Supervisory Regulation on Solvency Requirements for Credit Risk

Transcription

1 DE NEDERLANDSCHE BANK N.V. Supervisory Regulation on Solvency Requirements for Credit Risk Regulation of De Nederlandsche Bank N.V. dated 11 December 2006, no. Juza/2006/02447/CLR, providing for rules regarding the solvency requirements for credit risk for banks, investment firms and clearing institutions (Supervisory Regulation on Solvency Requirements for Credit Risk) De Nederlandsche Bank N.V., Having consulted Euronext, the Netherlands Bankers Association (Nederlandse Vereniging van Banken) and the Council for the Securities Industry (Raad van de Effectenbranche); Having regard to Articles 61(5), 69(2), 70(2), 71(3), 72(1), 73(2), 75(1), 76(1)(h), 78(3) and (5), 81(6), 82(1), 84(1)(b), 84(4), 85(2) and (3), 86(2), 102(3) and (4) and 105(4) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft); Having regard to Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) (OJ L177); Having regard to Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast) (OJ L 177); Decides: Chapter 1 General provisions Section 1.1 Introductory provisions Article 1:1 In this Regulation, the following terms shall be defined as follows: (a) nominated credit assessment institution: a credit assessment institution as referred to in Article 1 of the Decree which has been recognised as eligible pursuant to Article 88 of the Decree and in respect of which a financial undertaking has indicated that it will use that institution s credit assessments in the calculation of the capital requirement for its credit risk; (b) Decree: the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft); (c) board of directors: the persons referred to in Section 3:15 of the Act who meet the requirements under Sections 3:8 and 3:9(1), first sentence, of the Act; (d) derivatives: the instruments listed in Annex B to the Decree; (e) E* (fully adjusted exposure value): the value of the exposure after recognition of the risk mitigating effects of collateral and after application of volatility adjustments; (f) foundation IRB approach: the IRB approach where a financial undertaking uses its own estimates of PD but does not use its own estimates of LGD or conversion factors; 1

2 (g) eligible credit assessment institution: a credit assessment institution as referred to in Article 1 of the Decree which has been recognised as eligible pursuant to Article 88 of the Decree; (h) financial undertaking: bank or investment firm; (i) advanced IRB: the IRB approach where a financial undertaking uses its own estimates of PD, LGD and conversion factors; (j) covered bonds: bonds as referred to in Article 22(4) of the UCITS Directive, provided that they are collateralised by at least one of the assets listed in Annex 1; (k) IRB (internal ratings-based approach): the internal models approach referred to in Article 69 of the Decree; (l) credit event: an event defined in a contract agreed between parties that triggers payment under the contract; (m) credit quality step: a ranking of risk weights; (n) LGD*: the adjusted value of the loss given default after recognition of the effects of credit risk mitigation; (o) liquidation period (holding period): the transaction type-based number of days during which a price movement must be monitored in order to determine volatility; (p) management: the body of persons to whom the board of directors has delegated management responsibility with respect to all or part of the operations; (q) market value: the market value as referred to in Article 4 of the Decree on Mark-to-Market Value (Besluit actuele waarde); (r) public sector entity: a non-profit body established under public law hierarchically subordinate to the central, regional or local government; (s) reference obligation: the obligation used for determining the value of the cash settlement or of the deliverable obligation in the context of the credit derivative; (t) repo-style transaction: a transaction causing the origination of: (i) repurchase/reverse repurchase transactions, (ii) securities lending and borrowing transactions, or (iii) commodities lending and borrowing transactions, unless these are specifically excluded in the present Regulation; (u) risk weight: the weighting factor at which an exposure is included in the calculation of the minimum capital requirement; (v) risk-weighted exposure amounts: the assets and off-balance sheet items weighted by credit or dilution risk or, as applicable, the risk-weighted securitisation positions; (w) supervisory body: the body referred to in Section 3:9(1), second sentence, of the Act; (x) type of security: securities which: (i) have been issued by the same entity on the same issue date; (ii) have the same maturity, and (iii) are subject to the same liquidation period and the same terms and conditions as those under the financial collateral comprehensive method; (y) volatility adjustment: an adjustment to the exposure or collateral value reflecting price volatility or currency volatility; (z) exposure: an asset or contingent asset, including off-balance sheet amounts; (aa) Act: the Financial Supervision Act (Wet op het financieel toezicht). Article 1:1 Chapters 1, 2 and 7, as well as the standardised approach in Chapter 6 of this Regulation shall apply mutatis mutandis to clearing institutions, unless: (a) this Regulation provides otherwise; (b) the nature of the provisions of an Article rules out such application, or 2

3 (b) the system of this Regulation rules out such application. Section 1.2 Indexation of residential property Subsection Principles Article 1:3 1. If this Subsection has been declared applicable, a financial undertaking may use the indexation method referred to in this Subsection in order to determine the forced-sale value of residential property within an existing residential mortgage portfolio, but only to the extent that: (a) application of the indexation method leads to a reliable and prudent estimate of the forcedsale value of the residential property in the mortgage portfolio and of the associated credit risk, and (b) the indexation method is applied and validated in an unequivocal, consistent and verifiable manner. 2. For the purposes of this Subsection, the 99% confidence interval lower limit outcomes shall be calculated with the aid of the following formula: average sample value minus (2.33 * (1/ n) * the standard deviation of the sample values), where n is the size of the sample. Article 1:4 1. A financial undertaking shall apply the indexation method at regular intervals, but at least once a year, to all residential property included in its residential mortgage portfolio, except for: (a) residential property where the mortgage loans were granted under a government guarantee; (b) residential property where total mortgage loans are lower than or equal to 25% of the most recent individually appraised forced-sale value; (c) residential property which, because of its extremely high value, unique characteristics or other factors, does not in reason lend itself to application of the indexation method. 2. For the purposes of subparagraph 1(b) above, De Nederlandsche Bank may, if developments give cause for such a measure, request the financial undertaking to update the loan-to-value ratio by means of a re-appraisal. 3. Notwithstanding the provisions of subparagraph 1(a) and (b) above, the financial undertaking may yet apply the indexation method to residential property as referred to in those subparagraphs, provided that it pursues a consistent policy in this regard. Article 1:5 Without prejudice to the requirements imposed on the management of credits and collateral under Chapter 4, the financial undertaking shall ensure that the system used in the context of its administrative organisation: (a) provides for such detail that proper re-appraisal of the forced-sale value is possible for each dwelling on the basis of the portfolio approach; (b) the most recent individually appraised forced-sale value is not exceeded by the forced-sale value estimated using the indexation method, and (c) differences between the forced-sale value estimated using the indexation method and the forced-sale value based on an individual re-appraisal are recorded. Subsection Indexation method 3

4 Article 1:6 1. Before being subjected to the indexation method, all eligible residential property shall be broken down into relatively homogeneous portfolio segments, providing for at least a regional breakdown; under no circumstances shall the breakdown reflect the loan-to-value ratio. Following the breakdown, the residential property shall not, except on account of natural wastage, be shifted into, out of or between portfolio segments. 2. For the determination of the indexed forced-sale value of the residential property in the portfolio segments, the financial undertaking shall adjust the individually appraised forcedsale value, as determined immediately prior to the application of the indexation method, using one of the following indices: (a) an index of the Netherlands Association of Estate Agents (Nederlandse Vereniging van Makelaars); (b) an index of the Netherlands Land Register (Kadaster), or (c) another index, provided that the financial undertaking is able to demonstrate that this alternative index is determined independently and truly reflects the value development of residential property in the Netherlands. 3. The indices referred to in paragraph 2 above shall be used only if they have the same breakdown into portfolio segments as that used by the financial undertaking. Article 1:7 1. Where no individual appraisal has been performed immediately prior to the application of the indexation method, the indexed forced-sale value of a dwelling shall be equal to the most recent forced-sale value multiplied by the revaluation factor for the portfolio segment in which the dwelling has been classified. 2. The revaluation factor shall be: (a) in the event of an increase in the index for the portfolio segment: 75% of that increase; (b) in the event of a decrease in the index for the portfolio segment: 100% of that decrease. 3 Where individual appraisal has been performed prior to the application of the indexation method, the revaluation factor referred to in paragraph 2 above shall be adjusted for the fact that the value change concerns a different period. To that end, the change in value shall be assumed to have been evenly spread over the revaluation period concerned, unless market developments prompt more prudent adjustment of the revaluation factor. Subsection Validation and supervision Article 1:8 1 The valuation on the basis of the indexation method shall be validated prior to its first application and shall subsequently be validated regularly, but at least once every three years. A financial undertaking shall perform an interim validation, if so requested by De Nederlandsche Bank in the event of specific circumstances or market developments. 2. The validation shall be performed on the basis of a random sample, drawn at one single moment from the entire indexed residential mortgage portfolio. 3. The size of the validating sample shall be set before the data on the individual dwellings are gathered and processed and shall comprise at least 100 dwellings from the indexed residential mortgage portfolio. 4. The dwellings included in the sample shall be appraised in a relatively brief period. If the sample includes dwellings for which a recently appraised forced-sale value is known, that forced-sale value may be used as a sample observation, provided that it is not older than six months and that the market has not undergone any major changes. 4

5 Article 1:9 1. For the purposes of the validation referred to in the Article 1:8, the following steps shall be taken: (a) the financial undertaking shall calculate for each dwelling in the sample the ratio of the dwelling s forced-sale value on the basis of the indexation (Wi) to the forced-sale value of the dwelling on the basis of the appraisal in the sample (Wt). This ratio is denoted as Qi and is calculated as follows: Qi = Wi / Wt. (b) using recognised statistical methods, the financial undertaking shall ascertain whether the average value of Qi is significantly lower than 1, using a one-tailed 99% confidence interval. (c) if the average value of Qi is significantly lower than 1, the indexation method may, on the basis of this statistical test, be regarded as sufficiently prudent. Article 1:10 On the basis of the results of the validating sample, all dwellings in the indexed portfolio may be revalued upwards or all dwellings in the sample shall be revalued downwards by a factor k in such a way that the test statistic calculated for the test as referred to in Article 1:9 is equal to the lower limit of the 99% confidence interval. Article 1:11 1. Without prejudice to the other provisions of this Section, the financial undertaking shall make downward interim adjustments to the indexed forced-sale values if prompted by market developments or if so requested by De Nederlandsche Bank. 2. If the application of the indexation method by a financial undertaking does not meet the requirements set out in Article 1:3(1)(a) or (b), De Nederlandsche Bank may require the financial undertaking to revert to individual appraisals for the calculation of the credit risk associated with its mortgage portfolio. Chapter 2 Standardised approach Section 2.1 General provisions Article 2:1 In this Chapter, the following terms shall be defined as follows: (a) regional governments and local authorities: regional and local administrative and executive bodies of a State, with the proviso that, for the Netherlands, this term only covers the provinces, municipalities and water boards; (b) Regulation 1745/2003: Regulation (EC) No 1745/2003 of the European Central Bank of 12 September 2003 on the application of minimum reserves (ECB/2003/9) (OJ L 250). (c) tangible assets: the assets referred to in Article 336 of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek); (d) undrawn credit facilities: agreements to lend, purchase securities, or to provide guarantees or acceptance facilities, and Section 2.2 Risk weights Subsection Exposures to central governments and central banks Article 2:2 5

6 1. Exposures to central governments or central banks for which there is a credit assessment by a nominated credit assessment institution shall be assigned a risk weight derived from the credit quality step including that rating, as set out in table A in Annex 2A. 2. Notwithstanding the provisions of paragraph 1 above, exposures to the European Central Bank shall be assigned a risk weight of 0%. Article 2:3 1. In assigning risk weights to exposures to central governments and central banks, a financial undertaking may apply the credit assessments of an export credit agency, if the credit assessments are a consensus risk score from export credit agencies participating in the OECD Arrangement on Guidelines for Officially Supported Export Credits, or if: (a) the export credit agency publishes its credit assessments; (b) the export credit agency subscribes to the OECD agreed methodology, and (c) the credit assessment is associated with one of the eight MEIPs (minimum export insurance premiums) that the OECD agreed methodology establishes. 2. Exposures to central governments or central banks for which there is a credit assessment by an export credit agency as referred to in paragraph 1 above, shall be assigned a risk weight that corresponds with the relevant MEIP as set out in table B in Annex 2B. Article 2:4 Notwithstanding the provisions of Articles 2:2 and 2:3, exposures to European Union Member States' central governments or central banks denominated and funded in the domestic currency of the Member State concerned shall be assigned a risk weight of 0 %. Article 2:5 Notwithstanding the provisions of Articles 2:2, 2:3 and 2:4, a financial undertaking may assign to exposures to the central government or the central bank of a country which is not a Member State of the European Union the same lower risk weight which the supervisory authority of that country has assigned to exposures to its central government or central bank, if: (a) the exposures are denominated and funded in the domestic currency of that country, and (b) that country applies supervisory practices and arrangements at least equivalent to those in the European Union, and (c) the supervised financial undertakings in that country are also allowed to assign to exposures to their national central government or central bank a lower risk weight than the risk weights referred to in Articles 2:2, 2:3 and 2:4. Article 2:6 Exposures to central governments or central banks not covered by the provisions of Articles 2:2 to 2:5 shall be assigned a risk weight of 100%. Subsection Exposures to regional governments and local authorities Article 2:7 1. Exposures to regional governments or local authorities shall be assigned a risk weight derived from the credit quality step that includes the assessment for their central government, as set out in table A in Annex 2A. 2. Exposures to regional governments or local authorities of countries with a central government for which no credit assessment is available shall be assigned a risk weight of 100%. 6

7 Article 2:8 Notwithstanding the provisions of Article 2:7, exposures to regional governments and local authorities listed in Annex 2B shall be assigned the same risk weight as exposures to the central government of the country of those regional governments or local authorities. Article 2:9 Notwithstanding the provisions of Articles 2:7 and 2:8, a financial undertaking may assign to exposures to regional governments or local authorities of a country which is not a Member State of the European Union the same lower risk weight which the supervisory authority of that country has assigned to exposures to its regional governments or local authorities, if: (a) that country applies supervisory practices and arrangements at least equivalent to those in the European Union, and (b) the supervised financial undertakings in that country are also allowed to treat exposures to their regional governments or local authorities in the same manner as exposures to their central government. Subsection Exposures to public sector entities, churches and other religious communities constituted as a legal entity Article 2:10 Exposures to public sector entities or to churches or other religious communities established under public law shall be assigned a risk weight of 100%, unless otherwise provided for in this Subsection. Article 2:11 1. Exposures to public sector entities established in the Netherlands shall be assigned a risk weight of 20%, unless the provisions of paragraph 2 below are applicable. 2. Exposures to public sector entities which are established in the Netherlands and in respect of which the financial undertaking holding the exposure can show that a central government guarantee is available, shall be assigned a risk weight of 0% up to the amount of the guarantee. 3. That part of the exposure for which no central government guarantee is available shall be subject to the provisions of paragraph 1 above. Article 2:12 If in a Member State of the European Union exposures to public sector entities are treated as exposures to financial undertakings or as exposures to the central government of the country where they are established, exposures of financial undertakings established in the Netherlands to those public sector entities shall be treated in the same manner. Article 2:13 In accordance with the provisions of Subsection 2.2.6, a financial undertaking may treat exposures to public sector entities of a country which is not a Member State of the European Union as exposures to financial undertakings, if: (a) that country applies supervisory practices and arrangements at least equivalent to those in the European Union, and (b) the supervisory authority of that country also allows its financial undertakings to treat exposures to that country s public sector entities as exposures to financial undertakings. 7

8 Article 2:14 1. The risk weights referred to in Subsection shall apply mutatis mutandis to churches or other religious communities which: (a) have been established under public law; (b) have been conferred a statutory right to raise taxes, and (c) use that statutory right to raise taxes. 2. The churches and other religious communities referred to in paragraph 1 above shall not be subject to the provisions of Article 76(1) of the Decree. Subsection Exposures to multilateral development banks Article 2:15 1. Exposures to multilateral development banks shall be assigned the same risk weight as referred to in Article 2: Notwithstanding the provisions of paragraph 1 above, exposures to the multilateral development banks listed in Annex 2C shall be assigned a risk weight of 0%. 3. Notwithstanding the provisions of paragraphs 1 and 2 above, a risk weight of 20% shall be assigned to the portion of unpaid capital subscribed to the European Investment Fund. Subsection Exposures to international organisations Article 2:16 Exposures to the European Community, the International Monetary Fund and the Bank for International Settlements shall be assigned a risk weight of 0%. Subsection Exposures to financial undertakings and financial institutions Article 2:17 Without prejudice to the provisions of Articles 2:18 to 2:22, exposures to financial undertakings which are supervised by a supervisory authority and are subject to prudential requirements equivalent to the prudential requirements applied to financial undertakings pursuant to the Act shall be assigned the same risk weight as exposures to financial undertakings, unless otherwise provided for in this Subsection. Article 2:18 1. Exposures to financial undertakings with an original effective maturity of more than three months for which a credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight derived from the credit quality step including that rating, as set out in table A in Annex 2A. 2. Exposures to financial undertakings with an original effective maturity of more than three months for which no credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight of 50%. 3. Notwithstanding the provisions of paragraph 2 above, the risk weight of an exposure to a financial undertaking for which no credit assessment by a nominated credit assessment institution is available shall not be lower than the risk weight of exposures to the central government of the country where the financial undertaking has its registered office.. Article 2:19 1. Exposures to financial undertakings with an original effective maturity of three months or less for which a credit assessment by a nominated credit assessment institution is available 8

9 shall be assigned a risk weight derived from the credit step including that rating, as set out in table A in Annex 2A. 2. Exposures to financial undertakings with an original effective maturity of three months or less for which no credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight of 20%. Article 2:20 1. If there is no specific short-term exposure assessment, paragraph 1 of Article 2:19 shall apply mutatis mutandis to all exposures to financial undertakings of up to three months residual maturity. 2. If there is a specific short-term exposure assessment and such an assessment determines the assignment of an identical or lower risk weight than the risk weight that should be assigned under the provisions of paragraph 1 of Article 2:19, that short-term exposure assessment shall be used for that specific exposure only. Other short-term exposures shall be treated in accordance with paragraph 1 of Article 2: If there is a specific short-term exposure assessment and such an assessment determines the assignment of a higher risk weight than the risk weight that should be assigned under the provisions of paragraph 1 of Article 2:19, the provisions of paragraph 1 of Article 2:19 shall not apply. Instead, all unrated short-term exposures shall be assigned the risk weight arising from the specific short-term exposure assessment. Article 2:21 A financial undertaking may assign to exposures to financial undertakings with a residual maturity of three months or less denominated and funded in the currency of the country where the financial undertaking to which the exposure is held has its registered office, a risk weight that is one category less favourable than the risk weight of the central government of that country. Article 2:22 Investments in equities or regulatory capital instruments issued by financial undertakings shall be risk-weighted at 100%, unless deducted from own funds. Subsection Minimum reserves required by the European Central Bank Article 2:23 Where an exposure to a financial undertaking is in the form of minimum reserves required by the European Central Bank or by the central bank of a Member State of the European Union, that exposure may be assigned the risk weight of an exposure to the central bank concerned, provided that: (a) the reserves are held in accordance with Regulation 1745/2003 or subsequent Community legislation replacing that Regulation or are held in conformity with national regulations that, in a material sense, are fully equivalent to said Regulation, and (b) in the event of the bankruptcy or insolvency of the financial undertaking where the reserves are held, the reserves must, under the terms of the underlying agreement, be repaid in full and in time to the owner financial undertaking and may not be available to meet other liabilities of the financial undertaking where the exposure is held. Subsection Exposures to corporates Article 2:24 9

10 Exposures to corporates for which a credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight that is derived from the credit quality step including that rating, as set out in table A in Annex 2A. Article 2:25 Exposures to corporates for which no credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight of 100% or the risk weight that applies to the central government of the country where the corporate has its registered office, whichever is the higher. Subsection Short-term exposures to financial undertakings and corporates Article 2:26 Short-term exposures to a financial undertaking or corporate for which a specific credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight that is derived from the credit quality step including that rating, as set out in table A in Annex 2A. Subsection Retail exposures Article 2:27 An exposure that meets the following conditions shall be assigned a risk weight of 75%: (a) the exposure is either to an individual person or individual persons, or to a small or medium-sized entity; (b) the exposure does not exceed 0.2% in value terms of a portfolio of similar exposures; (c) the total amount owed to the financial undertaking and any parent undertaking and subsidiaries, including any past due exposure, by the obligor client or group of connected clients, but excluding claims or contingent claims secured by residential real estate collateral, does not, to the knowledge of the financial undertaking, which shall have taken reasonable steps to confirm the situation, exceed 1 million, and (d) the exposure is not in the form of securities. Subsection Exposures secured by property Article 2:28 Exposures secured in full by property shall be assigned a risk weight of 100%, unless otherwise provided for in this Subsection. Article 2:29 The following exposures or any part of an exposure fully and completely secured as referred to in Article 2:28 shall be assigned a risk weight of 35%: (a) exposures or any part of an exposure secured by mortgages on residential property which is or will be occupied or let by the owner; (b) exposures or any part of an exposure secured by shares in Finnish residential housing companies, operating in accordance with the Finnish Housing Company Act of 1991 or subsequent equivalent legislation, in respect of residential property which is or will be occupied or let by the owner, and (c) exposures to a tenant under a residential property leasing transaction under which the financial undertaking is the lessor and the tenant has an option to purchase. 10

11 Article 2:30 An exposure is fully and completely secured as referred to in Article 2:29, if: (a) the value of the property does not materially depend upon the credit quality of the obligor; (b) the risk of the borrower does not materially depend upon the performance of the underlying property or project, but rather on the underlying capacity of the borrower to repay the debt from other sources. (c) repayment of the facility as such does not materially depend on any cash flow generated by the underlying property serving as collateral; (d) the amount of the exposure is less than or equal to 75% of the value of the property; (e) the provisions of Articles 4:57 to 4:59 have been duly observed. Article 2:31 In the case of an existing portfolio of mortgages on residential property, a financial undertaking may determine the forced-sale value of the residential property in the portfolio using the indexation method referred to in Section 1.2. Article 2:32 Exposures or any part of an exposure fully and completely secured, as referred to in Article 2:30, by one or more mortgages on commercial property situated in the Federal Republic of Germany shall be assigned a risk weight of 50%, provided that the conditions set by the German supervisory authority for the application of a risk weight of 50% by financial undertakings established in the Federal Republic of Germany are satisfied. Subsection Past due items Article 2:33 1. The unsecured portion of any item that is past due for more than 90 days shall, irrespective of the amount of that unsecured portion, be assigned a risk weight of: (a) 150% if value adjustments are less than 20% of the unsecured part of the exposure, gross of value adjustments; (b) 100% if value adjustments are 20% or more of the unsecured part of the exposure, gross of value adjustments. 2. For the purpose of defining the secured part of the past due item, eligible collateral and guarantees shall be those eligible under Chapter 4. Article 2:34 Exposures referred to in Article 2:29 shall be assigned a risk weight of 100% net of value adjustments if they are past due for more than 90 days. If value adjustments are 20% or more of the exposures gross of value adjustments, the risk weight applicable to the remainder of the exposure shall be 50%. Article 2:35 Exposures referred to in Article 2:32 shall be assigned a risk weight of 100% if they are past due for more than 90 days. Subsection Items belonging to regulatory high-risk categories Article 2:36 The following items shall be assigned a risk weight of 150%: (a) investments in venture capital firms; 11

