only changes in the group scope from 1 January 2025 will be taken into account, without retroactivity.
Question 7: What are your views with regards to the proposed three alternative calculation approaches instead of a unique alternative approach to be defined? Please explain and provide arguments for your answer.
We would like to point out that carrying out the 3 calculation methods, documenting them and selecting the one that has the greatest impact on own funds is complicated and administratively very burdensome, particularly if the calculations have to be carried out and the documentation prepared for every entity present in the scope of the BI.
For example, financial information is difficult to obtain in the case of a business acquisition, if:
- the entity has been in business for less than 3 years;
- there are no financial statements for the activity subject to the acquisition;
- or in the case of securities acquired on the basis of foreign accounting standards (USGAAP).
Accordingly, the three alternative calculation approaches should be replaced by a unique alternative approach based on the acquired company’s first financial statements after its acquisition. The historical data should be rebuilt as shown below (adjusted with proposal on issue regarding the timeline for calculation of the operational risk capital requirements in the general comments): (please refer to the pdf file attached))
Calculation methodology of the M&A factor:
Could you please specify the calculation methodology of the M&A factor? On which years/periods is it calculated? To the benefit of the industry, an illustrative example based on a concrete calculation with numbers would be most welcome.
Question 8: What are your views with regards to not providing any alternative method but adjustment to the effective perimeter of the disposal? Please explain and provide arguments for your answer.
In the context of disposals, it should be noted that if the group is called upon to guarantee liabilities for disposed entities, the group will bear and recognise the losses in its financial accounts, whereas the disposed entity, which no longer exists within the group, will have been removed from the scope of consolidation. Hence such commitments will continue to be taken into account in the BI calculation of the group, even though the disposed entity has been removed from the consolidation scope: the elements required to determine the operational risk will indeed be in the group accounts. There is therefore little sense in keeping the disposed entity and the historical financial statements within the group for the purposes of calculating operational risk, at the risk of unduly increasing the BI.
- In case of disposed entities, institutions have no longer any accounting item in the scope of the financial statements of the group. Thus, it would be cumbersome to calculate the BI using the average over 3 financial years for an entity that leaves the group. Neither would it give a fair representation of the size of the institution, which is the purpose of the BI.
- In the case of authorisations when disposed entities, we suggest that a response period of 3 months should be defined beyond which the absence of a response from the supervisor would be equivalent to confirmation.
Could you please specify what needs to be done in case of a disposal if approval to exit the divested entity has been asked and is not yet obtained?
Question 9: What are your views with regards to the inclusion of a threshold? Please explain and provide arguments for your answer, as well, if applicable, further evidence on situations where BI adjustments as set out under articles 1 and 2 would not be feasible or deemed excessively cumbersome and identify potential consequences on the dynamics of the European financial markets.
We are in favour of the inclusion of a threshold for acquisitions and mergers as this would avoid high operational costs for acquired or merged entities that have no significant impact on the Business Indicator of the group.
We suggest that the relevant basis for calculation would be the Net Operating Income of the group as defined in the FINREP reporting. The materiality threshold would be defined as a percentage of the Net Operating Income (NOI) of the group and should be calibrated as 3% of NOI Below the threshold, no manual retreatment of the BI is done. Entities acquired would only impact the BI through future FinReps.
Question 10: What are your views with regards to the basis for the calculation of the threshold? Please explain and provide arguments for your answer.
While we agree that using the operational risk capital requirements as the basis for the calculation of the threshold, it would indeed entail going through the full calculation of the adjustments to the business indicator for every operation. We therefore propose using NOI (net operating income) as a basis for the calculation of the threshold. This basis ensures that non-material operations with insignificant impact on the NOI are not making the process of business indicator adjustment unduly cumbersome.
Question 11: What are your views with regards to the level you consider would be appropriate for the threshold? Please explain and provide arguments for your answer.
The materiality threshold should apply at the level where capital requirements for operational risk are being calculated and should represent 3% of the related NOI.