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OFFICIAL INFORMATION OF THE CZECH NATIONAL BANK of 27 June 2012 on the verification of sufficient coverage of credit losses I. The purpose of this official information The purpose of this official information is to provide information about the approach of the Czech National Bank during the performance of supervision as regards the evaluation of whether a bank or a credit union (hereinafter only an “Institution”) has sufficient coverage of credit losses from assets. II. Coverage of credit losses 1. Every Institution may be exposed to a credit loss, irrespective of what approach it uses to calculate the capital requirement for credit risk. 2. Pursuant to Article 8b(1)(b) and Article 8b(2) of the Act on Banks, respectively Article 7a(1)(b) and Article 7a(2) of the Act on Credit Unions in connection with Article 24(1) and (4) and Article 29(1) of Decree No. 123/2007 Coll., stipulating the prudential rules for banks, credit unions and investment firms (hereinafter only the “Decree”), an Institution must, when managing risks, take into account all significant risks and risk factors that it is or could be exposed to in view of the nature, scope and complexity of activities, and must maintain adequate capital to cover the risks that it is or could be exposed to. 3. For the given reasons, an Institution, if exposed to credit risk, shall also manage the risk connected with credit loss and cover it with capital to an adequate extent. The Czech National Bank therefore, during its supervision of all Institutions, also addresses the coverage of these losses. 4. At an Institution with a standardised approach 1 the Czech National Bank shall evaluate credit losses in particular from receivables from financial activities. Receivables from financial activities are, similarly as for the purposes of the rules for evaluating assets pursuant to Article 14(c) of the Act on Banks and Article 11(2)(c) of the Act on Credit Unions in connection with Article 194 to 204 of the Decree, in particular provided loans, financial leasing receivables, receivables from a deposit, receivables from guarantees, receivables from letter of credit receivables, factoring receivables, advance payments for 1 An Institution that uses an approach based on an internal rating (IRB approach) for the stipulation of the capital requirement for a credit risk must, within the framework of capital adequacy, stipulate the expected credit losses not only for receivables from financial activities, but also for all exposures (assets and selected off-balance-sheet items) and compare them with value adjustments, meaning the created allowances, accumulatived assets writeoff or acumulated losses from the valuation of assets at fair value on the basis of credit risk, and created provisions for these exposures. If an Institution has expected credit losses higher than the sum of value adjustments and created provisions, it must pursuant to legislation cover this difference with capital (the difference is a deductible item from capital). When stipulating the expected credit loss it is possible to take into account only protection that is elegible for the purposes of capital adequacy. the acquisition of securities provided for a period of over 30 calendar days, receivables from the sale of securities with deferment of the due date of the sale price for a period of over 30 calendar days, and receivables from the sale of securities not settled within 30 days after the stipulated settlement date. 5. When evaluating adequate coverage of credit losses from receivables from financial activities, the Czech National Bank establishes the extent to which these losses are covered through created allowances. For this it employs the concept of regulatory expected credit losses. III. The concept of regulatory expected credit losses 6. For its evaluation of sufficient coverage of credit losses, the Czech National Bank requests information from Institutions about receivables from financial activities in default and receivables from financial activities without default, namely information a) about the book value not reduced by allowances (gross value) and information about allowances, and b) broken down according to category of homogenous receivables and according to the subordination of the receivables. 7. The categories of homogenous receivables are stipulated in particular taking into account the category of exposure for the purposes of capital adequacy, e.g. retail receivables, corporate receivables, receivables secured by real estate, and receivables past due. 8. For every group of homogenous receivables from financial activities, the Czech National Bank calculates the expected credit loss as follows: REL = E * RPD * RLGD, where: REL........regulatory stipulated expected credit loss E.............book value not reduced by allowances (gross value) RPD........regulatory stipulated probability of default RLGD.....regulatory stipulated loss given default. 9. The parameters of the concept of regulatory stipulated credit losses are given in the annex. 10. The Czech National Bank compares the regulatory stipulated expected credit losses with the allowances that the Institution created for the receivables, and establishes any eventual difference. 11. If the difference between the regulatory stipulated expected credit losses and the created allowances of the Institution in question is not insignificant, the Czech National Bank evaluates the risk profile of that Institution and potentially requests it to provide a detailed explanation of the factors that influenced the amount of its allowances for receivables from financial activities. IV. Remedial measures 2 12. If the Czech National Bank, during the performance of its supervision, discovers that an Institution is not complying with stipulated risk management requirements arising from legislations, in particular requirements to manage credit risk and concentration risk, the requirement to evaluate assets and modify the evaluation of assets if they are devalued, it is entitled, pursuant to the nature of the deficiency discovered, to require the Institution to ensure remedy within a stipulated deadline. 