12 (b) private equity investments; (c) exposures to obligors whose external credit assessment by an eligible credit assessment institution has been withdrawn. Article 2:37 Non-past-due items which would be assigned a risk weight of 150% pursuant to Article 2:36 and for which value adjustments have been established shall be assigned a risk weight of: (a) 100% if the value adjustments are 20% or more of the exposure value, gross of value adjustments, and (b) 50% if the value adjustments are 50% or more of the exposure value, gross of value adjustments. Subsection Positions in covered bonds Article 2:38 A financial undertaking shall comply with the minimum requirements and the valuation rules referred to in Subsection for real estate collateralising covered bonds. Article 2:39 Notwithstanding the provisions of Article 1:1(j) and of Article 2:38, bonds meeting the definition of Article 22(4) of the UCITS Directive and issued before 31 December 2007 shall be eligible for treatment in accordance with Article 2:40 until maturity. Article 2:40 Covered bonds shall be assigned a risk weight derived from the risk weight of senior nonguaranteed exposures to the financial undertaking issuing them, with the following correspondence applying between the two risk weights: (a) if the exposures to the financial undertaking are assigned a risk weight of 20%, the covered bond shall be assigned a risk weight of 10%; (b) if the exposures to the financial undertaking are assigned a risk weight of 50%, the covered bond shall be assigned a risk weight of 20%; (c) if the exposures to the financial undertaking are assigned a risk weight of 100%, the covered bond shall be assigned a risk weight of 50%, and (d) if the exposures to the financial undertaking are assigned a risk weight of 150%, the covered bond shall be assigned a risk weight of 100%. Subsection Items representing securitisation positions Article 2:41 Risk-weighted exposure amounts for securitisation positions shall be determined in accordance with the provisions of Subsection 10.4 and Article 88 of the Decree. Subsection Exposures in the form of collective investment undertakings (CIUs) Article 2:42 Exposures in the form of a CIU shall be assigned a risk weight of 100%, unless otherwise provided in this Subsection.. Article 2:43 12

13 Exposures in the form of a CIU for which a credit assessment by a nominated credit assessment institution is available shall be assigned a risk weight derived from the credit quality step including that rating, as set out in table A in Annex 2A. Article 2:44 Positions in a CIU associated with particularly high risks, irrespective of whether a credit assessment by a nominated credit assessment institution is available, shall be assigned a risk weight of 150%. Article 2:45 1. Notwithstanding the provisions of the Articles 2:42 to 2:44, a financial undertaking may determine the risk weight for a CIU in accordance with the remaining Articles of this Subsection, if the CIU is managed by a company which is subject to supervision by a supervisory authority in the European Union. 2. On request, a financial undertaking may, notwithstanding the provisions of the preceding Articles, be given permission to determine the risk weight of a CIU in accordance with the remaining Articles of this Subsection, if the CIU is managed by a company which is subject to supervision by a supervisory authority in a country which is not a Member State of the European Union, provided that: (a) the supervisory practices and arrangements in that country are at least equivalent to the practices and arrangements in the European Union, and (b) the cooperation between De Nederlandsche Bank and the supervisory authority of the third country concerned is sufficiently ensured. 3. For the purposes of paragraphs 1 and 2 above, the business of the CIU shall be reported on at least an annual basis to enable an assessment to be made of the assets and liabilities, income and operations over the reporting period. 4. For the purposes of paragraphs 1 and 2 above, the financial undertaking shall ensure that the CIU's prospectus or equivalent document includes: (a) the categories of assets in which the CIU is authorised to invest, and (b) if investment limits apply, the relative limits and the methodologies to calculate them. Article 2:46 Where a financial undertaking is aware of the underlying exposures of a CIU, it may look through to those underlying exposures in order to calculate an average risk weight for the CIU in accordance with the methods set out this Chapter. Article 2:47 Where a financial undertaking is not aware of the underlying exposures of a CIU, it may calculate an average risk weight for the CIU in accordance with the methods set out in this Chapter with the proviso that, in doing so, it shall assume that the CIU first invests, to the maximum extent allowed under its mandate, in the exposure classes attracting the highest capital requirement, and then continues making investments in descending order until the maximum total investment limit is reached. Article 2:48 A financial undertaking may rely on a third party to calculate and report a risk weight for the CIU, in accordance with the methods set out in Articles 2:46 and 2:47, provided that the correctness of the calculation and report is adequately ensured. Subsection Other risk weights 13

14 Article 2:49 In the case of asset sale and repurchase agreements and outright forward purchases, the risk weights shall be those assigned to the assets in question and not to the counterparties to the transactions. Article 2:50 1. Where a financial undertaking provides credit protection for a number of exposures under terms that the n th default among the exposures shall trigger payment and that this credit event shall terminate the contract, and where the product has an external credit assessment from an eligible credit assessment institution, the risk weights prescribed in Subsection 10.4 and Article 88 of the Decree shall be assigned. 2. If the product has no external credit assessment by an eligible credit assessment institution, the risk weights of the exposures included in the basket shall be aggregated, excluding n-1 exposures, up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted exposure amount. 3. The n-1 exposures to be excluded from the aggregation shall be determined on the basis that they shall include those exposures each of which produces a lower risk-weighted exposure amount than the risk-weighted exposure amount of any of the exposures included in the aggregation. Article 2:51 Gold bullion held in the financial undertaking s own vaults or on an assigned basis to the extent that it is backed by bullion liabilities, and cash in hand and equivalent cash items shall attract a 0% risk weight. Article 2:52 Cash items in process of collection shall attract a 20% risk weight. Article 2:53 The following assets shall attract a risk weight of 100%: (a) tangible assets; (b) prepayments and accrued income for which a financial undertaking is unable to determine the counterparty; (c) holdings of equity and other participations except where deducted from own funds, and (d) exposures not listed in this Section. Section 2.3 Use of credit assessments from credit assessment institutions for the determination of risk weights Subsection Treatment Article 2:54 1. A financial undertaking may nominate one or more eligible credit assessment institutions whose credit assessments it will use for the determination of risk weights applicable to the assets and the items referred to in Annex 2D. 2. A financial undertaking which decides to use the credit assessments produced by an eligible credit assessment institution shall use them in a continuous and consistent way over time. Article 2:55 14

15 A financial undertaking which decides to use the credit assessments produced by an eligible credit assessment institution for a certain class of items shall use those credit assessments consistently for all exposures belonging to that class. Article 2:56 A financial undertaking shall only use credit assessment institutions credit assessments that take into account all amounts both in principal and in interest owed to it. Article 2:57 1. If only one credit assessment is available from a nominated credit assessment institution for a rated item, that credit assessment shall be used to determine the risk weight for that item. 2. If two or more credit assessments are available from nominated credit assessment institutions for a rated item, the second highest credit assessment shall be used to determine the risk weight. If the two most favourable credit assessments lead to the same risk weight, that risk weight shall be applied. Subsection Credit assessment of issuing parties and new issues Article 2:58 Where a credit assessment exists for a specific issuing programme or facility to which the item constituting the exposure belongs, that credit assessment shall be used to determine the risk weight applicable to that item. Article 2:59 Where no directly applicable credit assessment exists for a certain item, but a credit assessment exists for a specific issuing programme or facility to which the item constituting the exposure does not belong or a general credit assessment exists for the issuer, that credit assessment shall be used if: (a) it produces a higher risk weight than would otherwise be the case, or (b) it produces a lower risk weight and the exposure in question ranks pari passu or senior in all respects to the specific issuing program or facility or to senior unsecured exposures of that issuer. Subsection Long-term and short-term credit assessments Article 2:60 1. Short-term credit assessments shall only be used for assets and items as referred to in Annex 2D, constituting short-term exposures to financial undertakings and corporates. 2. Any short-term credit assessment shall only apply to the item to which the credit assessment refers and shall not be used to derive risk weights for any other item. 3. Notwithstanding the provisions of paragraph 2 above, if a short-term rated facility attracts a 150% risk weight, then all unrated unsecured exposures to that debtor, whether short-term or long-term, shall also attract a 150% risk weight. 4. Notwithstanding the provisions of paragraph 2 above, if a short-term rated facility attracts a 50% risk weight, no unrated short-term exposure shall attract a risk weight lower than 100%. Subsection Domestic and foreign currency items Article 2:61 15

16 A credit assessment that refers to an item denominated in the debtor s domestic currency shall not be used to derive a risk weight for another exposure to that same debtor that is denominated in a foreign currency. Article 2:62 Notwithstanding the provisions of Article 2:61, when an exposure arises through a financial undertaking s participation in a loan that has been extended by a multilateral development bank whose preferred creditor status is recognised in the market, the financial undertaking may determine the risk weight using the credit assessment on an item denominated in the domestic currency of the debtor. Chapter 3 Internal ratings-based approach Section 3.1 Definitions Article 3:1 In this Chapter, the following terms shall be defined as follows: (a) ancillary services undertaking: an undertaking as referred to in Article 3:268(1)(h) of the Act; (b) commodities finance: a method of funding of exchange-traded commodities, with a selfliquidating character of the exposures in the sense that the repayment obligation is met from the proceeds of the sale of commodities and the obligor, apart from structuring the transaction, has no other independent capacity to repay the loan; (c) finance of income-producing real estate: a method of funding where the repayment obligation is met from the income produced by the real estate such as rent, lease income or the sale of the real estate; (d) internal audit function: an independent function reporting directly to the board of directors, with the duty of checking and assessing the organisational structure and control mechanism; (e) object finance: a method of funding where the repayment obligation depends primarily and almost exclusively on the proceeds generated by the assets that serve as collateral for the loan; (f) project finance: a method of funding where the repayment obligation depends primarily and almost exclusively on the proceeds generated by the project to be funded; and (g) rating system: a system that comprises all of the methods, processes, controls and systems that support the assessment of credit risk, the assignment of obligors and exposures to grades or pools (rating) and the quantification of estimates of default, losses given default and conversion factors for a given type of obligor or exposure; Section 3.2 General provisions on applying the internal ratings-based approach Subsection Application package requirements and prohibition on permanent combination of approaches Article 3:2 1. The following information and documentation shall be supplied with the application as referred to in Article 69(1) of the Decree: (a) a general description of the way in which the financial undertaking applies the IRB approach; 16

17 (b) a risk management framework; (c) a list of the rating systems used by the financial undertaking; (d) an analysis of the impact on the financial undertaking s capital adequacy of moving to the IRB approach; (e) a self-assessment as to whether the provisions of the Decree are complied with. 2. A financial undertaking that wishes to claim the exemptions referred to in Article 76 of the Decree shall also include with the application a list of the exposures which will continue to be covered by the standardised approach. This list must be accompanied by the rationale for the choice, an estimate of the risk attaching to these exposures and an indication of the relative size of these exposures. Article 3:3 1. A financial undertaking may obtain permission to apply the foundation IRB approach or the advanced IRB approach. A permanent mix of the foundation IRB approach and the advanced IRB approach is not permitted. 2. Notwithstanding the provisions of paragraph 1 above, exposures as referred to in Article 3:6(1) may be treated permanently under the foundation IRB approach, even if the financial undertaking rolls out the advanced IRB approach for other exposures. 3. Notwithstanding the provisions of paragraph 1 above, exposures as referred to in Article 71(1)(d) of the Decree may only be treated under the advanced IRB approach, even if the financial undertaking implements the foundation IRB approach for other exposures. Subsection Supplementary rules regarding the classification of exposures Article 3:4 The following exposures shall also be assigned to the class referred to in Article 71(1)(a) of the Decree: (a) exposures to regional governments, local authorities or public sector entities which are treated as exposures to central governments under Articles 2:8, 2:11(2) or 2:12; (b) exposures to multilateral development banks or international organisations which are assigned a risk weight of 0% under Articles 2:15(2) or 2:16. Article 3:5 The following exposures shall also be assigned to the class referred to in Article 71(1)(b) of the Decree: (a) exposures to regional governments and local authorities which are not treated as exposures to central governments under Article 2:7; (b) exposures to public sector entities which are treated as exposures to financial undertakings under Article 2:12; (c) exposures to multilateral development banks which are not assigned a risk weight of 0% under Article 2:15(2). Article 3:6 1. Exposures in the class referred to in Article 71(1)(c) of the Decree shall be recorded separately as specialised lending if they have the following characteristics: (a) the exposure shall be to an entity with the specific purpose of financing and/or operating physical assets; (b) the contractual arrangements shall give the lender a substantial degree of control over the assets and the income that they generate; and 17

18 (c) repayment of the obligation shall depend primarily on the income generated by the assets being financed, rather than the independent payment capacity of a broader commercial enterprise. 2. In recording these exposures separately as referred to in paragraph 1 above, a financial undertaking shall distinguish between the following types of funding: (a) project finance; (b) object finance; (c) commodities finance; and (d) finance of income-producing real estate. 3. Exposures which have the characteristics referred to in paragraph 1 above but which cannot be assigned to any of the classes referred to in paragraph 2 above shall be recorded as project finance for the application of the IRB approach. Article 3:7 1. Only exposures that meet the following conditions shall be assigned to the class referred to in Article 71(1)(d) of the Decree: (a) they shall be either to one or more natural persons or to a small or medium-sized entity; (b) they shall be treated by the financial undertaking in its risk management consistently over time and in a similar manner; (c) they shall not be managed individually; and (d) they shall each represent one of a significant number of similarly managed exposures. 2. Exposures to small or medium-sized entities must meet the supplementary condition that the total amount owed to the financial undertaking and to any parent undertaking and its subsidiaries by the obligor client or group of connected clients may not exceed 1 million. This limit shall include any past due exposure but shall exclude claims secured by residential real estate. The financial undertaking must take reasonable steps to confirm that the latter requirement is met. 3. Only exposures secured by real estate that meet the following conditions shall be included in the class referred to in Article 71(1)(d) of the Decree: (a) none of the counterparties shall own more than five real estate objects that are secured by mortgage loans granted by the financial undertaking; and (b) none of the real estate objects referred to in subparagraph (a) above shall consist of more than five residential units. 4. The present value of retail minimum lease payments shall be eligible for inclusion in the class referred to in Article 71(1)(d) of the Decree. Article 3:8 1. A distinction shall be drawn in the class referred to in Article 71(1)(d) of the Decree between: (a) exposures secured by real estate; (b) qualifying revolving exposures; and (c) other retail exposures. 2. Exposures shall only be classified as qualifying revolving exposures if they meet the following conditions: (a) they shall be to individuals; (b) they shall be revolving, unsecured positions and, to the extent that they are not drawn, shall be immediately and unconditionally cancellable by the financial undertaking; (c) the maximum exposure to a single individual in the subportfolio shall be 100,000; and 18

19 (d) the use of a correlation factor of 0.04 shall be restricted to portfolios that have exhibited low volatility of loss rates, suitable to the correlation, relative to their average level of loss rates, especially within the low PD bands. 3. For the purposes of subparagraph 2(d) above, the financial undertaking shall review the volatility of the loss rates of all qualifying revolving subportfolios separately and the aggregate qualifying revolving portfolio and shall relate this volatility to that of the other subclasses listed in paragraph 1 above. Article 3:9 The following exposures shall also be assigned to the class referred to in Article 71(1)(e) of the Decree: (a) indirect equity exposures; (b) non-debt exposures conveying a subordinated, residual claim on the assets or income of the issuing financial undertaking; (c) debt exposures, the economic substance of which is similar to the exposures specified in subparagraph (b) above. Article 3:10 The class referred to in Article 71(1)(g) of the Decree shall also include the residual value of leased properties insofar as this residual value is not included in the lease exposure as defined in Article 3:54(4). Subsection Supplementary conditions regarding state-reinsured guarantees that are eligible for treatment under the standardised approach Article 3:11 Guarantees as referred to in Article 4:83 shall be recognised as state guarantees or as statereinsured guarantees as defined in Article 76(1)(h) of the Decree. Subsection Supplementary rules regarding the requirements for a phased implementation of the IRB approach Article 3:12 1. The permission to adopt a phased roll out of the IRB approach as referred to in Article 70(1) of the Decree shall be granted if: (a) the financial undertaking has a roll-out plan; (b) the financial undertaking has set up structures to manage the roll-out project, including control of the roll out at a senior management level in the financial undertaking; and (c) it may reasonably be expected from the roll-out plan and details of the project structure that the financial undertaking will have placed all relevant exposures under its chosen form of the IRB approach within three years. 2. The roll-out plan referred to in paragraph 1 above shall be submitted for approval to De Nederlandsche Bank and shall at least include the following information: (a) the type of IRB approach that the financial undertaking wishes to implement; (b) the sequence of roll out that the financial undertaking will use, supported from the risk management and operational viewpoints; (c) the deployment of people and resources; (d) the business units for which the capital requirements on the basis of the IRB approach will be calculated and at what time; and 19

20 (e) in outline, the activities that the financial undertaking still has to implement at a specific business unit in order to move to calculating the capital requirements on the basis of the IRB approach. 3. Separate permission from De Nederlandsche Bank is required to calculate the capital requirements using the IRB approach for a specific business unit or class as referred to in Article 71 of the Decree. The information as referred to in Article 3:2(1)(d) and (e) shall be supplied with the application for such approval. Article 3:13 1. The following shall apply to each type of phased roll out of the IRB approach as referred to in Article 70(1) of the Decree: (a) the transitional period within which a phased roll out must be completed is three years, irrespective of the type of IRB approach that a financial undertaking wishes to apply on implementation; (b) the roll out of the advanced IRB approach cannot begin until the phased roll out of the foundation IRB approach has been fully completed; (c) minimising the capital requirements by means of a strategic roll out during the roll-out period shall not be permitted; and (d) Article 25a of the Decree shall apply in full during the roll-out period. 2. If the IRB approach is rolled out in a business unit for the class referred to in Article 71(1)(c) of the Decree, the IRB approach shall also be rolled out on the subclass referred to in Article 3:6(1). Article 3:14 1. From the start of the roll out, a financial undertaking shall collect the following relevant information for the IRB approach for all exposures on which a type of IRB will be rolled out in accordance with the approved roll-out plan: (a) for exposures assigned to the class referred to in Article 71(1)(a), (b) or (c) of the Decree: the information set out in Article 3:74(2)(e) and (f), and the information referred to in Article 3:74(4)(e) and (g) insofar as this information refers to realised defaults; and (b) for exposures assigned to the class referred to in Article 71(1)(d) of the Decree: the information set out in Article 3:75(2)(c), (d) and (e) insofar as this information refers to realised defaults. 2. During the roll-out period, and in the event of an extension of the application of the IRB approach after the roll-out period, the financial undertaking shall publish comparative figures at least once a year on the exposures placed under the IRB approach during that year. Article 3:15 1. A financial undertaking shall forthwith inform DNB of any changes and problems which could endanger the realisation of the roll-out plan. 2. The financial undertaking shall draw up a revised roll-out plan and submit it for approval to De Nederlandsche Bank if there is a change of circumstances that could lead to significant departures from the approved roll-out plan. The revised roll-out plan shall at least contain the information referred to in Article 3:12(2). Section 3.3 Calculation of risk-weighted assets for credit risk and dilution risk and offbalance sheet items and expected loss amounts Subsection General provisions 20

21 Article 3:16 1. The risk-weighted assets and off-balance sheet items for exposures assigned to one of the classes referred to in Article 71(1)(a) to (e) and (g) of the Directive, if they are not deducted from the regulatory capital, shall be calculated using the method set out in Articles 3:20 to 3: The risk-weighted exposure amounts for dilution risk associated with purchased receivables, with or without recourse to the seller, shall be calculated on the basis of Article 3: Where a financial undertaking has full recourse in respect of purchased receivables for credit risk and for dilution risk, to the seller of the purchased receivables, the specific requirements set out in this Chapter regarding the calculation of risk-weighted exposure amounts for purchased receivables need not be applied. The exposures may instead be treated as collateralised exposures. Article 3:17 1. The input parameters probability of default (PD), loss given default (LGD), maturity (M) and exposure value referred to in Article 73 of the Decree shall be determined in accordance with Sections 3.4, 3.5 and Without prejudice to paragraph 1 above, the risk-weighted exposure amounts for exposures in the subclasses referred to in Article 3:6(1) shall be calculated in accordance with the method described in Article 3: Without prejudice to paragraph 1 above, the risk-weighted exposure amounts for all positions assigned to the class referred to in Article 71(1)(e) of the Decree shall be calculated using one of the methods described in Articles 3:27 to 3: Without prejudice to paragraph 1 above, the risk-weighted exposure amounts for all positions assigned to the class referred to in Article 71(1)(g) of the Decree shall be calculated using one of the methods described in Article 3:33. Article 3:18 A financial undertaking applying the foundation IRB approach for exposures assigned to one of the classes referred to in Article 71(1)(a) to (c) of the Decree shall use the LGD values set out in Article 3:44 and shall also apply the conversion factors as determined on the basis of Article 3:58(1). Article 3:19 1. The expected loss amounts for exposures assigned to one of the classes referred to in Article 71(1)(a) to (e) of the Decree shall be calculated using the methods referred to in Articles 3:35 to 3: The expected loss amounts for the dilution risk of purchased receivables shall be calculated using the methods set out in Article 3:38. Subsection Risk-weighted exposure amounts for exposures to central governments and central banks, banks and investment firms and corporates Article 3:20 1. Except as provided for in paragraph 2 below and the other Articles of this Section, the riskweighted exposure amounts for exposures assigned to one of the classes referred to in Article 71(1)(a) to (c) of the Decree shall be calculated in accordance with formulas 1 to 4 in Annex 3. The risk-weighted exposure amounts for exposures meeting the requirements set out in Articles 4:76, 4:88 and 4:89 may be adjusted in accordance with formula 4a in Annex 3. 21

22 2. The financial undertaking may use formula 5 in Annex 3, rather than formula 1 in Annex 3, to determine the correlation factor for exposures to corporates where the total annual sales of the consolidated group which the corporate is part of are less than 50 million. 3. The weighted average annual sales of the corporates to which the individual receivables in the pool relate are the basis for determining whether formula 5 in Annex 3 can be used for purchased receivables. 4. If total assets is a more meaningful indicator of the size of the enterprise than total annual sales, the total assets of the consolidated group will be used to determine whether the modified correlation factor can be applied. Article 3:21 1. If a financial undertaking cannot meet the minimum requirements for PD estimates set out in Section 3.6 for one or more of the subclasses referred to in Article 3:6, it shall use table 1 in Annex 3 to determine the risk weights for exposures from these areas. 2. A financial undertaking may assign a risk weight of 50% to exposures with a remaining maturity of 2.5 years or more in class 1 of the table referred to in paragraph 1 above and a risk weight of 70% to such exposures in class 2 of that table, provided that it can demonstrate that the risk characteristics of the exposure for that class are substantially more positive than is normal for that class. 3. In assigning risk weights to exposures in accordance with paragraph 1 above, financial undertakings shall take into account the following factors: (a) financial strength of the specific project or the counterparty; (b) political and legal environment; (c) transaction or asset characteristics; (d) financial strength of the sponsor and developer, including any public-private partnership income stream or security package. Article 3:22 1. Financial undertakings shall meet the minimum requirements set out in Article 3:84 and apply the same methods as prescribed in Article 3:20(1) for determining the risk-weighted exposure amounts for purchased receivables against counterparties assigned to the class referred to in Article 71(1)(c) of the Decree. 2. The standards referred to in Section 3.6 for quantifying the risk of retail exposures may be used for purchased receivables smaller than 100,000 that meet the conditions set out in Article 3:25(1) and for which it would be too burdensome for the financial undertaking to apply the standards set out in Section 3.6 for risk quantification of exposures to corporates. 3. For purchased corporate receivables, refundable purchase discounts, collateral or partial guarantees that provide first-loss protection for default losses, dilution losses, or both, may be treated as first-loss positions subject to the provisions of Title 6.5. Article 3:23 1. Where a financial undertaking provides credit protection for a number of exposures under the condition that the nth default among the exposures, as defined in a contract between the parties, shall trigger payment and that this credit event shall terminate the contract, the risk weights set out in Subsection shall be applied if the product has an external credit assessment from an eligible external credit assessment institution. 2. If the product is not rated by an eligible external credit assessment institution, the risk weights of the exposures included in the basket shall be aggregated, excluding n-1 exposures, whereby the sum of the expected loss amount multiplied by 12.5 and the risk-weighted 22

23 exposure amount shall not exceed the nominal amount of the protection provided by the credit derivative multiplied by The n-1 exposures to be excluded from the aggregation are those exposures each of which produces a lower risk-weighted exposure amount than the risk-weighted exposure amount of any of the exposures included in the aggregation. Subsection Risk-weighted exposure amounts for retail exposures Article 3:24 1. Without prejudice to paragraphs 2 and 3 below, the risk-weighted exposure amounts for exposures assigned to the class referred to in Article 71(1)(d) of the Decree shall be calculated in accordance with formulas 6, 7 and 8 in Annex 3. The risk-weighted exposure amounts for retail exposures that meet the requirements set out in Articles 4:76, 4:88 and 4:89 may be adjusted in accordance with formula 4a in Annex Instead of formula 6 in Annex 3, the financial undertaking shall apply a correlation factor (R) of 0.15 to retail exposures secured by real estate. 3. Instead of formula 6 in Annex 3, the financial undertaking shall apply a correlation factor (R) of 0.04 to qualifying revolving exposures to individuals. Article 3:25 1. A financial undertaking shall apply the same methods as referred to in Article 3:24 and shall meet the minimum requirements set out in Article 3:84 for determining the riskweighted exposure amounts for purchased retail receivables assigned to the class referred to in Article 71(1)(d) of the Decree. The following conditions shall also be met: (a) the financial undertaking shall have purchased the receivables from unrelated, third-party sellers and its exposure to the obligor of the receivable shall not include any exposures that are directly or indirectly originated by the financial undertaking itself; (b) the purchased receivables shall be generated on an arm s-length basis between the seller and the obligor and shall not concern intercompany accounts receivables and receivables subject to contra-accounts between firms that buy and sell to each other; (c) the purchasing financial undertaking has a claim on all proceeds from the purchased receivables or a pro rata interest in these proceeds; and (d) the pool of purchased receivables is sufficiently diversified, to the extent that no purchased receivable against a single counterparty may exceed 0.2% of the pool they are assigned to. 2. For purchased retail receivables, refundable purchase discounts, collateral or partial guarantees that provide first-loss protection for default losses, dilution losses, or both, may be treated as first-loss positions subject to the provisions of Title For hybrid pools of purchased retail receivables where the purchasing financial undertaking cannot or do not wish to separate exposures secured by real estate and qualifying revolving retail exposures from other retail exposures, the risk weight function producing the highest capital requirements for these exposures shall apply. Subsection Risk-weighted exposure amounts for equity exposures Article 3:26 1. The simplified risk weight approach, the internal models approach or the PD/LGD approach may be used for calculating the risk-weighted exposure amounts for exposures assigned to the class referred to in Article 71(1)(e) of the Decree. 23

24 2. A financial undertaking may apply different approaches for different portfolios if it also applies these different approaches internally and if the different approaches are applied consistently to the different portfolios. 3. The choice of the different approaches may not be determined by capital arbitrage considerations. 4. Notwithstanding the provisions of paragraph 1 above, a financial undertaking may determine the risk-weighted exposure amounts for equity exposures to ancillary services undertakings in accordance with Article 3:33. This only applies to undertakings which offer ancillary services on a non-commercial basis only to the financial undertaking or a group of financial undertakings that the financial undertaking is a member of, which together fully own the ancillary services undertaking. Article 3:27 1. In the simplified risk weight approach, the risk-weighted exposure amounts for equity exposures shall be calculated in accordance with formula 9 in Annex In the simplified risk weight approach, short cash positions and derivative instruments held in the non-trading book are permitted to offset long positions in the same individual stocks provided that these instruments have been explicitly designated as hedges of specific equity exposures and that they provide a hedge for at least another year. In respect of maturity mismatched positions, Section 4.9 shall apply accordingly to determining the effect of the maturity mismatch. 3. Short positions other than those referred to in paragraph 2 above are to be treated as long positions with the relevant risk weight applied to the absolute value of each position. 4. In the simplified risk weight approach, a financial undertaking may recognise unfunded credit protection obtained on an equity exposure. Notwithstanding the provisions of paragraph 1 above, the risk weight shall be calculated in accordance with Article 3:29. The requirements set out in Article 3.29(3) shall apply accordingly to that calculation. Article 3:28 1. In the internal models approach, the risk-weighted exposure amounts for equity exposures shall be the potential loss on the financial undertaking s equity exposures as derived using internal value-at-risk (VaR) models subject to the 99th percentile, one-tailed confidence interval of the difference between quarterly returns and an appropriate risk-free rate computed over a long-term period, multiplied by When developing internal VaR models, the financial undertaking shall take account of the provisions of Article 3: In the internal models approach, the risk-weighted exposure amounts at the individual equity exposure level shall not be less than the sum of the minimum risk-weighted exposure amount required under the PD/LGD approach and the corresponding expected loss amount multiplied by 12.5, and calculated on the basis of the PD value set out in Article 3:54(2)(a), the corresponding LGD values set out in Article 3:55, and the M value set out in Article 3: In the internal models approach, the financial undertaking may recognise unfunded credit protection obtained on an equity exposure. The financial undertaking shall develop a consistent and explainable method of determining the effect of unfunded credit protection on the equity exposures. Without prejudice to paragraph 3 above, the provisions of Article 3:83 shall, insofar as relevant, apply accordingly to unfunded credit protection. Article 3:29 1. In the PD/LGD approach, the risk-weighted exposure amounts shall be calculated in 24

25 accordance with the formulas referred to in Article 3:20(1). If financial undertakings do not have sufficient information to use the definition of default set out in Article 1 of the Decree and Article 3:40 of this Regulation, a scaling factor of 1.5 shall be assigned to the risk weights. 2. In the PD/LGD approach, the sum of the expected loss amount at the individual exposure level multiplied by 12.5 and the risk-weighted exposure amount shall not exceed the exposure value multiplied by In the PD/LGD approach, the financial undertaking may recognise unfunded credit protection obtained on an equity exposure in accordance with the method set out in Article 4:93(3) and (5). For determining LGD and M, the provisions of Article 3:52 shall apply accordingly. Article 3:30 1. If exposures in the form of positions in a collective investment undertaking meet the criteria set out in Article 2:45 and a financial undertaking is aware of all the underlying exposures of the collective investment undertaking, it shall look through to those underlying exposures in order to calculate the risk-weighted exposure amounts and expected loss amounts of the underlying exposures, in accordance with the IRB methods. 2. If the conditions of the first sentence of paragraph 1 above are met, but the financial undertaking does not apply the IRB approach to the underlying exposures in the class, the risk-weighted exposure amounts and expected loss amounts shall be calculated as follows: (a) the approach set out in Article 3:27 shall be used for exposures assigned to the class referred to in Article 71(1)(e) of the Decree. If the financial undertaking is unable or unwilling to differentiate between positions in non-exchange traded equity, exchange traded equity and other equity, it shall treat the relevant exposures as other equity exposures; (b) the standardised approach set out in Chapter 2 shall be used for all other underlying exposures, provided that: (i) the exposures are assigned to an exposure class that is associated with the risk weight of the credit quality step immediately above the credit quality step that would normally be assigned to the exposure; and (ii) exposures assigned to a higher credit quality step, to which a risk weight of 150% would normally be attributed, receive a risk weight of 200%. Article 3:31 1. If the conditions set out in the first sentence of Article 3:30(1) are not met, a financial undertaking shall calculate the risk-weighted exposure amounts and expected loss amounts of the underlying exposures in accordance with the mandate of the collective investment undertaking, using the simplified risk weight approach referred to in Article 3:27(1). 2. For the purposes of the calculation referred to in paragraph 1 above, the underlying exposures, other than equity exposures, shall be assigned to one of the classes referred to in formula 9 in Annex 3. If the financial undertaking does not differentiate between positions in non-exchange traded equity, exchange traded equity and other equity, it shall treat the relevant underlying exposures as other equity exposures. Exposures where the underlying exposures are unknown shall also be treated as other equity exposures. Article 3:32 1. As an alternative for the method described in Article 3:31, a financial undertaking may rely on a third party to calculate and report the average risk-weighted exposure amounts based on the underlying exposures of the collective investment undertaking, or it may calculate these 25

26 exposure amounts itself. In both cases, the financial undertaking shall ensure that the calculation and, in the case of calculation by a third party, the report are carried out in accordance with this Regulation. 2. The following approaches shall be used for the calculations referred to in paragraph 1 above: (a) the approach set out in Article 3:27(1) shall be followed for exposures assigned to the class referred to in Article 71(1)(e) of the Decree. If the financial undertaking does not differentiate between positions in non-exchange traded equity, exchange traded equity and other equity, it shall treat the relevant exposures as other equity exposures. (b) the standardised approach set out in Chapter 2 shall be used for all other underlying exposures, provided that: (i) the exposures are assigned to an exposure class that is associated with the risk weight of the credit quality step immediately above the credit quality step that would normally be assigned to the exposure; and (ii) exposures assigned to a higher credit quality step, to which a risk weight of 150% would normally be attributed, receive a risk weight of 200%. Subsection Risk-weighted exposure amounts for other non-credit obligation assets and for the dilution risk of purchased receivables Article 3:33 The risk-weighted exposure amounts for other non-credit obligation assets shall be calculated in accordance with formula 10 in Annex 3. Article 3:34 1. The risk-weighted exposure amounts for the dilution risk of purchased corporate and retail receivables shall be calculated in accordance with the formulas set out in Article 3:20(1). 2. A financial undertaking does not have to calculate risk-weighted exposure amounts if it demonstrates that the dilution risk is negligible. Subsection Calculation of expected loss amounts Article 3:35 1. The expected loss amounts for exposures assigned to one of the classes referred to in Article 71(1)(a) to (d) of the Decree shall, subject to the provisions of Article 3:36, be calculated in accordance with formulas 11 and 12 in Annex The calculation referred to in paragraph 1 above shall for each exposure be based on the same input parameters for PD, LGD and exposure value as those used for calculating riskweighted exposure amounts in accordance with Articles 3:16 to 3: Financial undertakings applying the advanced IRB approach shall calculate the expected loss amount for defaulted exposures using their best estimate of EL (ELBE) in accordance with Article 3:81(8). Article 3:36 1. If a financial undertaking uses the method described in Article 3:21(1) for exposures assigned to one of the subclasses referred to in Article 3:6, an EL value shall be attributed to such exposures using, instead of formula 11 in Annex 3, table 2 in Annex 3. This value shall then be used in formula 12 in Annex If for exposures assigned to one of the subclasses referred to in Article 3:6, a financial undertaking takes advantage of the possibility referred to in Article 3:21(2) to attribute a 26

27 preferential risk weight of 50% to all exposures in class 1 of table 2 and a risk weight of 70% to all exposures in class 2 of table 2, the EL value shall be 0% for exposures in class 1 and 0.4% for exposures in class 2. These values shall then be used in formula 12 in Annex 3. Article 3:37 1. The expected loss amounts for exposures assigned to the class referred to in Article 71(1)(e) of the Decree, where the risk-weighted exposure amounts are determined in accordance with the method set out in Article 3:27, shall be calculated in accordance with formula 13 in Annex The expected loss amounts for exposures assigned to the class referred to in Article 71(1)(e) of the Decree, where the risk-weighted exposure amounts are determined in accordance with the method set out in Article 3:28, shall be 0%. 3. The expected loss amounts for exposures assigned to the class referred to in Article 71(1)(e) of the Decree, where the risk-weighted exposure amounts are determined in accordance with the method set out in Article 3:29, shall be calculated in accordance with formulas 14 and 15 in Annex 3. The provisions of Article 3:35(2) and (3) shall apply accordingly. Article 3:38 Unless Article 3:34(2) applies, the expected loss amounts for the dilution risk of purchased receivables shall be calculated in accordance with formulas 16 and 17 in Annex 3. The provisions of Article 3:35(2) and (3) shall apply accordingly. Section 3.4 Provisions on the determination of the input parameters PD, LGD and M Subsection General provisions on input parameters PD, LGD and M Article 3:39 1. The input parameters probability of default (PD), loss given default (LGD) and maturity (M) for calculating the risk-weighted exposure amounts and expected loss amounts specified in Section 3.3, shall be estimated by financial undertakings subject to the provisions of this Section and those of Section In calculating the risk-weighted exposure amounts and expected loss amounts specified in Section 3.3, the input parameters PD and LGD shall be expressed in decimals and the input parameter M in years. Article 3:40 A financial undertaking shall regard at any rate the following elements as indication that it is unlikely that the obligor will fully meet its obligations: (a) the financial undertaking puts the exposure to the obligor on non-accrued status; (b) the financial undertaking makes a value adjustment as a result of a significant perceived decline in credit quality subsequent to the financial undertaking taking on the exposure to the obligor; (c) the financial undertaking sells the exposure to the obligor at a material credit-related economic loss; (d) the financial undertaking consents to a distressed restructuring of the exposure to the obligor where this is likely to result in a diminished exposure caused by the material forgiveness, or postponement, of principal, interest or (where relevant) fees, or the distressed restructuring of the equity capital in the case of equity exposures assessed under a PD/LGD approach; 27

28 (e) the financial undertaking has filed for the obligor s bankruptcy or a similar order in respect of the obligor s credit obligation to the financial undertaking, the parent undertaking or any of its subsidiaries; (f) the obligor has sought or has been placed in bankruptcy or similar protection where repayment of a credit obligation to the financial undertaking, the parent undertaking or any of its subsidiaries would not be effected in accordance with the contract. Subsection PD, LGD and M for exposures to central governments and central banks, banks and investment firms and corporates Article 3:41 1. The PD of an obligor of an exposure assigned to one of the classes referred to in Article 71(1)(b) and (c) of the Decree shall be at least The PD for an obligor in default shall be 1. Article 3:42 1. Purchased corporate receivables in respect of which a financial undertaking cannot demonstrate that its individual PD estimates meet the minimum requirements set out in Section 3.6 for PDs for corporates shall, subject to the provisions of Article 3:22(2), be determined according to the following methods: (a) the PD for senior claims on purchased corporate receivables shall be the financial undertaking s estimate of EL for the default risk of the entire pool of receivables, divided by the LGD for these receivables; (b) the PD for subordinated claims on purchased corporate receivables shall be the financial undertaking s estimate of EL for the default risk of the entire pool of receivables. 2. If the financial undertaking applies the advanced IRB approach, it shall, notwithstanding the provisions of paragraph 1 above, decompose its EL estimates for the default risk of purchased corporate receivables in a reliable manner into PDs and LGDs. Article 3:43 1. A financial undertaking applying the foundation IRB approach, may recognise unfunded credit protection in accordance with Sections 4.7 and A financial undertaking applying the advanced IRB approach may recognise unfunded credit protection by adjusting its PDs subject to the provisions of Article 3:45(3). Article 3:44 1. A financial undertaking applying the foundation IRB approach for exposures assigned to one of the classes referred to in Article 71(1)(a) to (c) shall use the following LGD values for these exposures: (a) for senior exposures without eligible collateral: 0.45; (b) for subordinated exposures without eligible collateral: 0.75; (c) for covered bonds as defined in Annex 1: (d) for senior purchased corporate receivables: 0.45; and (e) for subordinated purchased corporate receivables: The financial undertaking may recognise funded and unfunded credit protection in the LGD in accordance with Chapter Without prejudice to paragraph 2 above, for the recognition of funded and unfunded credit protection in the LGD in accordance with the last sentence of Article 3:20(1), the LGD of a comparable direct exposure to the protection provider shall either be the LGD associated with an unhedged facility to the guarantor or the unhedged facility of the obligor, depending upon 28

29 whether in the event both the guarantor and the obligor default during the life of the hedged transaction, available evidence and the structure of the guarantee indicate that the amount recovered would depend on the financial condition of the guarantor or the obligor, respectively. Article 3:45 1. A financial undertaking applying the advanced IRB approach for exposures assigned to one of the classes referred to in Article 71(1)(a) to (c) of the Decree shall prepare its own LGD estimates, subject to the minimum requirements set out in Section If the financial undertaking applying the advanced IRB approach uses the methods referred to in Article 3:42(1), it shall decompose its EL estimates for the default risk of purchased corporate receivables in a reliable manner into PDs and LGDs. 3. The financial undertaking applying the advanced IRB approach may recognise unfunded credit protection by adjusting its PD and/or LGD estimates, subject to the minimum requirements set out in Article 3:83. The financial undertaking shall not assign to guaranteed exposures an adjusted PD and/or LGD such that the adjusted risk weight would be lower than that of a comparable direct exposure to the guarantor. 4. Without prejudice to paragraph 3 above, for the purposes of the last sentence of Article 3:20(1), the LGD of a comparable direct exposure to the protection provider shall either be the LGD associated with an unhedged facility to the guarantor or the unhedged facility of the obligor, depending upon whether in the event both the guarantor and the obligor default during the life of the hedged transaction, available evidence and the structure of the guarantee indicate that the amount recovered would depend on the financial condition of the guarantor or the obligor, respectively. Article 3:46 1. A financial undertaking shall, subject to the provisions of paragraph 4 below, calculate M for each exposure in the following manner: (a) for an instrument subject to a cash flow schedule, M shall be calculated in accordance with formula 18 in Annex 3; (b) for derivative instruments subject to a master netting agreement, M shall be the weighted average remaining maturity of the exposure, where M shall be at least one year. The notional amount of each exposure shall be used for weighting the maturity; (c) for exposures arising from fully or nearly-fully collateralised derivative instruments listed in Annex B to the Decree and fully or nearly-fully collateralised margin lending transactions or repurchase transactions subject to a master netting agreement, M shall be the weighted average maturity of the transactions, where M shall be at least ten days. The notional amount of each exposure shall be used for weighting the maturity; (d) for purchased corporate receivables, M for drawn amounts shall equal the purchased receivables weighted average maturity, where M shall be at least 90 days; (e) the value of M as referred to in subparagraph (d) above shall also be used for undrawn amounts under a committed purchase facility of corporate receivables, provided that the purchase facility contains effective covenants, early amortisation triggers or other features that protect the purchasing financial undertaking against a significant deterioration in the quality of the future receivables it is required to purchase over the facility s term; (f) if the effective protection measures referred to in subparagraph (e) above are absent, M for undrawn amounts under a committed purchase facility of corporate receivables shall be calculated as the sum of the longest-dated potential receivable under the purchase facility and the remaining maturity of the purchase facility, where M shall be at least 90 days. 29

30 2. Notwithstanding the provisions of subparagraphs 1(a), (b) and (d) to (f) above, M shall be at least one day for: (a) fully or nearly-fully collateralised derivative instruments listed in Annex B to the Decree; (b) fully or nearly-fully collateralised margin lending transactions; (c) repurchase transactions, securities or commodities lending or borrowing transactions provided that the documentation requires daily re-margining and daily revaluation and includes provisions that allow for the prompt liquidation or setoff of collateral in the event of default or failure to re-margin; and (d) other short-term exposures that are not part of the financial undertaking's ongoing financing of the obligor. 3. For all other instruments than those listed in paragraphs 1 and 2 above, or for all instruments where the financial undertaking is not in a position to calculate M as set out in subparagraph 1(a) above, M shall be the maximum remaining time (in years) that the obligor is permitted to take to fully discharge its contractual obligations, where M shall be at least one year. 4. Maturity mismatches shall be treated in the manner as specified in Section For financial undertakings using the internal model method set out in Section 5.6 to calculate the exposure values, M shall, in accordance with formula 18a in Annex 3, be calculated for exposures to which they apply this method and for which the maturity of the longest-dated contract contained in the netting set is greater than one year. For netting sets in which all contracts have an original maturity of less than one year, the provisions of paragraph 1 above shall apply insofar as the exception referred to paragraph 2 above does not apply. 6. Notwithstanding the provisions of paragraph 5 above, a financial undertaking that uses an internal model to calculate a one-sided credit valuation adjustment (CVA) may use, subject to the prior approval of De Nederlandsche Bank, the effective credit duration estimated by this internal model as M. 7. For the purposes of the last sentence of Article 3:20(1), M shall be the effective maturity of the credit protection but at least one year. Subsection PD and LGD for retail exposures Article 3:47 1. The PD of an exposure assigned to the class referred to in Article 71(1)(d) of the Decree shall be at least The PD of an exposure in default shall be Unfunded credit protection may be recognised by adjusting the PD subject to the provisions of Article 3:48(2). Article 3:48 1. A financial undertaking applying the IRB approach for exposures assigned to the class referred to in Article 71(1)(d) of the Decree shall prepare its own LGD estimates, subject to the minimum requirements set out in Section Unfunded credit protection to cover an individual exposure or pool of exposures may be recognised by adjusting the PD or LGD estimates, subject to the minimum requirements set out in Article 3:83. The financial undertaking shall not assign to guaranteed exposures an adjusted PD or LGD such that the adjusted risk weight would be lower than that of a comparable direct exposure to the guarantor. 3. Without prejudice to paragraph 2 above, for the purposes of the last sentence of Article 3:24(1), the LGD of a comparable direct exposure to the protection provider shall either be 30

31 the LGD associated with an unhedged facility to the guarantor or the unhedged facility of the obligor, depending upon whether, in the event both the guarantor and the obligor default during the life of the hedged transaction, available evidence and the structure of the guarantee indicate that the amount recovered would depend on the financial condition of the guarantor or the obligor, respectively. Subsection PD, LGD and M for the application of the PD/LGD approach for equity exposures Article 3:49 1. The PD shall be determined according to the methods for corporate exposures. 2. The following minimum PDs shall apply: (a) for exchange traded equity exposures where the investment is part of a long-term customer relationship; (b) for non-exchange traded equity exposures where the returns on the investment are based on regular and periodic cash flows not derived from capital gains; (c) for exchange traded equity exposures including short positions as set out in Article 3:27(2) and (3); (d) for all other equity exposures including short positions as referred to in Article 3:27(2) and (3). Article 3:50 1. An LGD of 0.65 may be assigned to positions in non-exchange traded equities where a financial undertaking can demonstrate that they are included in sufficiently diversified portfolios and where a lower risk weight is justified by historical figures. 2. All other equity exposures shall be assigned an LGD of 0.9. Article 3:51 All equity exposures shall be assigned an M of five years. Article 3:52 If, for determining the risk-weighted exposure amount, a financial undertaking recognises unfunded credit protection in conformity with the provisions of Article 3:29(3), the exposure to the provider of the hedging instrument shall have an LGD and M in conformity with Articles 3:50 and 3:51. Subsection PD, LGD and M for the dilution risk of purchased corporate and retail receivables Article 3:53 1. A financial undertaking shall prepare its own estimates of EL for the dilution risk of purchased corporate and retail receivables. Depending on the treatment under Article 3:42(1), this estimate may be at the individual level of the purchased receivable or at the aggregated level of the pool. 2. The PD for the dilution risk shall be equal to the EL estimate for the dilution risk. 3. The LGD for the dilution risk shall be If the financial undertaking applies the advanced IRB approach, it shall, notwithstanding the provisions of paragraphs 1 to 3 above, decompose its EL estimates for the dilution risk of purchased receivables in a reliable or conservative manner into PDs and LGDs. 5. The M for the dilution risk shall be one year. 31