13. If the Czech National Bank judges that measures of a qualitative nature would not be effective to ensure remedy, it is entitled to proceed to the exercise of measures of a quantitative nature. 14. In the case of receivables from the financial activities of an Institution, when exercising remedial measures of a quantitative nature through which it requires the maintenance of capital above the level required by capital adequacy, potentially the creation of the corresponding level of allowances, the Czech National Bank will use the difference between the regulatory stipulated expected credit losses from receivables from financial activities and the allowances for these receivables. V. Calculation of the credit losses for an Institution 15. If an Institution calculates its own credit losses using the method pursuant to points 8 and 9, then the finding that the losses calculated in this way are lower than the allowances that the Institution created cannot in any case be taken as an impulse to commence the dissolution of the allowances, as the values of the regulatory stipulated parameters without modification may not adequately take into account the risk specifics of the Institution in question. 16. Pursuant to Article 29(3)(a) of the Decree an Institution must, when reducing and covering risks, prudentially take into account factors that influence the results of the evaluation or measurement of the assumed risks, including the influences of the creation of allowances. Pursuant to Article 200(3) of the Decree, an Institution should be capable of demonstrating the adequacy and justification of the allowances. The Czech National Bank will consider it a breach of these provisions of the Decree if the Institution, on the basis of its own calculation of credit loss, proceeds to dissolve allowances without adequately and in compliance with all prescribed procedures (compare e.g. Article 10 of the Decree) verifying that the values of the regulatory stipulated parameters sufficiently take into account its risk specifics. Vice-Governor: prof. PhDr. Ing. Vladimír Tomšík, Ph.D., duly signed Annex Financial Market Regulation and International Cooperation Department Responsible employee: Ing. Svobodová, tel. 224 412 383 3 Annex Parameters of the concept of regulatory expected credit losses 1. Receivables from financial activities to which zero expected loss is allocated a) receivables against an entity with a risk weight of 0%, e.g. receivables against central governments and central banks of Member States in their own currency, if they are financed in the same currency, receivables against the European Central Bank, receivables against international development banks and international organisations, b) receivables secured by financial collateral, if the Institution uses the financial collateral simple method and the secured exposure value is allocated a risk weight of 0%, c) receivables secured by financial collateral, if the Institution uses the financial collateral comprehensive method and the fully adjusted exposure value (E* value) is zero, d) receivables secured by a third party, if the provider of the security is an entity with a risk weight of 0%. 2. Regulatory stipulated probability of default (RPD) The RPD of receivables without default a) The Czech National Bank calculates the value of the RPD parameter on the basis of the market average of the probability of default (PD) values, obtained from the data of banks using the IRB approach (hereinafter only the “Selected Banks”). The sources of these data are statements regularly submitted to the Czech National Bank, joint stress tests and internal estimates of the Czech National Bank using the register of credits. b) Banks whose data the Czech National Bank uses to calculate the RPD value always represent at least 80% of the credit institution sector without the inclusion of branches of foreign banks. c) Exposure at default (EAD) values from the Selected Banks are used to calculate the RPD. d) The market average of PD is established as the weighted average across all the Selected Banks (for the portfolio in question): n RPD EAD * PD i i 1 i n EAD i 1 , i where the index i represents the individual banks. e) The use of the weighted average through EAD means that the banks with the largest portfolios have the highest weighting in the resulting RPD value, which most credibly describes the actual average market value. 4 RPD of receivables in default f) The RPD value for receivables in default equals 100%. Table No. 1 Receivables from financial activities Receivables against institutions and against persons to which the same risk weight is allocated as for institutions Receivables secured by financial collateral, if the Institution uses the financial collateral simple method and the secured exposure value is allocated a risk weight of 20% Receivables secured by a third party if the provider of the security is an entity with a risk weight of 20% Corporate receivables Retail receivables with the exception of receivables secured by real estate Receivables secured by real estate Receivables past due RPD receivables without receivables with debtor default debtor default 0.03% 100% 0.03% 100% 0.03% 100% 2.11% 3.85% 100% 100% 2.24% x 100% 100% RPD updating g) The RPD values given in table No. 1 are the result of calculations that the Czech National Bank performed in March 2012. h) The Czech National Bank envisages that the RPD values will be updated at least once a year. 3. Regulatory loss given default (RLGD) The Czech National Bank, when exercising the concept of regulatory expected credit losses uses an RLGD based on the recommendations of the Basel Committee on Banking Supervision 2 , and thus takes into account additional available data about loss given default, in particular from the statements submitted to the Czech National Bank from joint stress tests and investigations (table No. 2). Table No. 2 Receivables from financial activities Receivables secured through real estate with a risk weight of 35% Retail receivables with the exception of receivables secured by real estate Other receivables RLGD subordinate receivables other than subordinate receivables 75% 35% 2 75% 55% 75% 45% Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework Comprehensive Version 5