32 6. The financial undertaking may recognise unfunded credit protection in calculating the PD in accordance with Sections 4.7 and 4.8. Section 3.5 Provisions on determining the input parameter exposure value Subsection Exposure value for exposures to central governments and central banks, banks and investment firms, and corporate and retail exposures Article 3:54 1. Unless stated otherwise, the exposure value of exposures assigned to the classes referred to in Article 71(1)(a) to (d) of the Decree shall be determined on the basis of their on-balance sheet value gross of value adjustments. The previous sentence shall also apply to assets purchased at a price different from the amount owed. For such purchased assets, the difference between the amount owed and the value recorded on the balance sheet of financial undertakings shall be denoted discount if the amount owed is larger, and premium if the amount owed is smaller. 2. Where a financial undertaking uses master netting agreements in relation to repurchase agreements or securities or commodities lending or borrowing, the exposure value shall be calculated in accordance with the appropriate method set out in Subsection For on-balance sheet netting of loans and deposits, the financial undertaking shall apply the appropriate method set out in Subsection for the calculation of the exposure value. 4. The exposure value for leases shall be the discounted flow of minimum lease payments. Minimum lease payments are the payments over the lease term that the lessee is or can be required to make as well as any bargain option. Any guaranteed residual value fulfilling the set of conditions set out in Article 4:75 regarding the eligibility of protection providers as well as the minimum requirements for recognising other types of guarantees as referred to in Articles 4:79 to 4:83 shall also be included in the minimum lease payments. Article 3:55 The amount to be used for calculating risk-weighted exposure amounts of purchased receivables shall be the outstanding amount of the pool of purchased receivables minus the capital requirement for the dilution risk but before any effects of credit risk mitigation as referred to in Chapter 4. Article 3:56 1. The value of a derivative referred to in Annex B to the Decree shall be determined using the methods set out in Chapter 5 of this Regulation. Article 3:57 1. Where an exposure takes the form of securities or commodities sold, posted or lent under repurchase transactions, securities or commodities lending or borrowing transactions, long settlement transactions and margin lending transactions, the exposure value shall be the value of the securities or commodities determined in accordance with the accounting framework designated in Article 4 of the Decree. 2. Where the financial collateral comprehensive method as set out in Subsection is used, the exposure value shall be increased by the volatility adjustment appropriate for such securities or commodities as set out in Subsection The exposure value in repurchase transactions, securities or commodities lending or borrowing transactions, long settlement transactions and margin lending transactions may be 32

33 determined in accordance with Article 4:12(2) and Subsection or in accordance with Chapter Without prejudice to paragraph 3 above, the exposure value of credit risk exposures outstanding with a central counterparty shall be determined in accordance with Article 5:5(3), provided that the central counterparty's counterparty credit risk exposures with all participants in its arrangements are fully collateralised on a daily basis. Article 3:58 1. A financial undertaking applying the foundation IRB approach shall determine the exposure value for the following off-balance sheet items by multiplying the committed but undrawn amount by the relevant conversion factors set out below: (a) for uncommitted credit lines that are unconditionally cancellable at any time by the financial undertaking without prior notice or that effectively provide for automatic cancellation due to deterioration in an obligor s credit quality, a conversion factor of 0% shall apply, provided that the financial undertaking closely monitors the obligor s financial condition and its internal control systems enable it to immediately detect a deterioration in the obligor s credit quality; (b) for undrawn purchase commitments for revolving purchased receivables that are unconditionally cancellable or that effectively provide for automatic cancellation at any time by the financial undertaking without prior notice, a conversion factor of 0% shall apply, provided that the financial undertaking closely monitors the obligor s financial condition and its internal control systems enable it to immediately detect a deterioration in the obligor s credit quality; (c) for short-term letters of credit arising from the movement of goods, a conversion factor of 20% shall apply to both the issuing and confirming financial undertaking; (d) for other credit lines, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) as referred to in Annex 2D, subparagraph 2(e), a conversion factor of 75% shall apply; 2. Where an item as referred to in Annex 2D refers to the extension of another item in that Annex, the lower of the two conversion factors associated with the individual item in that Annex shall be used. 3. The financial undertaking applying the advanced IRB approach shall use its own estimates to determine the value of the exposures referred to in Annex 2D across product types unless the type of product qualifies as a full risk item under Annex 2D. Article 3:59 For all items referred to in Annex 2D other than those referred to in Articles 3:54 to 3:58, the exposure value shall be determined in accordance with the following percentages of the value: (a) 100% if it is a full risk item; (b) 50% if it is a medium risk item; (c) 20% if it is a medium/low risk item; and (d) 0% if it is a low risk item. Subsection Exposure value for equity exposures, other non-credit obligation assets and dilution risk Article 3:60 The exposure value for equity exposures shall be based on the accounting policies that are also used for the value presented in the financial statements. 33

34 Article 3:61 The value for calculating the risk-weighted exposure amounts for other assets which are noncredit obligations shall be based on the accounting policies that are also used for the value presented in the financial statements. Article 3:62 The value for calculating the risk-weighted exposure amounts for dilution risk shall be the outstanding amount of the pool of purchased receivables. Section 3.6 Minimum requirements for internal ratings-based systems Subsection General minimum requirements for internal ratings-based systems Article 3:63 1. A financial undertaking shall demonstrate that its internal ratings-based systems are sound, are implemented with integrity and meet the following conditions: (a) the financial undertaking s internal ratings-based systems shall allow it to make a meaningful assessment of obligor and transaction characteristics and shall lead to a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk; (b) internal ratings and estimates of default and losses given default used in the calculation of capital requirements and the associated systems and processes shall play an essential role in the risk management and internal decision-making process, and in the credit approval, internal capital allocation and internal control functions of the financial undertaking; (c) the financial undertaking shall have a credit risk control unit responsible for its internal ratings-based systems that shall be able to operate with a sufficient degree of independence and shall not be subject to any influence that jeopardises its operational independence; (d) the financial undertaking shall collect and store all relevant data to provide effective support to its credit risk measurement and management process; and (e) the financial undertaking shall document its internal ratings-based systems and the rationale for their design and shall validate these systems. Article 3:64 1. The financial undertaking shall document the design and operational details of its rating systems. The documentation shall evidence compliance with the minimum requirements set out in this Section and, without prejudice to any other specific requirements or documentation set out in this Section, it shall address in particular portfolio differentiation, rating criteria, responsibilities of parties that rate obligors and exposures, frequency of rating reviews and management oversight of the rating process. 2. The financial undertaking shall document the rationale for and analysis supporting its choice of rating criteria. The financial undertaking shall document all major changes in the risk rating process and such documentation shall support identification of changes made to the risk rating process subsequent to the last review by De Nederlandsche Bank and the reasons underlying these changes. The organisation of rating assignments including the rating assignment process and the internal control structure shall also be documented. 3. The financial undertaking shall document the specific definitions of default and loss that are used internally and shall demonstrate that these definitions are consistent with the definition of default set out in Article 1 of the Decree and Article 3:40 of this Regulation. 4. If the financial undertaking employs statistical models in the rating process or for its own estimates, it shall document the methodology of these models. This material shall: (a) provide a detailed outline of the theory, assumptions and/or mathematical and empirical 34

35 basis of the assignment of estimates to grades, individual obligors, exposures or pools and the data sources used to build the model; (b) establish a rigorous statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and (c) indicate any circumstances under which the model does not work effectively. 5. In cases where a model has been obtained from a third-party vendor that claims proprietary technology, the financial undertaking must continue to comply with documentation and any other requirements for rating systems Article 3:65 1. If a financial undertaking uses multiple rating systems, the rationale for assigning an obligor or a transaction to a rating system shall be documented and applied in a manner that appropriately reflects the level of risk. 2. Assignment criteria and processes shall be periodically reviewed to determine whether they remain appropriate for the current portfolio and external conditions. Article 3:66 Where a financial undertaking uses direct estimates of risk parameters, these may be seen as the outputs of grades on a continuous rating scale. Subsection Structure of rating systems Article 3:67 1. A rating system for exposures assigned to the classes referred to in Article 71(1)(c) of the Decree shall take into account obligor and transaction risk characteristics. 2. A rating system as referred to in paragraph 1 above shall have an obligor rating scale which exclusively reflects quantification of the risk of obligor default. The obligor rating scale shall have a minimum of seven grades for non defaulted obligors and at least one for defaulted obligors. 3. A financial undertaking shall document the relationship between obligor grades in terms of the level of default risk each grade implies and the criteria used to distinguish the levels of default risk. 4. For the purposes of paragraph 3 above, an obligor grade shall be understood to mean a risk category within a rating system s obligor rating scale, to which obligors are assigned on the basis of a specified and distinct set of rating criteria, from which estimates of PD are derived. 5. A financial undertaking with portfolios concentrated in a particular market segment and in a particular range of default risk shall ensure that there are enough obligor grades within that range to avoid undue concentrations of obligors in a particular grade. Significant concentrations within a single grade shall be supported by convincing empirical evidence showing that the obligor grade covers a reasonably narrow PD band and that the default risk posed by all obligors in the grade falls within that band. 6. A financial undertaking applying the advanced IRB approach shall have a rating system that incorporates a distinct facility rating scale which exclusively reflects LGD-related transaction characteristics. 7. A facility grade shall mean a risk category within a rating system s exposure scale to which exposures are assigned on the basis of a specified and distinct set of rating criteria from which LGD estimates are derived. The grade definition shall include both a description of how exposures are assigned to a grade and of the criteria used to distinguish the level of risk across grades. 35

36 8. Significant concentrations within a single facility grade shall be supported by convincing empirical evidence showing that the facility grade covers a reasonably narrow LGD band and that the risk posed by all exposures in the grade falls within that band. 9. A financial undertaking applying the method set out in Article 3:21(1) for assigning risk weights to one of the subclasses referred to in Article 3:6 shall be exempt for these exposures from the requirement to have an obligor rating scale which exclusively quantifies the risk of obligor default. Notwithstanding the provisions of paragraph 2 above, the financial undertaking shall have at least four grades for non-defaulted obligors and at least one grade for defaulted obligors for these exposures. Article 3:68 1. A financial undertaking shall ensure that its rating systems for exposures assigned to the class referred to in Article 71(1)(d) of the Decree shall reflect both obligor and transaction risk and shall capture all relevant obligor and transaction characteristics. Financial undertakings may apply the definition of default as set out in Article 1 of the Decree and Article 3:40 of this Regulation at facility level. 2. The level of risk differentiation shall ensure that the number of exposures in a given grade or pool is sufficient to allow for meaningful quantification and validation of the loss characteristics at grade or pool level. The distribution of exposures and obligors across grades or pools shall be such as to avoid excessive concentrations. 3. The financial undertaking shall demonstrate that assigning exposures to grades or pools provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogeneous exposures and allows for accurate and consistent estimation of loss characteristics at grade or pool level. For purchased receivables the grouping shall reflect the seller s underwriting practices and the heterogeneity of its customers. 4. The financial undertaking shall consider the following risk drivers when assigning exposures to grades or pools: (a) obligor risk characteristics; (b) transaction risk characteristics, including product or collateral types, or both. The financial undertaking shall explicitly address cases where several exposures benefit from the same collateral; and (c) delinquency, unless the financial undertaking demonstrates to De Nederlandsche Bank that delinquency is not a material risk driver for the exposure. Subsection Classification of obligors or exposures into grades or pools Article 3:69 1. A financial undertaking shall have specific definitions, processes and criteria for assigning obligors or exposures to grades or pools within a rating system. 2. The definitions and criteria of the grades or pools shall be sufficiently detailed to allow those charged with assigning ratings to consistently assign obligors or exposures posing similar risk to the same grade or pool. This consistency shall exist across the financial undertaking s lines of business, departments and geographic locations. 3. The documentation of the rating process shall allow third parties to understand the assignments of obligors or exposures to grades or pools, to replicate grade and pool assignments and to evaluate the appropriateness of the assignments to a grade or pool. 4. The criteria for the grades and pools shall also be consistent with the financial undertaking s internal lending standards and its policies for handling distressed obligors and problem facilities. 36

37 5. The financial undertaking shall take all relevant information into account in assigning obligors and exposures to grades or pools. Information shall be current and shall enable the financial undertaking to forecast the future performance of the exposure. The less information a financial undertaking has, the more conservative shall be its assignments of exposures to obligor and facility grades or pools. If the financial undertaking uses an external rating as a primary factor for determining an internal rating assignment, the financial undertaking shall ensure that it also considers other relevant information. 6. For grade and pool assignments, financial undertakings shall document the situations in which human judgment may override the inputs or outputs of the assignment process and the personnel that are responsible for approving these overrides. Financial undertakings shall document these overrides and the personnel responsible. Financial undertakings shall analyse the performance of the exposures whose assignments have been overridden. This analysis shall include an assessment of the performance of exposures whose rating has been overridden by a particular person, with account being rendered for all responsible personnel. Article 3:70 If a financial undertaking uses statistical models and other mechanical methods to assign obligors or exposures to obligor or facility grades or pools, then it: (a) shall demonstrate that the model has good predictive power and that capital requirements are not distorted as a result of its use. The input variables shall form a reasonable and effective basis for the resulting predictions. The model shall not have material biases; (b) shall have in place a process for vetting data inputs into the model which includes an assessment of the accuracy, completeness and appropriateness of the data; (c) shall demonstrate that the data used to build the model is representative of the population of the financial undertaking s existing obligors or exposures; (d) shall have a regular cycle of model validation that includes monitoring of model performance and stability, review of model specification, and testing of model outputs against outcomes; (e) shall complement the statistical model by human judgment and human oversight to review model-based assignments and to ensure that the models are used appropriately. Review procedures shall aim at finding and limiting errors associated with model weaknesses. Human judgments shall take into account all relevant information not considered by the model. The financial undertaking shall document how human judgment and model results are to be combined. Article 3:71 1. Without prejudice to the provisions of Articles 3:69 and 3:70, the provisions in this Article shall also apply to the classification into grades of exposures and obligors of exposures assigned to the classes referred to in Article 71(1)(a) to (c) of the Decree. 2. Each obligor shall be assigned to an obligor grade as part of the credit approval process. Each separate legal entity to which the financial undertaking has an exposure shall be separately rated. The financial undertaking shall demonstrate that it has an acceptable policy regarding the treatment of individual obligors and groups of connected obligors. 3. Several exposures to the same obligor shall be assigned to the same obligor grade, irrespective of any differences in the nature of each specific transaction. Exceptions, where several exposures are allowed to result in multiple grades for the same obligor, are the following: (a) country transfer risk, this being dependent on whether the exposures are denominated in local or foreign currency; 37

38 (b) where the treatment of associated guarantees to an exposure may be reflected in an adjusted assignment to an obligor grade; and (c) where consumer protection, bank secrecy or other legislation prohibit the exchange of client data. 4. If a financial undertaking applies the advanced IRB approach, each exposure shall also be assigned to a facility grade as part of the credit approval process. 5. A financial undertaking that applies the methods set out in Article 3:21(1) for assigning risk weights to the subclasses referred to in Article 3:6 shall assign each of these exposures to a grade in accordance with the provisions of Article 3:67(9). 6. Assignments and periodic reviews of assignments shall be completed or approved by an independent party that does not directly benefit from credit decisions. 7. The financial undertaking shall update assignments at least annually. High-risk obligors and problem exposures shall be subject to more frequent review. The financial undertaking shall undertake a new assignment as soon as material information on the obligor or exposure becomes available. 8. The financial undertaking shall have an effective process to obtain and update relevant information on obligor characteristics that affect PDs and on transaction characteristics that affect LGDs and conversion factors. Article 3:72 1. Without prejudice to the provisions of Articles 3:69 and 3:70, the provisions of this Article shall also apply to the classification into grades of exposures assigned to the class referred to in Article 71(1)(d) of the Decree 2. Each exposure shall be assigned to a grade or pool as part of the credit approval process. 3. The financial undertaking shall at least annually update the obligor and facility grade assignments or review the loss characteristics and delinquency status of each identified risk pool. High-risk obligors and problem exposures shall be subject to more frequent review. The financial undertaking shall undertake a new assignment as soon as material information on the obligor or exposure becomes available. 3. The financial undertaking shall at least annually review the status of a representative sample of individual exposures within each pool as a means of ensuring that exposures continue to be assigned to the correct pool. Subsection Data maintenance Article 3:73 A financial undertaking shall collect and store information on the aspects of its internal ratings as required under Article 3:74a of the Act. Article 3:74 1. Without prejudice to the provisions of Article 3:73, the supplementary provisions of this Article shall apply to maintaining data on exposures assigned to the classes referred to in Article 71(1)(a) to (c) of the Decree. 2. A financial undertaking shall collect and store the following information: (a) complete rating histories on obligors and recognised guarantors; (b) the dates the ratings were assigned; (c) the key data and methodology used to derive the ratings; (d) the persons and models responsible for the rating assignments and estimates; (e) the identity of obligors and exposures that have defaulted; (f) the date and circumstances of such defaults and exposures in arrears; and 38

39 (g) data on the PDs and realised default rates associated with rating grades and ratings migration. 3. A financial undertaking applying the foundation IRB approach shall collect data on comparisons between realised LGDs and the values set out in Article 3:44 and between realised conversion factors and the values set out in Article 3: A financial undertaking applying the advanced IRB approach shall also collect and store the following information: (a) complete histories of data on the facility ratings and LGD and conversion factor estimates associated with each rating scale; (b) the dates the ratings were assigned and the estimates were made; (c) the key data and methodology used to derive the facility ratings and LGD and conversion factor estimates; (d) the persons and models responsible for assigning the facility ratings and providing LGD and conversion factor estimates; (e) data on the estimated and realised LGDs and conversion factors associated with each defaulted exposure; (f) data on the LGD of the exposure before and after evaluation of the effects of a guarantee or credit derivative for those financial undertakings that reflect the credit risk mitigating effects of guarantees or credit derivatives through LGD; and (g) data on the components of loss for each defaulted exposure. Article 3:75 1. Without prejudice to the provisions of Article 3:73, the provisions of this Article shall also apply to maintaining data on exposures assigned to the class referred to in Article 71(1)(d) of the Decree. 2. A financial undertaking shall collect and store the following information: (a) data used in the process of assigning exposures to grades or pools; (b) data on the estimated PDs, LGDs and conversion factors associated with grades or pools of exposures; (c) the percentage of obligors and exposures that have defaulted; (d) for defaulted exposures, data on the grades or pools to which the exposure was assigned over the year prior to default and the realised outcomes on LGD and conversion factor; (e) data on loss rates for qualifying revolving retail exposures. Subsection Risk quantification Article 3:76 1. A financial undertaking s own estimates of the risk parameters PD, LGD, conversion factor and EL shall incorporate all relevant data, information and methods. The estimates shall be derived using both historical experience and empirical evidence and shall not be based purely on subjective considerations. The estimates shall be intuitively plausible and shall be based on the material drivers of the respective risk parameters. The less data the financial undertaking has, the more conservative it shall be in its estimation. 2. The financial undertaking shall be able to provide a breakdown of its loss experience in terms of PD, LGD and conversion factor (or loss where EL estimates are used) by the factors it sees as the drivers of the respective risk parameters. The financial undertaking shall demonstrate that its estimates are representative of long-run experience. 3. Any changes in lending practice or the process for pursuing recoveries over the observation periods referred to in this Section shall be taken into account. The financial undertaking s estimates shall reflect the implications of technical advances and new data and other 39

40 information, as soon as it becomes available. Financial undertakings shall review their estimates when new information comes to light but at least on an annual basis. 4. The population of exposures represented in the data used for estimation, the lending standards used when the data was generated and other relevant characteristics shall be comparable with those of the financial undertaking s exposures and standards. The financial undertaking shall also demonstrate that the economic or market conditions that underlie the data are relevant to current and foreseeable conditions. The number of exposures in the sample and the data period used for quantification shall be sufficient to provide the financial undertaking with confidence in the accuracy and robustness of its estimates. 5. The financial undertaking shall add to its estimates a margin of conservatism that is related to the expected range of estimation errors. 6. If the financial undertaking uses different estimates for the calculation of risk weights than those used for internal purposes, this shall be documented and their reasonableness shall be demonstrated. 7. A financial undertaking must demonstrate that for data collected prior to the date of implementation of this Regulation which is not itself consistent with the definitions of default or loss as referred to in Article 1 of the Decree, appropriate adjustments have been made to achieve broad equivalence with the definitions of default or loss. 8. If a financial undertaking uses data that is pooled across financial undertakings, it shall demonstrate that: (a) the rating systems and criteria of other financial undertakings in the pool shall be similar with its own; (b) the pool shall be representative of the portfolio for which the pooled data is used; (c) the pooled data shall be used consistently over time by the financial undertaking for its permanent estimates. 9. If the financial undertaking uses data that is pooled across financial undertakings, it shall remain responsible for the integrity of its rating systems. The financial undertaking shall demonstrate that it has sufficient in-house understanding of its rating systems including an effective ability to monitor and audit the rating process. Article 3:77 Financial undertakings that use external data that is not itself consistent with the definition of default as referred to in Article 1 of the Decree and Article 3:40 of this Regulation, shall demonstrate that appropriate adjustments have been made to achieve broad equivalence with the definition of default. Article 3:78 1. If a financial undertaking considers that a previously defaulted obligor or exposure is such that no trigger of default continues to apply, the financial undertaking shall rate the obligor or exposure as it would for a non-defaulted exposure. Should the definition of default as referred to in Article 1 of the Decree and Article 3:40 of this Regulation subsequently be triggered, another default would be deemed to have occurred. Article 3:79 1. Without prejudice to the provisions of Articles 3:76 to 3:78, the provisions of this Article shall also apply to the PD estimates for obligors of exposures assigned to the classes referred to in Article 71(1)(a) to (c) of the Decree. 2. A financial undertaking shall estimate PDs by obligor grade from long-run averages of oneyear default rates. 40

41 3. If the financial undertaking uses data on internal default experience for the estimation of PDs, it shall demonstrate in its analysis that the estimates are reflective of the underwriting standards and of any differences between the rating system that generated the data and the current rating system. Where underwriting standards or rating systems have changed, the financial undertaking shall add a greater margin of conservatism in its estimate of PD. 4. If the financial undertaking associates or maps its internal grades to the scale used by an external credit assessment institution or similar organisation and then attributes the default rate observed for the external organisation s grades to the financial undertaking s grades, the following conditions shall apply: (a) the mappings shall be based on a comparison of internal rating criteria to the criteria used by the external organisation and on a comparison of the internal and external ratings of any common obligors; (b) the external organisation s criteria underlying the data used for quantification shall be oriented to default risk only and shall not reflect transaction characteristics; (c) the financial undertaking s analysis shall include a comparison of the default definitions used, subject to the requirements set out in Article 1 of the Decree and Articles 3:40 and 3:78 of this Regulation; and (d) the financial undertaking shall document the basis for the mapping. 5. If a financial undertaking uses statistical default prediction models, it is allowed to estimate PDs as the simple average of default probability estimates for individual obligors in a given grade. The financial undertaking s use of default probability models for this purpose shall meet the standards specified in Article 3: Financial undertakings shall use PD estimation techniques only with supporting analysis, and shall recognise the importance of subjective considerations in combining results of techniques and in making adjustments for limitations of techniques and information. 7. Irrespective of whether a financial undertaking is using external, internal or pooled data sources or a combination of the three for its PD estimation, the underlying historical observation period used shall be at least five years for at least one source. If the available observation period spans a longer period of time for any source, and this data is relevant, this longer period shall be used. This paragraph also applies to the PD/LGD approach to equity. A financial undertaking applying the foundation IRB approach shall ensure that, upon implementing the IRB approach, it has relevant data at its disposal that cover a period of at least two years. The period to be covered shall increase by one year each year until the relevant data cover a period of five years. Article 3:80 1. Without prejudice to the provisions of Articles 3:76 to 3:78, the provisions of this Article shall also apply to the PD estimates for exposures assigned to the class referred to in Article 71(1)(d) of the Decree. 2. A financial undertaking shall estimate PDs by obligor grade or pool from averages of oneyear default rates. 3. Notwithstanding the provisions of paragraph 2 above, PD estimates may also be derived from realised losses and appropriate estimates of LGDs. 4. The financial undertaking shall regard internal data for assigning exposures to grades or pools as the primary source of information for estimating loss characteristics. Financial undertakings are permitted to use external data (including pooled data) or statistical models for quantification provided that a strong link can be demonstrated between: (a) the financial undertaking s process of assigning exposures to grades or pools and the process used by the external data source; (b) the financial undertaking s internal risk profile and the composition of the external data. 41

42 5. If the financial undertaking derives long-run average estimates of PD and LGD from an estimate of total losses and an appropriate estimate of PD or LGD, the process for estimating total losses shall meet the overall standards for estimation of PD and LGD set out in this Section and the outcome shall be consistent with the concept of LGD as set out in Article 3:81(2). 6. Irrespective of whether the financial undertaking is using external, internal or pooled data sources or a combination of the three for its estimation of loss characteristics, the underlying historical observation period used shall be at least five years for at least one source. If the available observation period spans a longer period of time for any source, and this data is relevant, this longer period shall be used. The financial undertaking need not give equal importance to historical data if it can demonstrate that more recent data is a better predictor of loss rates. The financial undertaking shall ensure that, upon implementing the IRB approach, it has relevant data at its disposal that cover a period of at least two years. The period to be covered shall increase by one year each year until the relevant data cover a period of five years. 7. The financial undertaking shall identify and analyse expected changes in risk parameters over the life of credit exposures (seasoning effects). Article 3:81 1. Without prejudice to the provisions of Articles 3:76 to 3:78, the provisions of this Article shall also apply to LGD estimates. 2. A financial undertaking shall estimate LGDs by facility grade or pool on the basis of the average realised LGDs by facility grade or pool using all observed defaults within the data sources: the default weighted average. 3. A financial undertaking shall use LGD estimates that take into account an economic downturn if these are more conservative than the long-run average. If a rating system is expected to deliver realised LGDs at a constant level by grade or pool over time, the financial undertaking shall make adjustments to its estimates of risk parameters by grade or pool to limit the capital adequacy impact of an economic downturn. 4. In estimating LGD, the financial undertaking shall consider the extent of any dependence between the risk of the exposure with that of the collateral or collateral provider. Cases where there is a significant degree of dependence shall be addressed in a conservative manner. 5. Currency mismatches between the underlying obligation and the collateral shall be treated conservatively in the financial undertaking s assessment of LGD. 6. If LGD estimates take into account the existence of collateral, these estimates shall not solely be based on the collateral s estimated market value. LGD estimates shall take into account the effect of the potential inability of financial undertakings to expeditiously gain control of their collateral and liquidate it. 7. If LGD estimates take into account the existence of collateral, the financial undertaking shall establish internal requirements for collateral management, legal certainty and risk management that are generally consistent with the requirements set out in Articles 4:2, 4:4 to 4:6, 4:11, 4:28 to 4:31, 4:34(b), 4:57, 4:58, 4:61, 4:62, 4:65, 4:66, 4:69, 4:72(2), 4:73(2), and 4:79 to 4: For the specific case of an exposure already in default, the financial undertaking shall use the sum of its best estimate of expected loss for that exposure given current economic circumstances and exposure status and the possibility of further unexpected losses during the liquidation period. 9. If unpaid overdue fees have been capitalised in the financial undertaking s profit and loss account, they shall be added to the financial undertaking s measure of exposure and loss. 42

43 10. Estimates of LGDs for exposures assigned to the classes referred to in Article 71(1)(a) to (c) of the Decree shall be based on data over a minimum of five years for at least one data source, increasing by one year each year after implementation until a minimum of seven years is reached. If the available observation period spans a longer period of time for any source, and the data is relevant, this longer period shall be used. 11. Estimates of LGDs for exposures assigned to the class referred to in Article 71(1)(d) of the Decree shall be based on data over a minimum of five years. The financial undertaking shall ensure that, upon implementing the IRB approach, it has relevant data at its disposal that cover a minimum of two years. The period to be covered shall increase by one year each year until the relevant data cover a period of five years. The financial undertaking need not give equal importance to historical data if it can demonstrate that more recent data is a better predictor of loss rates. 12. Notwithstanding the provisions of paragraph 2 above, LGD estimates for exposures assigned to the class referred to in Article 71(1)(d) of the Decree may be derived from realised losses and appropriate estimates of PDs. 13. Notwithstanding the provisions of Article 3:82(4), for exposures assigned to the class referred to in Article 71(1)(d) of the Decree, the financial undertaking may reflect future drawings either in its LGD estimates or in its conversion factor. 14. To the extent that the financial undertaking recognises collateral for determining the exposure value for counterparty credit risk according to Section 5.5 or Section 5.6, respectively, any amount expected to be recovered from the collateral shall not be taken into account in the LGD estimates. Article 3:82 1. Without prejudice to the provisions of Articles 3:76 to 3:78, the provisions of this Article shall also apply to estimates of conversion factors. 2. A financial undertaking shall estimate conversion factors by facility grade or pool on the basis of the average realised conversion factors by facility grade or pool using all observed defaults within the data sources: the default weighted average. 3. The financial undertaking shall use conversion factor estimates that are appropriate for an economic downturn if these are more conservative than the long-run average. If a rating system is expected to deliver realised conversion factors at a constant level by grade or pool over time, the financial undertaking shall make adjustments to its estimates of risk parameters by grade or pool to limit the capital adequacy impact of an economic downturn. 4. The conversion factors estimated by the financial undertaking shall reflect the possibility of additional drawings by the obligor up to and after the time a default event is triggered. The conversion factor estimate shall incorporate a larger margin of conservatism where a stronger positive correlation can reasonably be expected between the default frequency and the magnitude of the conversion factor. 5. In arriving at estimates of conversion factors, the financial undertaking shall consider its specific policies and strategies adopted in respect of account monitoring and payment processing. The financial undertaking shall also consider its ability and willingness to prevent further drawings in circumstances short of payment default, such as covenant violations or other technical default events. 6. The financial undertaking shall have adequate systems and procedures in place to monitor facility amounts, current outstandings against committed lines and changes in outstandings per obligor and per grade. The financial undertaking shall be able to monitor outstanding balances on a daily basis. 43

44 7. Notwithstanding the provisions of paragraph 4 above, for exposures assigned to the class referred to in Article 71(1)(d) of the Decree, the financial undertaking may reflect future drawings either in its LGD estimates or in its conversion factor. 8. The estimates of the conversion factors for exposures assigned to the classes referred to in Article 71(1)(a) to (c) of the Decree shall be based on data over a minimum of five years for at least one data source, increasing by one year each year after implementation until a minimum of seven years is reached. If the available observation period spans a longer period of time for any source, and the data is relevant, this longer period shall be used. 9. The estimates of the conversion factors for exposures assigned to the class referred to in Article 71(1)(d) of the Decree shall be based on data over a period of at least five years. The financial undertaking need not give equal importance to historical data if it can demonstrate that more recent data is a better predictor of loss rates. The financial undertaking shall ensure that, upon implementing the IRB approach, it has relevant data at its disposal that cover a minimum of two years. The period to be covered shall increase by one year each year until the relevant data cover a period of five years. Subsection Minimum requirements for assessing the effect of guarantees and credit derivatives on own estimates of PD and/or LGD Article 3:83 1. A financial undertaking shall have clearly specified criteria for the types of guarantors it recognises for the calculation of risk-weighted exposures. 2. Articles 3:69, 3:71 and 3:72 shall apply accordingly to eligible guarantors. 3. A guarantee shall be: (a) evidenced in writing; (b) non-cancellable on the part of the guarantor; (c) in force until the obligation is satisfied in full to the extent of the amount and tenor of the guarantee, and (d) legally enforceable against the guarantor in a jurisdiction where the guarantor has assets to attach and enforce a judgment. 4. Notwithstanding the provisions of subparagraph 3(d) above, guarantees prescribing conditions under which the guarantor may not be obliged to perform (conditional guarantees) may also be recognised. The financial undertaking shall demonstrate that the assignment criteria adequately address any potential reduction in the risk mitigation effect. 5. The financial undertaking shall have clearly specified criteria for adjusting grades, pools or LGD estimates and, in the case of guarantees covering exposures assigned to the class referred to in Article 71(1)(d) of the Decree, for adjusting the process of allocating exposures to grades or pools, to reflect the impact of guarantees for the calculation of risk-weighted assets. These criteria shall comply with the minimum requirements set out in Articles 3:69, 3:71 and 3: The criteria shall be plausible and intuitive and shall address: (a) the guarantor s ability and willingness to perform under the guarantee; (b) the likely timing of any payments from the guarantor; (c) the degree to which the guarantor s ability to perform under the guarantee is correlated with the obligor s ability to repay; and (d) the extent to which residual risk to the obligor remains. 7. The minimum requirements for guarantees set out in this Section shall also apply to singlename credit derivatives. In the event of a mismatch between the underlying obligation and the reference obligation of the credit derivative or the obligation used for determining whether a 44

45 credit event has occurred, the requirements set out in Article 4:87 shall apply. For exposures assigned to the class referred to in Article 71(1)(d) of the Decree, this paragraph shall apply accordingly to the process for assigning exposures to grades or pools. 8. Without prejudice to paragraphs 4 and 5 above, the criteria for the effect of credit derivatives shall address the payout structure of the credit derivative and conservatively assess the impact this has on the level and timing of recoveries. The financial undertaking shall consider the extent to which other forms of residual risk remain. Subsection Minimum requirements for purchased receivables Article 3:84 1. The structure of the facility for purchased receivables shall ensure that under all foreseeable circumstances the financial undertaking has effective ownership and control of all cash remittances from the receivables. 2. When the obligor makes payments directly to a seller or servicer, the financial undertaking shall verify regularly that payments are forwarded in full and within the contractually agreed terms. For the purposes of this Article, servicer shall mean an entity that manages a pool of purchased receivables or the underlying credit exposures on a day-to-day basis. 3. The financial undertaking shall have procedures in place to ensure that ownership of the receivables and cash receipts is protected against bankruptcy stays or legal challenges that could materially delay the lender s ability to liquidate or assign the receivables or obtain control over cash receipts. 4. The financial undertaking shall monitor both the quality of the purchased receivables and the financial condition of the seller and servicer. The financial undertaking shall, in particular: (a) assess the correlation between the quality of the purchased receivables and the financial condition of both the seller and servicer, and have in place internal policies and procedures that provide adequate safeguards to protect against such contingencies, including the assignment of an internal risk rating to each seller and servicer; (b) have clear and effective policies and procedures for determining seller and servicer eligibility. The financial undertaking shall ensure periodic reviews of sellers and servicers in order to verify the accuracy of reports from the seller or servicer, detect fraud or operational weaknesses and verify the quality of the seller s credit policies and the servicer s collection policies and procedures. The findings of these reviews shall be documented; (c) assess the characteristics of the purchased receivables pools, including over-advances, history of the seller s arrears, bad debts and bad debt provisions, payment terms and potential contra-accounts; (d) have effective policies and procedures for monitoring on an aggregate basis single-obligor concentrations both within and across purchased receivables pools; and (e) ensure that it receives from the servicer timely and sufficiently detailed reports of receivables ageings and dilutions to ensure compliance with the financial undertaking s eligibility criteria and advancing policies governing purchased receivables, and provide an effective means with which to monitor and confirm the seller s terms of sale and dilution. 5. The financial undertaking shall have systems and procedures for detecting deteriorations in the seller s financial condition and the quality of purchased receivables at an early stage and for addressing emerging problems pro-actively. In particular, the financial undertaking shall have clear and effective policies, procedures and information systems to monitor covenant violations, and clear and effective policies and procedures for initiating legal actions and dealing with problem purchased receivables. 6. The financial undertaking shall have clear and effective policies and procedures governing the control of purchased receivables, credit and cash. In particular, written internal policies 45

46 shall specify all material elements of the receivables purchase programme, including the advancing rates, eligible collateral, necessary documentation, concentration limits and the way cash receipts are to be handled. These elements shall take appropriate account of all relevant and material factors, including the seller s and servicer s financial condition, risk concentrations and trends in the quality of the purchased receivables and the seller s customer base. Internal systems shall ensure that funds are advanced only against specified supporting collateral and documentation. 7. The financial undertaking shall have an effective internal process for assessing compliance with all internal policies and procedures. The process shall include: (a) regular audits of all critical phases of the financial undertaking s receivables purchase programme; (b) verification of the segregation of duties between firstly the assessment of the seller and servicer and the assessment of the obligor, and secondly between the assessment of the seller and servicer and the field audit of the seller and servicer; (c) evaluations of back-office operations, with particular focus on qualifications, experience, staffing levels and automated support systems. Article 3:85 1. Without prejudice to the provisions of Articles 3:76 to 3:82, the requirements set out in this Article shall apply to quantifying the risk of purchased receivables. 2. The estimates for purchased receivables shall reflect all relevant information available to the financial undertaking regarding the quality of the underlying receivables, including data for similar pools provided by the seller, the purchasing financial undertaking or external sources. The financial undertaking shall evaluate any data used which is provided by the seller. 3. For purchased receivables assigned to the class referred to in Article 71(1)(c) of the Decree, instead of the PD, the financial undertaking may estimate the EL by obligor grade from longrun averages of one-year realised default rates. 4. If the financial undertaking derives average estimates of PDs and LGDs for purchased receivables assigned to the class referred to in Article 71(1)(c) of the Decree from an estimate of EL and an appropriate estimate of PD or LGD, it shall ensure that the process for estimating total losses meets the overall standards for the estimation of PD and LGD set out in this Section and that the outcome is consistent with the concept of LGD set out in Article 3:81(2). 5. Notwithstanding the provisions of Article 3:80(4), a financial undertaking may use external and internal reference data for purchased receivables assigned to the class referred to in Article 71(1)(d) of the Decree. The financial undertaking shall use all relevant data sources as points of comparison. 6. A financial undertaking may use external and internal reference data to estimate LGDs for purchased receivables assigned to the class referred to in Article 71(1)(d) of the Decree. 7. In determining the impact of guarantees or credit derivatives, Article 3:83(5), (6) and (8) shall apply accordingly to purchased receivables. Subsection Minimum requirements for the use of the internal models approach for equity exposures Article 3:86 1. In developing an internal model for calculating capital requirements for equity exposures in accordance with an internal models approach as referred to in Article 3:28, the financial undertaking shall meet the standards set out in this Article. 46

47 2. In constructing VaR models estimating potential quarterly losses, the financial undertaking may use quarterly data or convert shorter time-horizon data to a quarterly equivalent using an analytically appropriate method supported by empirical evidence and through a welldeveloped and documented thought process and analysis. Such an approach shall be applied conservatively and consistently over time. Where only limited relevant data is available, the financial undertaking shall add appropriate margins of conservatism. 3. The models used shall be able to capture adequately all the material risks embodied in equity returns including both the general market risk and the specific risk exposure of the financial undertaking s equity portfolio. This shall be demonstrated by empirical analysis. 4. The internal model shall be appropriate for the risk profile and complexity of the financial undertaking's equity portfolio. Where the financial undertaking has material positions with values that are highly non-linear in nature, the internal models shall be designed to capture appropriately the risks associated with such instruments. 5. The internal models shall adequately explain historical price variation and shall capture both the magnitude and changes in the composition of potential concentrations. 6. The estimates of the return volatility of equity exposures shall incorporate all relevant and available data, information and methods. Independently reviewed internal data or data from external sources (including pooled data) shall be used. 7. The mapping of individual positions to proxies, market indices and risk factors shall be plausible, intuitive and conceptually sound. 8. The estimate of potential loss shall be robust to adverse market movements relevant to the long-term risk profile of the financial undertaking s specific equity holdings. The data used shall be sufficient to provide conservative, statistically reliable and robust loss estimates that are not based purely on subjective considerations. The financial undertaking shall combine empirical analysis of available data with adjustments based on a variety of factors in order to attain model outputs that achieve appropriate realism and conservatism. 9. The population of exposures represented in the data used for estimation shall be closely matched to or shall at least be comparable with those of the financial undertaking s equity exposures. The data used to represent return distributions shall reflect the longest sample period for which data is available that is representative of the risk profile of the financial undertaking s specific equity exposures. Subsection Stress testing and validation of IRB systems and internal estimates Article 3:87 1. A financial undertaking shall have in place sound stress testing processes for use in the assessment of its capital adequacy. A financial undertaking shall perform stress tests on exposures in both the lending portfolio and the equity portfolio. Stress testing shall involve identifying possible events or future changes in economic conditions that could have unfavourable effects on the financial undertaking s credit risk exposures and assessment of the financial undertaking s ability to withstand such changes. If the financial undertaking uses formula 4a in Annex 3 to calculate the risk-weighted exposure amounts, it shall consider as part of its stress testing framework the impact of a deterioration in the credit quality of protection providers, in particular the impact of protection providers falling outside the eligibility criteria. 2. The financial undertaking shall regularly perform credit risk stress tests to assess the effect of certain specific conditions on its total capital requirement for credit risk. The stress test to be employed shall be relevant and reasonably conservative, considering at least the effect of a mild recession in which there is no growth for two consecutive quarters. The financial undertaking shall assess migration in its ratings under the stress test scenarios. The portfolios 47

48 subject to stress testing shall contain the vast majority of a financial undertaking's total credit risk exposures. 3. The financial undertaking shall regularly stress test its equity exposures. For exposures treated under the internal models approach as referred to in Article 3:28, the financial undertaking shall demonstrate that the simulated shock provides a conservative estimate of potential losses over a relevant long-term market or business cycle. Article 3:88 1. A financial undertaking shall have robust systems in place to validate the accuracy and consistency of rating systems and internal models, equity exposures, processes and the estimation of all relevant risk parameters. 2. The financial undertaking shall demonstrate that the internal validation process enables it to assess the performance of internal rating and risk estimation systems consistently and meaningfully. To this end, all material elements of the internal rating and risk estimation systems, the modelling process and the validation shall be documented, including the responsibilities of parties involved in the modelling, model approval and model validation processes. 3. The financial undertaking shall regularly compare realised default rates with estimated PDs for each grade and, where realised default rates are outside the expected range for that grade, the financial undertaking shall specifically analyse the reasons for the deviation. 4. If the financial undertaking uses own estimates of LGDs or conversion factors, it shall also perform an analysis for these estimates as referred to in paragraph 3 above. 5. For equity exposures, the financial undertaking shall regularly compare actual equity returns (computed using realised and unrealised gains and losses) with modelled estimates. 6. The comparisons referred to in paragraphs 3 to 5 above shall make use of historical data that cover as long a period as possible. The financial undertaking shall document the methods and data used in such comparisons. This analysis and documentation shall be updated at least annually. 7. The financial undertaking shall also use other quantitative validation tools and comparisons with relevant external data sources. Such an analysis shall be based on data that are appropriate for the portfolio, are updated regularly and cover a relevant observation period. The financial undertaking s internal assessments of the performance of its rating systems shall be based on as long a period as possible. 8. The methods and data used for quantitative validation shall be consistent over time. Changes in estimation and validation methods and data, both data sources and periods covered, shall be justified and documented. 9. The financial undertaking shall have sound internal standards for situations where deviations in realised PDs, LGDs, conversion factors and total losses where EL is used and actual equity returns, from expectations become significant enough to call the validity of the estimates into question. These standards shall take account of the economic cycle and similar systematic variability in the default experience and equity returns. Where realised values continue to be higher than expected values, the financial undertaking shall revise estimates upward to reflect their default and loss experience. All adjustments made in response to these reviews of rating systems and internal models shall be justified and documented and be consistent with the internal standards for evaluating and adjusting rating systems and internal models. Subsection Provisions on internal control and oversight of IRB systems Article 3:89 48

49 With regard to the development and use of internal ratings-based systems and models for equity exposures, the financial undertaking shall, subject to the other provisions in this Section, establish policies, procedures and controls to ensure the integrity of the rating system and modelling process. These policies, procedures and controls shall have at least the following elements: (a) full integration of the internal ratings-based systems and the internal models for equity exposures into the overall management information systems of the financial undertaking and the management of the portfolio. The internal ratings-based systems and models for equity exposures shall be fully integrated into the risk management process if they are used in particular for: the internal approval of new exposures, the measurement and assessment of portfolio performance (including the risk adjusted performance), the allocation of internal capital to exposures and the evaluation of overall capital adequacy and position management; (b) established management systems, procedures and control functions for ensuring the periodic and independent review of all elements of the internal ratings-based systems and modelling process, including the approval of revisions in the rating system or model for equity exposures, the validation of inputs and the evaluation of results, such as direct verification of risk computations. These reviews shall assess the accuracy, completeness and appropriateness of inputs and results and shall focus on both finding and limiting potential errors associated with known weaknesses and identifying unknown weaknesses in the internal system or model for equity exposures. Such reviews may be conducted by a unit within the financial undertaking that is independent from the units accountable for commercial or financial performance, or by an independent external third party; (c) adequate systems and procedures for monitoring the risk limits, based on the internal ratings-based systems and models for equity exposures; (d) the units responsible for the design and application of the rating system or model for equity exposures shall be functionally independent from the units accountable for commercial or financial performance; and (e) the parties responsible for any aspect of the rating system or modelling process shall be adequately qualified. Article 3:90 1. All material aspects of the rating and estimation processes shall be approved by the financial undertaking s board of directors or a designated committee thereof and management. These parties shall possess a general understanding of the financial undertaking s rating systems and detailed comprehension of the associated management reports. 2. Management shall notify the board of directors or a designated committee thereof of material changes in or exceptions from established policies that will materially impact the operation of the financial undertaking s rating systems. 3. The board of directors or a designated committee thereof and management shall have a good understanding of the rating systems design and operation. They shall be informed regularly, and at least twice a year, by the credit risk control unit about the performance of the rating process, areas needing improvement and the status of efforts to improve previously identified deficiencies. Management shall ensure that the rating systems are operating properly. 4. An internal ratings-based analysis of the financial undertaking's credit risk profile shall be an essential part of the management reporting to the financial undertaking s board of directors or a designated committee thereof and management. Reporting shall include at least a risk profile by grade, migration across grades, estimation of the relevant parameters per grade, and a comparison of realised default rates and own estimates of LGDs and conversion factors 49

50 against expectations and stress-test results. Reporting frequencies shall depend on the significance and type of information and the level of the recipient. 5. The supervisory board shall supervise the fulfilment of the duties of the board of directors arising from this Chapter. To this end, the supervisory board shall assess in outline the organisational structure and control mechanisms set up by the financial undertaking under the direction of the board of directors. An internal ratings-based analysis of the financial undertaking s credit risk profile shall be an essential element of management reporting to the supervisory board. The supervisory board shall be notified of material changes in or exceptions from established policies that will materially impact the operation of the financial undertaking s rating systems. 6. The credit risk control unit shall be independent from the units accountable for commercial or financial performance and shall report directly to the board of directors. The unit shall be responsible for the design or selection, implementation, oversight and technical and procedural performance of the rating systems. It shall regularly produce and analyse reports on the output of the rating systems. 7. The areas of responsibility of the credit risk control unit shall include: (a) testing and monitoring grades and pools; (b) production and analysis of summary reports from the financial undertaking s rating systems; (c) implementing procedures to verify that grade and pool definitions are applied consistently across departments and geographical areas; (d) reviewing and documenting any changes to the rating process, including the reasons for the changes; (e) reviewing the rating criteria to evaluate if they remain predictive of risk. Changes to the rating process, criteria or individual rating parameters shall be documented and updated; (f) active participation in the design or selection, implementation and validation of models used in the rating process; (g) oversight and supervision of models used in the rating process; and (h) ongoing review and alterations to models used in the rating process. 8. The financial undertaking shall use proper segregation of duties to avoid potential conflicts of interest within the credit risk control units as a result of the duties referred to in paragraph 7 above; 9. Notwithstanding the provisions of paragraph 7 above, the financial undertaking which, in accordance with the provisions of Article 3:76(8) and (9), uses pooled data, may subcontract the following duties subject to the provisions of Chapter 5 of the Decree: (a) production of information relevant to testing and monitoring grades and pools; (b) production of summary reports from the financial undertaking s rating systems; (c) production of information relevant to review of the rating criteria to evaluate if they remain predictive of risk; (d) documentation of any changes to the rating process, criteria or individual rating parameters; (e) production of information relevant to ongoing review and alterations to models used in the rating process. 10. The internal audit unit shall review at least annually the financial undertaking s rating systems and its operations, including the operations of the credit risk control unit and the estimation of PDs, LGDs, ELs and conversion factors. Areas of review shall include adherence to all applicable minimum requirements in this Regulation. 11. The internal audit unit may engage independent internal or external experts for the review referred to in paragraph 10 above. 50

51 Chapter 4 Credit risk mitigation Section 4.1 General provisions Subsection Definitions Article 4:1 In this Chapter, the following terms shall be defined as follows: (a) capital market-driven transaction: any transaction other than a repo-style transaction, giving rise to an exposure secured by collateral which includes a provision conferring upon the institution the right to receive margin frequently; (b) core market participant: (i) entities as referred to in Article 4:22(b), if the exposures to these entities receive a 0% risk weight pursuant to Subsection 2.2.1; (ii) banks and investment firms; (iii) other financial undertakings including insurance undertakings, if the exposures to these undertakings receive a 20 % risk weight pursuant to Subsection 2.2.6; (iv) other financial undertakings which do not have a credit assessment from an eligible external credit assessment institution but are internally rated pursuant to Sections 3.3 and 3.4, according to which the probability of default shall be maximally equivalent to that associated with credit quality step 2 as referred to in table A in Annex 2A; (v) regulated collective investment undertakings that are subject to capital or leverage requirements; (vi) regulated pension funds; and (vii) recognised clearing organisations. (c) independent valuer: a person who possesses the necessary qualifications, ability and experience to execute a valuation and who is independent from, and has no interest in, the credit decision process; (d) own estimates volatility adjustments method: method using volatility adjustments that are calculated on the basis of the financial undertaking s own estimates. (e) secured lending transaction: any transaction giving rise to an exposure secured by collateral which does not include a provision conferring upon the lending financial undertaking the right to receive margin frequently; (f) supervisory volatility adjustments method: method using volatility adjustments that are not determined by the financial undertaking but by the supervisory authority; (g) VaR method: method using volatility adjustments that are determined by the financial undertaking on the basis of an internal model which takes into account correlation effects between security positions subject to a master netting agreement as well as the liquidity of the instruments concerned; Subsection General provisions Article 4:2 1. If, subject to the provisions of Article 80 of the Decree, a financial undertaking takes credit risk mitigation into account for the purposes of calculating risk-weighted exposure amounts or expected loss amounts: (a) it shall have adequate risk management processes to control the risks to which it may be exposed as a result of carrying out credit risk mitigation; and (b) it shall continue to undertake full credit risk assessment of the underlying exposure. 51

52 2. In the case of repo-style transactions the underlying exposure shall, only for the purposes of subparagraph 1(b) above, be deemed to be the net amount of the exposure. Article 4:3 The provisions of Article 2:57(2) shall apply accordingly to the recognition of credit risk mitigation if the financial undertaking thereby uses credit assessments issued by an eligible external credit assessment institution. Section 4.2 On-balance sheet netting Subsection On-balance sheet netting vis-à-vis the same counterparty Article 4:4 1. Loans and deposits in the name of the same counterparty may be subject to on-balance sheet netting if a lending financial undertaking and its counterparty have signed an on-balance sheet netting agreement that complies with the minimum requirements referred to in the next two Articles. 2. On-balance sheet netting referred to in paragraph 1 above may not take place under a master netting agreement covering repo-style transactions or capital market-driven transactions to which Section 4.3 applies. 3. Only the risk-weighted exposure amounts and expected loss amounts in respect of loans and deposits of the lending financial undertaking may be changed as a result of a netting agreement. Article 4:5 Without prejudice to the provisions of Article 4:4, on-balance sheet netting agreements may only be eligible for credit risk mitigation if the following conditions of legal certainty are complied with: (a) it shall be guaranteed in the netting agreement that in the event of default, insolvency or bankruptcy, only a single net amount shall be owed by one party to the other; and (b) the lending financial undertaking shall ascertain that the netting agreement remains legally effective and enforceable in all relevant jurisdictions. Article 4:6 Without prejudice to the provisions of Article 4:4, on-balance sheet netting agreements may only be eligible for credit risk mitigation if the following conditions of risk management are complied with: (a) the lending financial undertaking shall be able to determine at any time those assets and liabilities that are subject to the netting agreement; (b) the lending financial undertaking shall monitor and control the risks associated with the termination of the credit protection; and (c) without prejudice to the provisions of Article 4:2(2), the lending financial undertaking shall monitor and control the relevant exposures on a net basis. Subsection On-balance sheet netting vis-à-vis the same customer or group Article 4:7 1. Debit and credit balances in the name of the same customer or group may be subject to 52

53 on-balance sheet netting by a lending financial undertaking if, under a separate contract of pledge, the credit balance has been formally pledged to the lending financial undertaking as security for the debit balance. 2. Notwithstanding the provisions of paragraph 1 above, the contract of pledge referred to in that paragraph shall not be required if the relationship between the financial undertaking and its counterparty is governed by general terms and conditions that already provide for such a pledge, with the proviso that the legal effectiveness of those terms and conditions shall be guaranteed. Subsection On-balance sheet netting vis-à-vis affiliated entities Article 4:8 1. Linked accounts of different customers may be subject to on-balance sheet netting by a lending financial undertaking if one of the following conditions is met: (a) under a separate contract, the credit balance shall be formally pledged to the financial undertaking as security for the debit balance; or (b) the lending financial undertaking shall be authorised fully to discharge its obligations towards the creditor at any time by assigning to the creditor its exposure to the obligor; or (c) as regards the debit and credit balances, the following conditions shall apply: (i) the debit balance shall be for the creditor s account and risk, or the creditor shall stand surety for the obligor, or the creditor and the obligor shall carry joint and several liability; and (ii) the credit balance shall be formally pledged to the obligor as security for the creditor s obligation in respect of the relevant mechanism under subparagraph (i) above. 2. Notwithstanding the provisions of subparagraph 1(b)(ii) above, no contract of pledge shall be required if the relationship between the financial undertaking and the counterparty is governed by general terms and conditions that already provide for such a pledge, with the proviso that the legal effectiveness of those terms and conditions shall be guaranteed. Subsection Calculation of the fully adjusted exposure value Article 4:9 1. A financial undertaking shall calculate the fully adjusted exposure value (E*) according to formula 1a in Annex 4A, whereby loans from, and deposits with, the lending financial undertaking that are subject to on-balance sheet netting, shall be treated as cash collateral as referred to in Section A financial undertaking applying the standardised approach shall recognise E* as the value of the exposure to the counterparty. 3. A financial undertaking applying the foundation IRB approach shall use E* to derive LGD* according to formula 2 in Annex 4A. Such financial undertaking shall continue to calculate the value of the exposure without taking into account the effects of netting. 3. In calculating E*: (a) the supervisory volatility adjustments method shall be used; (b) a ten-day liquidation period shall apply; (c) a financial undertaking shall adapt the volatility adjustment in accordance with Article 4:50, if revaluation is carried out less than daily; and (d) the provisions of Section 4.9 shall apply accordingly Section 4.3 Master netting agreements covering repo-style transactions and capital market-driven transactions 53

54 Subsection Eligibility Article 4:10 1. A financial undertaking may recognise the effects of bilateral netting contracts covering repo-style transactions and capital market-driven transactions if the financial undertaking uses the financial collateral comprehensive method referred to in Subsection 4.4.6, and if the master netting agreement complies with the minimum requirements referred to in Article 4: Without prejudice to the provisions of Article 60(2) of the Decree, the financial undertaking shall ensure that the collateral taken and the securities or commodities borrowed within the master netting agreement referred to in paragraph 1 above, comply with the eligibility requirements for collateral referred to in Subsections and Subsection Minimum requirements Article 4:11 Master netting agreements as referred to in Article 4:10 shall only be eligible for credit risk mitigation if: (a) the agreement gives the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon the event of default, including in the event of the insolvency or bankruptcy of a counterparty; (b) the agreement provides for the netting of gains and losses on transactions closed out under a master agreement so that a single net amount shall be owed by one party to the other; and (c) the financial undertaking complies with the minimum requirements for the recognition of financial collateral under the financial collateral comprehensive method referred to in Subsection Subsection Calculation of the fully adjusted exposure value Article 4:12 1. If, for the calculation of the volatility adjustment, the supervisory volatility adjustments method or the own estimates volatility adjustments method is used, a financial undertaking shall calculate the fully adjusted exposure value (E*) according to formula 3 in Annex 4A, provided that: (a) the provisions of Articles 4:41 to 4:49 apply accordingly to this calculation; and (b) any maturity mismatch as referred to in Section 4.9 is taken into account in this calculation. 2. If, for the calculation of the volatility adjustment, the VaR method referred to in Subsection is used, the financial undertaking shall calculate E* according to formula 4 in Annex 4A, provided that: (a) in this calculation, the previous business day s model output is used; and (b) in this calculation, any maturity mismatch as referred to in Section 4.9 is taken into account. 3. Financial undertakings using the standardised approach shall recognise E* as the value of the exposure to the counterparty arising from the transactions subject to the master netting agreement. 54

55 4. Financial undertakings adopting the foundation IRB approach shall deem the EAD of the transactions under the master netting agreement to be equivalent to E*. Recognition of the risk mitigating effect of the collateral shall, in this respect, not lead to any adjustment of LGD. Subsection VaR method Article 4:13 1. If for the calculation of volatility adjustments, a financial undertaking opts for the VaR method, it shall use this method for all counterparties and securities, excluding immaterial portfolios where it may use the supervisory volatility adjustments method or the own estimates volatility adjustments method subject to the provisions of Article 4: Derivative transactions shall be excluded from treatment according to the VaR method. Article 4:14 1. The VaR method shall only be available to a financial undertaking using a recognised internal VaR model. 2. The recognition referred to in paragraph 1 above may be given on the basis of a request to that effect from a financial undertaking whose internal VaR model has not been recognised earlier, whether or not under this Article. 3. Financial undertakings whose internal VaR model has been recognised earlier under Article 77 of the Decree shall be deemed to have been given the recognition as referred to in paragraph 1 above. Article 4:15 The recognition referred to in Article 4:14(1) shall only be given if the requesting financial undertaking demonstrates that its risk management system for managing the risks arising from the transactions covered by the master netting agreement is conceptually sound and implemented with integrity and that the qualitative standards referred to in Articles 4:16 to 4:20 are met. Article 4:16 1. The requesting financial undertaking shall ensure that the internal VaR model for the calculation of potential price volatility of transactions has been integrated into its daily risk management process and serves as the basis for reporting exposures and output to its senior management. 2. For the purposes of paragraph 1 above, the financial undertaking shall ensure that the internal VaR model captures a sufficient number of risk factors in order to capture all material price risks. 3. De Nederlandsche Bank may allow a financial undertaking to use empirical correlations within risk categories and across risk categories if the financial undertaking s system for measuring correlations is sound and implemented with integrity. 4. Without prejudice to paragraphs 1 to 3 above, the requesting financial undertaking shall ensure that its internal VaR model complies with the provisions of Section 5.5. Article 4:17 The financial undertaking shall have a risk control unit which: (a) shall be able to operate with a sufficient degree of independence and shall not be subject to any influence that jeopardises its operational independence; (b) shall have sufficient numbers of staff skilled in the use of sophisticated models in the 55

56 area of risk management; (c) shall be responsible for designing and implementing the financial undertaking's risk management system; and (d) shall analyse daily the output of the VaR model and, if necessary, submit proposals to senior management on the appropriate measures to be taken in terms of position limits. Article 4:18 1. The requesting financial undertaking s board of directors and senior management shall recognise risk management as an essential part of the financial undertaking s business operations, in which they shall be actively involved and for which they shall make sufficient resources available. 2. The daily reports produced by the risk control unit shall be reviewed by a level of management with sufficient authority to enforce reductions of the financial undertaking s individual positions or overall exposure. Article 4:19 1. The financial undertaking shall be able to prove that its VaR models show sufficient predictive value. The proof referred to in the first sentence of this paragraph shall be provided through back-testing of the output of the VaR models using at least one year of data. 2. The requesting financial undertaking shall frequently conduct a rigorous programme of stress testing. The results of these tests shall be reviewed by senior management and reflected in the policies and limits it sets. 3. If the output of stress testing points to a special vulnerability under certain scenarios, the requesting financial undertaking shall forthwith inform De Nederlandsche Bank and shall forthwith take steps to ensure that the relevant risks are managed adequately. Article 4:20 1. The requesting financial undertaking shall have established procedures for monitoring and ensuring compliance with a documented set of internal policies and controls concerning the overall operation of the risk measurement system; 2. As part of its regular internal auditing process, the requesting financial undertaking shall conduct an independent review of its risk measurement system. This review shall include both the activities of the business trading units and of the independent risk control unit; 3. At least once a year, the requesting financial undertaking shall conduct a review of its risk management system. Article 4:21 1. The models used in the VaR method shall provide estimates of the potential changes in value of the unsecured exposure amounts. 2. The calculation of the potential change in value shall be subject to the following minimum requirements: (a) the potential change in value shall be calculated at least daily; (b) a 99th percentile, one-tailed confidence interval shall be used; (c) the following liquidation periods shall apply: (i) at least five days or an equivalent length of time for repo-style transactions, excluding commodities lending or borrowing transactions, and (ii) ten days or an equivalent length of time for other transactions; (d) the effective historical observation period shall be at least one year except where a shorter observation period is justified by a significant upsurge in price volatility; and 56

57 (e) data sets shall be updated every three months and more frequently if market conditions so require. Section 4.4 Financial collateral eligible under the standardised approach and the foundation IRB approach Subsection Financial collateral eligible under the financial collateral simple method and the financial collateral comprehensive method Article 4:22 Subject to the provisions of Subsection 4.4.3, the following financial instruments shall be recognised as eligible collateral: (a) cash on deposit with, or cash-assimilated instruments held by, a lending financial undertaking; (b) debt securities issued by central governments or central banks which securities have a credit assessment that according to table A in Annex 2A is associated with credit quality step 4 or above; (c) debt securities issued by institutions or other entities which securities have a credit assessment that according to table A in Annex 2A is associated with credit quality step 3 or above; (d) debt securities with a short-term credit assessment that according to table A in Annex 2A is associated with credit quality step 3 or above; (e) equities or convertible bonds that are included in a main index; and (f) gold. Article 4:23 The debt securities referred to in Article 4:22(b) shall be deemed to include: (a) debt securities issued by regional governments or local authorities, if under Subsection the exposures to these public authorities are treated as exposures to the central government in whose jurisdiction they are established; (b) debt securities issued by public sector entities which under Subsection are treated as exposures to the central government; (c) debt securities issued by multilateral development banks which under Subsection are assigned a 0% risk weight; and (d) debt securities issued by international organisations which under Subsection are assigned a 0% risk weight. Article 4:24 The debt securities referred to in Article 4:22(c) shall be deemed to include: (a) debt securities issued by regional governments or local authorities, if under Subsection the exposures to these public authorities are not treated as exposures to the central government in whose jurisdiction they are established; (b) debt securities issued by public sector entities, if under Subsection the exposures to these entities are treated as exposures to financial undertakings; and (c) debt securities issued by multilateral development banks other than those to which under Subsection a 0% risk weight is applied. Article 4:25 57

58 Debt securities issued by a financial undertaking which securities do not have a credit assessment from an eligible external credit assessment institution may, subject to the provisions of Subsection 4.4.3, be recognised as eligible collateral if: (a) the debt securities are listed on a recognised exchange; (b) the debt securities qualify as senior debt; (c) the issuing financial undertaking has not issued any other debt securities of the same seniority with a credit assessment that according to table A in Annex 2A is associated with a lower credit quality step than credit quality step 3; (d) the lending financial undertaking has no information to suggest that the issue of debt securities would justify a credit assessment below that which, according to table A in Annex 2A is associated with credit quality step 3; and (e) the issuing financial undertaking is able to demonstrate that the market liquidity of the instrument is sufficient for these purposes. Article 4:26 1. Subject to the provisions of Article 4:27, units in collective investment undertakings shall be recognised as eligible collateral if: (a) the units have a daily public price quote; and (b) the collective investment undertaking invests only in instruments that are eligible for recognition under Articles 4:22 to 4: The use or potential use by a collective investment undertaking of derivative instruments to hedge permitted investments shall not prevent units in that undertaking from being recognised as eligible collateral under paragraph 1 above. Subsection Financial collateral eligible under the financial collateral comprehensive method Article 4:27 1. In addition to the collateral set out in Articles 4:22 to 4:26, the following financial instruments shall also be recognised as eligible collateral if a financial undertaking uses the financial collateral comprehensive method referred to in Subsection 4.4.3, subject to the provisions of Subsection 4.4.3: (a) equities or convertible bonds not included in a main index but traded on a recognised exchange; and (b) units in collective investment undertakings whereby, without prejudice to the provisions of Articles 4:22 to 4:26, these undertakings may also invest in the instruments set out in subparagraph (a) above. 2. The provisions of Article 4:26(2) shall apply accordingly to subparagraph 1(b) above. Subsection Minimum requirements Article 4:28 The collateral referred to in Articles 4:22 to 4:27 shall be recognised as eligible for credit risk mitigation if the conditions set out in Articles 4:29 to 4:31 are met. Article 4:29 1. The requirements for correlation are: 58

59 (a) the credit quality of the obligor and the value of the collateral shall not materially depend on the same economic factors; and (b) securities issued by the obligor or any affiliated group entity shall not be recognised as eligible collateral. 2. Notwithstanding the provisions of subparagraph 1(b) above, the obligor s own issues of covered bonds falling within the terms set out in Subsection shall be recognised as eligible collateral if these covered bonds are posted as collateral for repurchase agreements and if the condition set out in subparagraph 1(a) above is met. Article 4:30 The requirements for legal certainty are: (a) The financial undertaking shall fulfil any contractual and legal requirements in respect of, and take all steps necessary to ensure, the enforceability of the collateral arrangements under the law applicable to these arrangements; and (b) the financial undertaking shall have conducted sufficient legal review confirming the enforceability of the collateral arrangements in all relevant jurisdictions. It shall reconduct such review as necessary to ensure continuing enforceability. Article 4:31 The operational requirements are: (a) The collateral arrangements shall be properly documented, with a clear and robust procedure for the timely liquidation of collateral; (b) The financial undertaking shall employ robust procedures and processes to control risks arising from the use of collateral, including: (i) risks of failed or reduced credit protection; (ii) valuation risks; (iii) risks associated with the termination of the credit protection; (iv) concentration risk arising from the use of collateral; and (v) the interaction with the financial undertaking s overall risk profile; (c) the financial undertaking shall have documented policies and practices concerning the types and amounts of collateral accepted; (d) the financial undertaking shall calculate the market value of the collateral with a minimum frequency of once every six months, and revalue it more often whenever the financial undertaking has reason to believe that a significant decrease in its market value has occurred; and (e) where the collateral is held by a third party, the financial undertaking shall take reasonable steps to ensure that the third party segregates the collateral from its own assets. Subsection General provisions in respect of the financial collateral simple method or the financial collateral comprehensive method Article 4:32 1. The financial collateral simple method may only be used by a financial undertaking that applies the standardised approach. 2. The financial collateral comprehensive method may be used by financial undertakings applying the standardised approach and by financial undertakings applying the foundation IRB approach. 3. A financial undertaking may not use both the financial collateral simple method and the financial collateral comprehensive method. 59

60 Article 4:33 Cash, securities or commodities purchased, borrowed or received under a repo-style transaction shall be treated as financial collateral in accordance with this Section. Subsection Risk weighting to be used in the financial collateral simple method Article 4:34 A financial undertaking shall use the risk weightings set out in this Subsection, whereby: (a) the value assigned to recognised financial collateral shall be equal to its market value, with due regard to the provisions of Article 4:31(c). (b) financial collateral shall only be recognised under the financial collateral simple method if the provisions of Subsection are complied with; and (c) the residual maturity of the protection shall be at least as long as the residual maturity of the exposure. Article 4:35 1. The risk weight that would apply under the standardised approach if the lender had a direct exposure to the collateral instrument shall apply to the portion of the exposure that is secured by financial collateral. This risk weight shall be a minimum of 20% except as specified in one of the following Articles in this Subsection. 2. The risk weight that would apply under the standardised approach to an uncollateralised exposure to the counterparty shall apply to the portion of the exposure that is not secured by financial collateral. Article 4:36 1. A risk weight of 0% shall be applied to the collateralised portion of the exposure arising from a repo-style transaction other than a commodity transaction which fulfils the criteria set out in Subsection If the counterparty to the transaction referred to in paragraph 1 above is not a core market participant, a risk weight of 10% shall be applied. Article 4:37 1. A risk weight of 0% shall apply to the collateralised portion of the value determined for the derivative instruments referred to in Annex B to the Decree that are subject to daily markingto-market and are collateralised by cash or cash-assimilated instruments where there is no currency mismatch. 2. Notwithstanding the provisions of paragraph 1 above, a risk weight of 10% shall apply to derivative instruments collateralised by debt securities issued by central governments or central banks which receive a 0% risk weight under Subsection For the purposes of the first sentence of this paragraph, debt securities issued by central governments or central banks shall be deemed to include the debt securities referred to in Article 4:23(a), (c) and (d). 3. The value determined for the derivative instruments referred to in paragraph 1 above shall be the value calculated in accordance with Section 5.5. Article 4:38 1. A risk weight of 0% shall apply to the collateralised portion in the case of transactions other than those referred to in Articles 4:36 and 4:37 if: (a) the exposure and the collateral are denominated in the same currency; 60

61 (b) the collateral is in the form of: (i) cash or a cash-assimilated instrument, or (ii) debt securities issued by central governments or central banks eligible for a 0% risk weight under Subsection 2.2.1, whose market value has been discounted by 20%. 2. For the purposes of paragraph 1 above, debt securities issued by central governments or central banks shall be deemed to include the debt securities referred to in Article 4:23(a), (c) and (d). Subsection Calculation of the fully adjusted exposure value under the financial collateral comprehensive method Article 4:39 1. Financial undertakings using the supervisory volatility adjustments method as well as financial undertakings using the own estimates volatility adjustments method shall calculate, subject to the provisions of Section 4.9: (a) the fully adjusted exposure value (E*): according to formula 1a in Annex 4A; (b) the volatility-adjusted exposure value to be taken into account: according to formula 1b in Annex 4A; and (c) the volatility-adjusted value of the collateral to be taken into account: according to formula 1c in Annex 4A. 2. Notwithstanding the provisions of subparagraph 1(c) above, where the collateral consists of a number of recognised items, the volatility adjustment shall be calculated according to formula 5 in Annex 4A. 3. Without prejudice to subparagraph 1(b) above, financial undertakings using the standardised approach shall calculate the exposure value in respect of off-balance sheet items as referred to in Annex 2D, as 100% of the value instead of the percentages of the exposure value set out in Article 61(2)(a) to (d) of the Decree. 4. Without prejudice to subparagraph 1(b) above, financial undertakings using the foundation IRB approach shall calculate the exposure value referred to in Articles 3:58 and 3:59 by using a conversion factor of 100% rather than the conversion factors or percentages indicated in the latter Articles. Article 4:40 1. If E* is calculated in the manner as set out in Article 4:39, E* shall be taken as the exposure value for the purposes of the standardised approach. 2. Notwithstanding the provisions of paragraph 1 above, in respect of off-balance sheet items as referred to in Annex 2D, E* shall be taken as the increased exposure value referred to in Article 61(2)(b) to (d) of the Decree. 3. For the purposes of the foundation IRB approach: (a) E* shall be used to derive LGD*; (b) LGD* calculated according to formula 2 in Annex 4A, shall be taken as LGD; and (c) financial undertakings shall continue to calculate the exposure value without taking the effects of the presence of any collateral into account. Article 4:41 1. A financial undertaking using the supervisory volatility adjustments method shall apply volatility adjustments to the market value of financial collateral and exposures as referred to in Articles 4:42 and 4: A financial undertaking using the own estimates volatility adjustments method shall apply 61

62 volatility adjustments to the market value of financial collateral and exposures as referred to in Articles 4:44 to 4: Where collateral is denominated in a currency that differs from that in which the underlying exposure is denominated, an adjustment reflecting currency volatility shall be added to the volatility adjustment referred to in paragraphs 1 and 2 above. 4. Notwithstanding the provisions of paragraph 3 above, even if multiple currencies are involved in the transactions, only a single volatility adjustment shall be applied in the case of OTC derivatives transactions covered by netting agreements recognised under Section 5.5, where there is a mismatch between the collateral currency and the settlement currency. Article 4:42 1. A financial undertaking using the supervisory volatility adjustments method shall apply the volatility adjustments set out in tables 1 to 4 in Annex 4B, provided that in accordance with the provisions of Subsection the volatility adjustments is adjusted if the frequency of the revaluation is less than daily. 2. For securities or commodities lent or sold under repo-style transactions or securities or commodities lending or borrowing transactions, which securities or commodities are not eligible under the provisions of Subsections and 4.4.2, the volatility adjustment shall be the same as for non-main index equities listed on a recognised exchange. 3. For eligible units in collective investment undertakings, the weighted average volatility adjustment shall apply which, having regard to the liquidation period as specified in Article 4:43, would apply to any of the assets in which the fund has invested. If the assets in which the fund has invested are not known to the financial undertaking, the volatility adjustment shall be the highest volatility adjustment that would apply to any of the assets in which the fund has the right to invest. 4. For unrated debt securities issued by a financial undertaking and satisfying the eligibility criteria set out in Article 4:25, the volatility adjustments shall be the same as for securities issued by a financial undertaking or corporate with an external credit assessment that according to table A in Annex 2A is associated with credit quality steps 2 or 3. Article 4:43 For the purposes of Article 4:42, the following shall apply: (a) for secured lending transactions: a liquidation period of twenty business days; (b) for repo-style transactions except where such transactions involve the transfer of commodities or guaranteed rights relating to title to commodities: a liquidation period of five business days; and (c) for capital market-driven and repo-style transactions which involve the transfer of commodities or guaranteed rights relating to title to commodities: a liquidation period of ten business days. Article 4:44 1. A financial undertaking complying with the quantitative requirements set out in Articles 4:45 to 4:47 and the qualitative requirements set out in Article 4:48 may use its own estimates for calculating the volatility adjustments to be applied to collateral and exposures. 2. For the purposes of paragraph 1 above, the financial undertaking shall estimate the volatility of the collateral or the currency mismatch without taking into account any correlations between the unsecured exposure, the collateral and the exchange rate. 3. Debt securities having a credit assessment from an eligible external credit assessment institution equivalent to investment grade may be divided by the financial undertaking into categories, whereby the financial undertaking shall take into account the type of issuer of the 62

63 debt securities, the external credit assessment of the debt securities, their residual maturity, and their modified duration. 4. For all debt securities within a category as referred to in paragraph 3 above, the financial undertaking may calculate a combined volatility estimate, provided that this volatility estimate is representative of the debt securities included in that category. 5. For debt securities having a credit assessment from an eligible external credit assessment institution equivalent to below investment grade, and for other eligible collateral, the financial undertaking shall calculate the volatility adjustments for each individual item. Article 4:45 1. In calculating the volatility adjustments, the financial undertaking shall use a 99th percentile, one-tailed confidence interval. 2. A financial undertaking shall adapt the volatility adjustment in accordance with the provisions of Subsection if the frequency of the revaluation is less than daily. 3. A financial undertaking shall calculate the volatility adjustments at least every three months and more frequently if market conditions so require. Article 4:46 1. Volatility adjustments shall be calculated on the basis of the liquidation periods as referred to in Article 4: A financial undertaking shall convert the volatility adjustments calculated according to shorter or longer liquidation periods by scaling them up or down to the liquidation period referred to in paragraph 1 above for the type of transaction concerned, using formula 6 in Annex 4A. 3. The financial undertaking shall adjust upwards the liquidation period referred to in paragraph 1 above in cases where there is doubt concerning the liquidity of the collateral. 4. The financial undertaking shall also identify possible cases where historical data may understate future volatility. In such cases, the financial undertaking shall subject the volatility estimate to stress scenarios. Article 4:47 1. The historical observation period for calculating volatility adjustments shall have a minimum length of one year. 2. For a financial undertaking using a weighting scheme or other methods than the historical observation period referred to in paragraph 1 above, the effective observation period shall be at least one year, that is the weighted average time lag of the individual observations shall not be less than six months. 3. De Nederlandsche Bank may require a financial undertaking to calculate its volatility adjustments using a shorter observation period if, in the opinion of De Nederlandsche Bank, this is justified by a significant upsurge in price volatility. Article 4:48 1. A financial undertaking shall use the volatility estimates in its day-to-day risk management process including its internal exposure limits. 2. A financial undertaking shall have established procedures for monitoring and ensuring compliance with a documented set of internal policies and controls to operate its system for the estimation of volatility adjustments and for the integration of such estimations into its risk management process. 3. As part of the internal process referred to in paragraph 2 above, an independent review of the financial undertaking s system for the estimation of volatility adjustments 63

64 and for the integration of these adjustments into the financial undertaking s risk management process shall be carried out regularly, but at least once a year. Such review shall specifically address, at a minimum: (a) the integration of estimated volatility adjustments into daily risk management; (b) the validation of any significant changes in the procedure for the estimation of volatility adjustments; (c) the verification of the consistency, timeliness, reliability and independence of data sources used to run the system for the estimation of volatility adjustments; and (d) the accuracy and appropriateness of the volatility assumptions. Article 4:49 A financial undertaking using the own estimates volatility adjustments method shall use this method for the full range of instrument types. Notwithstanding the first sentence of this Article, a financial undertaking using the own estimates volatility adjustments method may also use the supervisory volatility adjustments method for immaterial portfolios. Subsection Revaluations where the frequency is less than daily Article 4:50 A financial undertaking calculating the volatility adjustments on the basis of the supervisory volatility adjustments method or the own estimates volatility adjustments method, shall use formula 7 in Annex 4A to scale up the volatility adjustments based on daily revaluation, if the frequency of revaluation is less than daily. Subsection Application of a 0% volatility adjustment Article 4:51 1. In relation to repo-style transactions other than commodities transactions, a financial undertaking using the supervisory volatility adjustments method or the own estimates volatility adjustments method may apply a 0% volatility adjustment instead of calculating the volatility adjustments according to Articles 4:42 to 4:50 if the conditions of this Subsection are met. 2. If in another Member State a 0% volatility adjustment as referred to in paragraph 1 above applies to a repo-style transaction involving securities issued by the domestic government of that Member State, a financial undertaking may also apply the same 0% volatility adjustment to a similar transaction. 3. The provisions of paragraphs 1 and 2 above do not apply to financial undertakings using the VaR method referred to in Subsection Article 4:52 For the purposes of Article 4:51(1), the following conditions shall apply to the exposure and the collateral: (a) both the exposure and the collateral shall be cash or debt securities issued by central governments or central banks in accordance with Articles 4:22(1)(b) and 4:23 and shall be eligible for a 0% risk weight under the standardised approach; and (b) the exposure and the collateral shall be denominated in the same currency. Article 4:53 For the purposes of Article 4:51(1), the following conditions shall apply to the transaction: 64

65 (a) the maturity of the transaction shall be no more than one day, unless both the exposure and the collateral are subject to daily marking-to-market or daily remargining; (b) the time between the last marking-to-market before any failure to remargin by the counterparty and the liquidation of the collateral shall be no more than four business days; (c) the transaction shall be settled through an adequate settlement system appropriate for that type of transaction; and (d) the counterparty shall be a core market participant. Article 4:54 For the purposes of Article 4:51(1), the following conditions shall apply to the documentation: (a) the documentation covering the agreement shall be standard market documentation for repurchase transactions or securities lending or borrowing transactions in the securities concerned; and (b) the transaction shall be governed by documentation specifying that if the counterparty fails to satisfy any obligation arising from the agreement, including at any rate the obligation to transfer cash or securities or to deliver margin, then the exposure shall be immediately payable. Section 4.5 Additional eligibility of collateral under the foundation IRB approach Subsection General Article 4:55 In addition to the collateral set out in Subsections and 4.4.2, the collateral set out in Subsections to shall also be eligible if a financial undertaking calculates riskweighted exposure amounts and expected loss amounts in accordance with the foundation IRB approach, provided that the provisions of the latter Subsections are complied with. Subsection Eligibility and other requirements with respect to real estate collateral Article 4:56 1. Residential real estate which is or will be occupied or let by the owner, or in the case of personal investment companies by the beneficial owner, and commercial real estate shall, subject to the provisions of Articles 4:57 and 4:58, be recognised as eligible collateral if: (a) the value of the property does not materially depend upon the credit quality of the obligor; and (b) the risk on the borrower does not materially depend upon the performance of the underlying property or project, but rather on the underlying capacity of the borrower to repay the debt from other sources, whereby repayment of the facility as such shall not materially depend on any cash flow generated by the underlying property serving as collateral. 2. Shares in Finnish residential housing companies operating in accordance with the Finnish Housing Company Act of 1991 or subsequent equivalent legislation in respect of residential property which is or will be occupied or let by the owner, shall be recognised as eligible residential real estate collateral, provided that the provisions of subparagraph 1(a) and (b) above are met. 3. Upon its request in writing, a financial undertaking may be permitted to recognise commercial real estate which does not meet the requirements of subparagraph 1(b) above, as eligible collateral in the Netherlands if the said real estate has been recognised by a 65

66 supervisory authority of a Member State of the European Union as eligible collateral in that Member State, provided that: (a) the commercial real estate is situated within the territory of that other Member State; (b) all conditions set by the supervisory authority in that other Member State are met; and (c) the other conditions referred to in Part 1, point 17 of Annex VIII to the recast Banking Directive for waiving the requirement set out in subparagraph 1(b) above are met. Article 4:57 1. Real estate collateral as referred to in Article 4:56 shall only be recognised if: (a) the financial undertaking has explicitly documented the types of residential and commercial real estate it takes as protection and its lending policies in this regard; (b) the financial undertaking has procedures to monitor that the property taken as protection is adequately insured against damage; (c) the mortgage is valid in law, legally enforceable in all jurisdictions that are relevant at the time of the conclusion of the loan agreement, and is properly filed on a timely basis; and (d) The mortgage agreement enables the financial undertaking to realise the value of the collateral within a reasonable timeframe. 2. Without prejudice to paragraph 1 above, the financial undertaking regularly reviews compliance by the counterparty of its obligations in respect of loan covenants, collateral arrangements and other legal requirements. Article 4:58 1. For the purposes of Article 4:57, the value of the property shall be monitored at a minimum once every year for commercial real estate and once every three years for residential real estate. More frequent monitoring shall be carried out where the market is subject to significant changes in conditions. The indexation method referred to in Section 1.2 may be used to monitor the value of the property and to identify property that needs revaluation. 2. When the loan exceeds 3 million or represents more than 5% of the financial undertaking s own funds, the property valuation shall be reviewed by an independent valuer at least every three years. 3. When information indicates that the value of the property may have declined materially relative to general market prices, the property valuation shall be reviewed by an independent valuer. 4. In other instances than those set out in paragraphs 2 and 3 above, the valuation of the property shall be reviewed by the financial undertaking at least once every year or once every three years, in accordance with paragraph 1 above. Article 4:59 1. For the valuation of real estate collateral, the property shall be valued by an independent valuer at or less than the market value. 2. The value of the collateral shall be the market value reduced as appropriate to reflect the results of the monitoring required under Articles 4:57 and 4:58 and to take account of any prior claims on the property. Subsection Eligibility and other requirements with respect to collateral in the form of receivables Article 4:60 1. Amounts receivable linked to commercial transactions or transactions with an original maturity of less than or equal to one year shall be recognised as eligible collateral, subject 66

67 to the provisions of Articles 4:61 and 4: Non-eligible receivables shall be: (a) receivables associated with securitisations, sub-participations or credit derivatives, and (b) receivables owed by affiliated parties, including receivables owed by affiliates of the borrower, which shall include at any rate subsidiaries, affiliated corporate entities and employees. Article 4:61 Receivables as referred to in Article 4:60 shall only be eligible for credit risk mitigation if the following conditions of legal certainty are met: (a) the legal mechanism by which the collateral is provided shall be robust and effective and shall ensure that the lender has distinct rights over the proceeds; (b) the financial undertaking shall have conducted sufficient legal review confirming the enforceability of the collateral arrangements referred to in subparagraph (a) in all relevant jurisdictions; (c) subject to the legal rights of preferential creditors, the financial undertaking shall take all steps necessary to ensure that the lender has a first priority claim over the collateral; (d) the collateral arrangements shall be adequately documented, with a clear and robust procedure for the realisation of collateral within a reasonable timeframe and according to the applicable legal requirements; and (e) if the borrower is in default or may reasonably be expected to be in default in the short term, the financial undertaking shall have legal authority to sell or assign the receivables to other parties without the consent of the borrower s counterparty in respect of the receivables concerned. Article 4:62 Receivables as referred to in Article 4:60 shall only be eligible for credit risk mitigation if the following conditions of risk management are met: (a) the financial undertaking shall have a sound process for determining the credit risk associated with the receivables, which shall at any rate include analyses of the borrower s business and industry and the types of customers with whom the borrower does business; (b) a margin shall be observed between the amount of the exposure and the value of the receivables. This margin shall reflect all appropriate factors, including at any rate: (i) the cost of collection; (ii) any concentration within the receivables pool pledged by an individual borrower; and (iii) the potential concentration risk within the financial undertaking s total exposures beyond that controlled by the financial undertaking s general methodology; (c) the financial undertaking shall maintain a continuous risk monitoring process appropriate for the receivables; (d) the compliance with loan covenants and other legal requirements and restrictions shall be reviewed on a regular basis; (e) the receivables pledged by a borrower shall be diversified and their value shall not materially depend on the same economic factors as the credit quality of the borrower; (f) the financial undertaking shall have documented procedures for collecting receivable payments in distressed situations and shall have the requisite facilities for collection in place, even if there are no reasons to assume that the financial undertaking will proceed to collection instead of the borrower; 2. Notwithstanding the provisions of subparagraph 1(a) above, the financial undertaking shall review the borrower s credit practices to ascertain their soundness and credibility if it relies on the borrower to ascertain the credit risk associated with the receivables; 67

68 3. Notwithstanding the provisions of subparagraph 1(e) above, where the value of the receivables materially depends on the same economic factors as the credit quality of the borrower, the attendant risks shall be taken into account in the setting of margins for the collateral pool as a whole. Article 4:63 The value of the receivables shall be equal to the amount receivable. Subsection Eligibility and other requirements with respect to other physical collateral Article 4:64 Physical collateral of a type other than that indicated in Article 4:56 shall be recognised as eligible collateral if the provisions of Articles 4:65 and 4:66 as well as the following conditions are met: (a) there shall be liquid markets for trading the collateral referred to in the preamble of this Article in an expeditious and economically efficient manner; and (b) there shall be well-established, public market prices for the collateral referred to in the preamble of this Article, and the financial undertaking shall be able to demonstrate that the net prices it receives when collateral is realised do not deviate significantly from these market prices. Article 4:65 Physical collateral as referred to Article 4:64 shall only be eligible for credit risk mitigation if the following legal certainty requirements are met: (a) the collateral arrangement shall ensure that the financial undertaking may realise the value of the property within a reasonable timeframe; (b) subject to the preferential rights referred to in Article 4:61(b), the financial undertaking shall have priority over all other lenders to the realised proceeds of the collateral. Article 4:66 Physical collateral as referred to in Article 4:64 shall only be eligible for credit risk mitigation if the following risk management requirements are met: (a) the loan agreement shall include detailed descriptions of the collateral plus detailed specifications of the manner and frequency of revaluation; (b) the value of the property shall be monitored at least once every year and more frequently where the market is subject to significant changes in conditions. (c) both initial valuation and revaluation shall take into account any deterioration or obsolescence of the collateral whereby particular attention shall be paid to the effects of the passage of time on fashion- or date-sensitive collateral; (d) under the agreement, the financial undertaking shall have the right to physically inspect the property taken as protection, and to monitor that this property is adequately insured against damage. For the exercise of this right, the financial undertaking shall have the appropriate policies and procedures in place; (e) the financial undertaking shall have clearly documented internal credit policies and procedures that determine the type and amount of physical collateral that shall be considered appropriate for a given exposure amount; and (f) the financial undertaking s credit policies shall address appropriate collateral requirements 68

69 relative to the exposure amount, the ability to liquidate the collateral readily, the ability and the timeframe to establish objectively a price or market value, and the volatility or a proxy of the volatility of the value of the collateral. Article 4:67 The physical collateral as referred to in Article 4:64 shall be valued at market value. Subsection Eligibility and other requirements with respect to collateral in the form of property leased Article 4:68 Without prejudice to the provisions of Article 4:69, exposures arising from transactions whereby a financial undertaking leases property to a third party shall be treated in the same manner as loans collateralised by the said type of property leased. Article 4:69 Exposures as referred to in Article 4:68 shall only be treated as collateralised if: (a) the conditions set out in Articles 4:57 and 4:58 or Articles 4:65 and 4:66, as appropriate, are met; (b) there is robust risk management on the part of the lessor with respect to the use, the age and planned obsolescence of the leased asset, including appropriate monitoring of the value of the collateral; (c) there is in place a robust legal framework establishing the lessor s legal ownership of the asset and the lessor s ability to exercise its rights as owner; and (d) where this has not already been ascertained in calculating the LGD level, the difference between the value of the amortisation component of the outstanding lease payments and the market value of the collateral must not be so large as to overstate the credit risk mitigation attributed to the leased assets. Subsection Calculation of risk-weighted exposure amounts and expected loss amounts with respect to additional eligibility of collateral under the foundation IRB approach Article 4:70 1. The value of LGD* shall be taken as the value of LGD for the purposes of the foundation IRB approach, provided that LGD* is calculated in the manner as provided for in this Article. 2. For the purposes of paragraph 1 above, depending on the ratio of the value of the collateral to the exposure value, the value of LGD* shall be (a) the value that applies under the IRB to uncollateralised exposures to the counterparty, if the ratio referred to in the preamble of this paragraph is below the threshold level C* referred to in table 5 in Annex 4B; or (b) the value specified in table 5 in Annex 4B for the collateral posted as security for the relevant exposures, if the ratio referred to in the preamble of this paragraph exceeds the threshold level C** referred to in table 5 in Annex 4B. 3. If the ratio referred to in paragraph 2 above lies between C* and C**, the exposure shall be considered to be two exposures, a portion that is collateralised and a portion that is uncollateralised. For the uncollateralised portion, the value of LGD* shall be the value referred to in subparagraph 2(a) above. For the collateralised portion, the value of LGD* shall be the value referred to in subparagraph 2(b) above. 69

70 Article 4:71 For the purposes of Article 4:70, the provisions of Section 4.9 shall apply accordingly. Section 4.6 Other funded credit protection Subsection Cash on deposit with third party financial undertakings Article 4:72 1. Cash on deposit with, or cash assimilated instruments held by, a third party financial undertaking in a non-custodial arrangement and pledged to the lending financial undertaking shall, subject to the provisions of paragraph 2 below, be recognised as eligible credit protection. 2. The credit protection provided by cash or cash assimilated instruments referred to in paragraph 1 above shall be eligible for the treatment referred to in paragraph 3 below, if: (a) the borrower s claim against the third party financial undertaking is openly, unconditionally and irrevocably pledged or assigned to the lending financial undertaking; (b) the pledge or assignment is legally effective and enforceable in all relevant jurisdictions; (c) the third party financial undertaking is notified of the pledge or assignment; and (d) as a result of the notification referred to in subparagraph (c), the third party financial undertaking is able to make payments solely to the lending financial undertaking or to other parties with the lending financial undertaking s consent. 3. Deposits with third party financial undertakings as referred to in paragraph 1 above may be treated as a guarantee by the third party financial undertaking, in accordance with the provisions of Article 4:93. The provisions of Article 4:79 shall apply accordingly to the deposits referred to in the first sentence of this paragraph. Subsection Life insurance policies pledged to the lending financial undertaking Article 4:73 1. Life insurance policies pledged to the lending financial undertaking shall be recognised as eligible credit protection up to the surrender value of the life insurance policy, if: (a) the company providing the life insurance is recognised as an eligible unfunded protection provider in accordance with Subsection 4.7.1; (b) the life insurance policy is openly pledged or assigned to the lending financial undertaking and the pledge or the assignment is legally effective and enforceable in all jurisdictions that are relevant at the time of the conclusion of the loan agreement ; (c) the company providing the life insurance is notified of the pledge or assignment and as a result may not pay amounts payable under the policy without the consent of the lending financial undertaking; (d) the declared surrender value is non-reducible; (e) the lending financial undertaking has the right to cancel the policy and receive the surrender value in a timely manner in the event of the default of the borrower; (f) the lending financial undertaking is informed of any non-payments under the policy by the policy-holder; and (g) the credit protection is provided for the maturity of the loan, or the amount deriving from the insurance contract serves the financial undertaking as security until the end of the duration of the loan agreement. 70

71 3. Life insurance policies pledged to lending financial undertakings as referred to in paragraph 1 above shall be treated as a guarantee by the company providing the life insurance, in accordance with the provisions of Article 4:93. The provisions of Article 4:80 shall apply accordingly to the life insurance policies referred in the first sentence of this paragraph. Subsection Instruments issued by financial undertakings that are repurchased on request Article 4:74 1. Instruments issued by third party financial undertakings which will be repurchased by that financial undertaking on request shall be recognised as eligible credit protection subject to the provisions of paragraph 2 below. 2. The credit protection provided by instruments issued by a third party financial undertaking referred to in paragraph 1 above shall be eligible for the treatment referred to in paragraph 3 below, if: (a) the issuing financial undertaking has a credit assessment that according to table A in Annex 2A is associated with credit quality step 1 for exposures to financial undertakings; and (b) the financial undertaking is able to demonstrate that the instruments are liquid. 3. Instruments of financial undertakings repurchased on request as referred to paragraph 1 above shall be treated as a guarantee by the issuing financial undertaking, in accordance with the provisions of Article 4:91. The provisions of Article 4:81 shall apply accordingly to the instruments referred to in the first sentence of this paragraph. 4. The value of the eligible credit protection referred to in paragraph 1 above shall be the following: (a) where the instrument is to be repurchased at its face value, the value of the protection shall be that face value; (b) where the instrument is to be repurchased at market price, the value of the protection shall be the value of the instrument calculated in the same way as the debt securities specified in Article 4:25. Section 4.7 Unfunded credit protection (guarantees and credit derivatives) Subsection Eligibility of protection providers under all approaches Article 4:75 1. The following parties shall be recognised as eligible providers of unfunded credit protection: (a) central governments and central banks; (b) regional governments and local authorities; (c) multilateral development banks; (d) international organisations, provided that the exposures to these organisations receive a 0% risk weight under the standardised approach; (e) public sector entities, provided that under the standardised approach the exposures to these entities are treated as exposures to financial undertakings or the central government; (f) financial undertakings; and (g) other entities, including parent, subsidiary and affiliated corporate entities of the financial undertaking, which (i) have a credit assessment from an eligible external credit assessment institution that according to table A in Annex 2A is associated with credit quality step 2 or above; or 71

72 (ii) do not have a credit assessment from an eligible external credit assessment institution, but are internally rated by a financial undertaking calculating the risk-weighted exposure amounts and expected loss amounts according to the foundation IRB approach. 2. The internal rating referred to in subparagraph 1(g)(ii) above shall only be applied for the purposes of this Article if this rating has a probability of default equivalent to that associated with a credit assessment from an eligible external credit assessment institution that according to table A in Annex 2A is associated with credit quality step 2 or above. 3. Where a financial undertaking calculates risk-weighted exposure amounts and expected loss amounts under the foundation IRB approach, to be eligible a guarantor must be internally rated by the financial undertaking. Subsection a Eligibility of unfunded credit protection providers for which the double default treatment under the IRB is allowed Article 4:76 1. Financial undertakings, insurance undertakings, reinsurance undertakings and export credit agencies may be recognised as eligible unfunded credit protection providers which under the IRB approach are eligible for the treatment referred to in Article 3:20(1), if: (a) the protection provider has sufficient expertise in providing unfunded credit protection; (b) the protection provider is regulated in a manner equivalent to the rules laid down in the recast Banking Directive or had, at the time the credit protection was provided, a credit assessment by an eligible external credit assessment institution that according to table A in Annex 2A is associated with credit quality step 3 or above; (c) the protection provider had, at the time the credit protection was provided, or for any period of time thereafter, an internal rating with a probability of default equivalent to the probability of default related to a credit assessment that according to table A in Annex 2A is associated with credit quality step 2 or above; and (d) the protection provider has an internal rating with a probability of default equivalent to the probability of default related to a credit assessment that according to table A in Annex 2A is associated with credit quality step 3 or above. 2. Credit protection provided by an export credit agency which is explicitly counterguaranteed by a central government shall not be eligible for the treatment referred to in Article 3:20(1). Subsection Eligible types of credit derivatives Article 4:77 1. The following types of credit derivatives, and instruments that are composed of such credit derivatives or that are economically effectively similar, shall be recognised as eligible credit protection, subject to the requirements set out in Articles 4:79, 4:80 and 4:84 to 4:87: (a) credit default swaps; (b) total return swaps; and (c) credit-linked notes to the extent of their cash funding. 2. Where a financial undertaking buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record the offsetting deterioration in the value of the asset that is protected, the credit protection shall not be recognised. Subsection Internal hedges 72

73 Article 4:78 1. When a financial undertaking conducts an internal hedge using a credit derivative, this derivative shall only be recognised as credit protection if the credit risk transferred to the trading book is transferred out to a third party. 2. If the provisions of paragraph 1 above are fulfilled and the transfer referred to in paragraph 1 above complies with the requirements for the recognition of credit risk mitigation set out in this Chapter, the provisions of Subsection shall apply accordingly to the acquisition of unfunded credit protection. 3. The financial undertaking shall ensure that data concerning internal hedges as referred to in paragraph 1 above, and related positions in the trading book are verifiable for supervisory and audit purposes. Subsection Minimum requirements Article 4:79 1. Without prejudice to the provisions of Articles 4:81 to 4:87, credit protection deriving from a guarantee or credit derivative shall only be recognised if: (a) the credit protection is direct; (b) the extent of the credit protection is clearly defined and incontrovertible; and (c) the credit protection contract shall not contain any clause, the fulfilment of which is outside the direct control of the lending financial undertaking and which: (i) would allow the protection provider unilaterally to cancel the protection; (ii) would increase the effective cost of protection as a result of deteriorating credit quality of the protected exposure; (iii) could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make any payments due; or (iv) could allow the maturity of the credit protection to be reduced by the protection provider. 2. Without prejudice to the provisions of paragraph 1 above, the following conditions shall also apply: (a) the financial undertaking shall have systems in place to manage the potential concentration of risk arising from the use of guarantees or credit derivatives; and (b) the financial undertaking shall be able to demonstrate how its strategy in respect of the use of guarantees and credit derivatives interacts with its company-wide risk management processes. Article 4:80 1. The provision to pay out in a timely manner as referred to in Article 4:79(1)(c)(iii) shall only apply if: (a) in the case of guarantees: a lending financial undertaking can call forthwith on the guarantor, unless the provisions of Article 4:82(2) and (3) apply; (b) in the case of credit derivatives with cash settlement: a lending financial undertaking has a predefined maximum period for loss determination (obtaining post credit event quotes), which period is in line with market standards. Article 4:81 1. A guarantee which is counter-guaranteed by a central government, a central bank, a regional government or local authority, or a public sector entity may be recognised as a direct guarantee provided by the entities concerned, if: (a) the exposure to these public authorities is treated under the standardised approach as 73

74 exposures to the central government in whose jurisdiction they are established, as exposures to a multilateral development bank to which a 0% risk weight is applied or as exposures to a public sector entity, exposures to which are treated as exposures to financial undertakings; (b) the counter-guarantee covers all credit risk elements of the underlying exposure; (c) both the original guarantee and the counter-guarantee meet the requirements set out in Articles 4:79 and 4:82(1), except that the counter-guarantee need not be direct; and (d) the cover is robust and nothing in the historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct guarantee by the entity concerned. 2. For the purposes of paragraph 1 above, an exposure which is counter-guaranteed by another entity than the entities listed in that paragraph shall also be eligible for treatment as a guarantee, if that exposure s counter-guarantee is in turn directly guaranteed by one of the listed entities and the conditions set out in subparagraphs 1(a) to (d) above are complied with. Article 4:82 1. A guarantee as referred to in Article 4:79(1) or as referred to in Article 4:81(1) shall be subject to the following additional requirements: (a) in the event of a qualifying default or non-payment by the counterparty, the lending financial undertaking shall have the right to payment in a timely manner, as referred to in Article 4:80, by the guarantor of any monies due under the exposure in respect of which protection has been provided, irrespective of whether the lending financial undertaking has pursued the obligor for such payment; (b) the guarantee shall be an explicitly documented obligation assumed by the guarantor; and (c) the guarantee shall cover all types of payments the obligor is expected to make in respect of the exposure. 2. For the purposes of paragraph 1 above, in the case of unfunded credit protection covering residential mortgage loans, the financial undertaking shall have a maximum period of 24 months to comply with the provisions of subparagraph 1(a) above and the provisions of Article 4:79(1)(c)(iii). 3. If the provisions of subparagraph 1(c) are not complied with, the guarantee value to be recognised shall be adjusted in such a way as to reflect the limited coverage. Article 4:83 1. In the case of guarantees which are issued by mutual guarantee schemes recognised for these purposes by De Nederlandsche Bank of which are issued or counter-guaranteed by the entities referred to in Article 4:81(1), it shall be assumed that the provisions of Article 4:82(1)(a) have been complied with, if: (a) the lending financial undertaking has the right to obtain in a timely manner a provisional payment by the guarantor which is reasonably proportionate to the amount of the economic loss likely to be incurred by the lending financial undertaking and the coverage provided by the guarantee; or (b) the lending financial undertaking demonstrates that the guarantee provides protection against economic losses. 2. For the purposes of paragraph 1 above, economic loss shall be understood to include: losses resulting from non-payment of interest and other types of payment which the borrower is obliged to make. Article 4:84 Without prejudice to the provisions of Article 4:79, for a credit derivative as referred to in Article 4:79(1) to be recognised, the additional requirements referred to in Articles 4:85 74

75 to 4:87 shall be met. Article 4:85 1. The credit events specified under the credit derivative as referred to in Article 4:79(1), shall at a minimum include: (a) the failure to pay the amounts due under the terms of the underlying obligation that are in effect at the time of such failure, provided that the grace period is closely in line with or shorter than the grace period in the underlying obligation; (b) the bankruptcy, insolvency or inability of the obligor to pay its debts, the obligor s admission in writing of its inability generally to pay its debts, or the obligor s failure to pay and analogous events; and (c) the restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event, i.e. a value adjustment or other similar debit to the profit and loss account. 2. If restructurings as referred to in subparagraph 1(c) above are not included in the credit events specified under the credit derivative, the credit protection may, notwithstanding the provisions of paragraph 1 above, nonetheless be recognised subject to a reduction in the recognised value in accordance with the provisions of Article 4:92(1). Article 4:86 1. The identity of the parties responsible for determining whether a credit event as referred to in Article 4:85(1) has occurred shall be clearly defined in the credit protection contract, whereby the protection buyer shall at least have the contractual right and the effective ability to inform the protection provider of the occurrence of a credit event. 2. In the case of credit derivatives allowing for cash settlement, a robust valuation process shall be in place in order to estimate loss reliably and obtain post-credit-event valuations of the underlying obligation within the period referred to in Article 4: If the protection buyer s contractual right and effective ability to transfer the underlying obligation to the protection provider are an essential requisite for settlement, the underlying obligation shall specify the grounds on which the counterparty to the underlying obligation may withhold its consent to such transfer. Article 4:87 A mismatch between the underlying obligation and the reference obligation or a mismatch between the underlying obligation and the obligation used for the purposes of determining whether a credit event has occurred is permissible only if: (a) the reference obligation or the obligation used for the purposes of determining whether a credit event has occurred, as the case may be, ranks pari passu with or is junior to the underlying obligation; and (b) the underlying obligation and the reference obligation or the obligation used for the purposes of determining whether a credit event has occurred, as the case may be, share the same obligor and there are in place legally enforceable cross-default or cross-acceleration clauses. Article 4:88 To qualify for the treatment referred to in Article 3:20(1), credit protection by a guarantee or a credit derivative must comply with the following conditions: (a) the underlying obligation shall be: (i) an exposure to a financial undertaking, excluding an insurance undertaking or a reinsurance undertaking; 75

76 (ii) an exposure to a regional government, local authority or a public sector entity, which is not treated as an exposure to a central government or a central bank; or (iii) an exposure to a small or medium sized entity, which is classified as a retail exposure. (b) the underlying obligors shall not be entities affiliated with the protection provider; (c) the exposure shall be secured by one of the following instruments: (i) single-name unfunded credit derivatives or single-name guarantees; (ii) first-to-default basket products, subject to the provisions of Article 4:89(1); (iii) nth-to-default basket products, subject to the provisions of Article 4:89(2), if eligible (n- 1)th default protection has also been obtained or if (n-1) of the assets within the basket has/have already defaulted, and if the same treatment is applied to the asset within the basket with the lowest risk-weighted exposure amount; (d) the credit protection shall meet the requirements set out in Articles 4:79, 4:83, 4:85 and 4:87; (e) the risk weight that is assigned to the underlying exposure prior to the treatment referred to in the preamble of this Article, shall not already factor in any aspect of the credit protection; (f)(i) the financial undertaking shall have the right and may reasonably expect to receive payment from the protection provider without having to take legal action to pursue the counterparty to the underlying exposure for payment; (ii) to the extent possible, the financial undertaking shall take steps to satisfy itself that the protection provider is willing to pay promptly should a credit event occur; (g) the purchased credit protection shall absorb all credit losses incurred on the secured portion of the exposure that arise due to the occurrence of credit events outlined in the contract. (h)(i) if the payout structure provides for physical settlement, there shall be legal certainty with respect to the deliverability of a loan, bond, or contingent liability; (ii) if a financial undertaking intends to deliver an obligation other than the underlying exposure, it shall ensure that the deliverable obligation is sufficiently liquid so that the financial undertaking would have the ability to purchase it for delivery in accordance with the contract; (i) the terms and conditions of credit protection arrangements shall be legally confirmed in writing by both the protection provider and the financial undertaking; (j) the financial undertaking shall have a process in place to detect excessive correlations between the creditworthiness of a protection provider and the counterparty to the underlying exposure due to their performance being dependent on similar factors other than systemic risk; and (k) if protection is provided against the dilution risk of purchased receivables, the protection provider shall not be an entity affiliated with the seller of the purchased receivables concerned. Article 4:89 1. In the case of an exposure secured by a first-to-default basket product as referred to in Article 4:88(b)(ii), the treatment referred to in Article 3:20(1) may be applied to the asset within the basket with the lowest risk-weighted exposure amount. 2 In the case of an exposure secured by a (n-1)-to-default basket product as referred to in Article 4:88(c)(iii), the treatment referred to in Article 3:20(1) may be applied to the asset within the basket with the lowest risk-weighted exposure amount. Subsection Calculation of risk-weighted exposure amounts and expected loss amounts 76

77 Article 4:90 Cash-funded credit-linked notes issued by the lending financial undertaking and meeting the requirements for credit derivatives as referred to in Section 4.7.4, shall be treated as cash collateral in accordance with the provisions of Section 4.4. Article 4:91 1. When a financial undertaking transfers a portion of the risk of an exposure, subdivided into one or more tranches each with a different risk profile, to a protection seller, the provisions of Chapter 6 shall apply accordingly. 2. Materiality thresholds on payments below which no payment is made in the event of loss shall be considered to be equivalent to retained first loss positions and to give rise to a tranched transfer of risk. Article 4:92 1. For the purposes of Article 4:85(2), a lending financial undertaking shall adjust the value of the credit protection using the method as set out in paragraph 2 below. 2. The value of unfunded credit protection (G), being the amount that the protection provider has undertaken to pay on the occurrence of a credit event as referred to in Article 4:85(1), shall be calculated in accordance with the provisions of Article 4:93, subject to the following: (a) if the amount the protection provider has undertaken to pay does not exceed the exposure value, the value of the credit protection shall be reduced by 40%; or (b) if the amount the protection provider has undertaken to pay is higher than the exposure value, the value of the credit protection shall be no higher than 60% of the exposure value. Article 4:93 1. A lending financial undertaking shall calculate the fully adjusted value of the credit protection (G*) in accordance with formula 8 in Annex 4A, provided that: (a) the volatility adjustments to be applied for any currency mismatch may be calculated based on the supervisory volatility adjustments approach or the own estimates volatility adjustments approach as set out in Subsections and 4.4.7; and (b) for the purposes of this Article, the provisions of Section 4.9 apply accordingly. 2. A lending financial undertaking applying the standardised approach shall assign the risk weight of the protection provider to the secured portion of the exposure. The risk weight of the obligor shall be assigned to the unsecured portion of the exposure. 3. A lending financial undertaking applying the foundation IRB approach shall use: (a) for the secured portion of the exposure, based on the adjusted value of the credit protection: the PD of the guarantor, or a PD between that of the borrower and that of the guarantor if a full substitution is deemed not to be warranted; (b) in the case of subordinated exposures with non-subordinated protection: the LGD to be applied to senior claims; and (c) for any unsecured portion of the exposure: the PD of the borrower and the LGD of the underlying exposure. 4. Where the protected amount is less than the exposure value and the secured and unsecured portions are of equal seniority so that the financial undertaking and the protection provider share any losses on a pro rata basis, the risk weight shall be calculated in accordance with formula 9 in Annex 4A for financial undertakings using the standardised approach. 5. The provisions of paragraph 1 above shall apply accordingly to the calculation of LGD by a lending financial undertaking using the foundation IRB approach. Article 4:94 77

78 The treatment referred to in Article 2:5 shall apply accordingly to exposures or portions of exposures guaranteed by the central government or central bank, if the guarantee is denominated in the domestic currency of the borrower and the exposure is funded in that currency. Section 4.8 Basket techniques for credit risk mitigation Subsection First-to-default credit derivatives Article 4:95 1. Credit protection may be combined for a number of exposures if the first default among the exposures by itself triggers payment under the contract and this credit event terminates the contract. The financial undertaking shall modify the calculation of the risk-weighted exposure amount and, as relevant, the expected loss amount of the exposure which would, in the absence of credit protection, have the lowest risk weight. 2. Credit protection may only be recognised if the value of the credit protection is higher than or equal to the value of the exposure that is subject to the modified calculation as referred to in paragraph 1 above. Subsection Nth-to-default credit derivatives Article 4:96 1. In the case where the nth default among the exposures triggers payment under the credit protection, the financial undertaking purchasing the protection may only recognise the protection for the calculation of risk-weighted exposure amounts and, as relevant, expected loss amounts if protection has also been obtained for defaults 1 to n-1 or when n-1 defaults have already occurred. 2. For the purposes of paragraph 1 above, the provisions of Article 4:95 shall apply accordingly. Section 4.9 Maturity mismatches Subsection General Article 4:97 1. Where, for the purposes of calculating risk-weighted exposure amounts, a maturity mismatch occurs because the residual maturity of the credit protection is less than that of the protected exposure, credit protection shall not be recognised if: (a) the original maturity of the protection is less than one year, (b) the exposure is a receivable as referred to in Article 3:46(2), or (c) the residual maturity of the protection is less than three months and the maturity of the underlying exposure exceeds that of the protection. Subsection Determination of effective maturity Article 4:98 1. The effective maturity of the underlying exposure shall be the longest possible period before the obligor is scheduled to meet its full obligations under the contract, on the understanding that for the calculation of the maturity mismatch this period shall be a maximum of five years. 78

79 2. The maturity of the protection shall be taken to be the following: (a) where the protection provider has the option to terminate the protection before contractual maturity: the time to the earliest date at which that option may be exercised; (b) where the protection buyer has the option to terminate the protection before contractual maturity and the terms of the arrangement at origination of the protection contain a positive incentive for the financial undertaking to terminate the transaction before contractual maturity: the time to the earliest date at which that option may be exercised; (c) in other cases: the time to the earliest date at which the protection may terminate, or be terminated before contractual maturity. 3. Where protection by a credit derivative may be terminated prior to expiration of any grace period and the expiration of this grace period is required for a credit event to occur as a result of a failure to pay, the maturity of the protection referred to in paragraph 2 above shall be reduced by the grace period. Subsection Valuation of protection Article 4:99 1. Where the financial collateral simple method is used for transactions subject to funded credit protection, the collateral shall not be recognised if there is a mismatch between the maturity of the exposure and the maturity of the protection. 2. Where the financial collateral comprehensive method is used for transactions subject to funded credit protection, the maturity of the credit protection and that of the exposure shall be reflected in the adjusted value of the collateral according to formula 10 in Annex 4A. 3. For transactions subject to unfunded credit protection, the maturity of the credit protection and that of the exposure shall be reflected in the adjusted value of the credit protection according to formula 11 in Annex 4A. Section 4.10 Combination of different forms of credit risk mitigation Subsection Treatment by financial undertakings using the standardised approach Article 4: Where a financial undertaking calculating risk-weighted exposure amounts under the standardised approach has more than one form of credit risk mitigation covering a single exposure, the financial undertaking shall subdivide the exposure into the corresponding portions and shall calculate the risk-weighted exposure amount for each portion separately in accordance with the provisions of Chapter 2 and this Chapter. 2. The provisions of paragraph 1 above shall apply accordingly if the credit protection provided by a single protection provider has differing maturities. Subsection Treatment by financial undertakings using the foundation IRB approach Article 4: Where risk-weighted exposure amounts and expected loss amounts are calculated under the foundation IRB approach, and an exposure is collateralised by both financial collateral and other eligible collateral, the LGD*, being the effective loss given default, which is to be taken 79

80 as the LGD for the purposes of the foundation IRB approach, shall be calculated as set out in paragraphs 2 and 3 below. 2. The financial undertaking shall be required to subdivide the volatility-adjusted value of the exposure into portions each covered by only one type of collateral. 3. For the purposes of paragraph 2 above, the financial undertaking shall divide the exposure, as relevant, into: (a) a portion covered by eligible financial collateral, (b) a portion covered by receivables, (c) a portion covered by commercial real estate collateral or residential real estate collateral, (d) a portion covered by other eligible collateral, or (e) an unsecured portion. 4. The LGD* for each portion of exposure shall be calculated separately in accordance with the relevant provisions of this Chapter. Chapter 5 Counterparty credit risk Section 5.1 General provisions Subsection Definitions Article 5:1 In this Chapter, the following terms shall be defined as follows: (a) actual distribution: a distribution of market values or exposures at a future time period where the distribution is calculated using historical or realised values; (b) central counterparty: an entity that acts as intermediary as referred to in Section 425 of Volume 7 of the Dutch Civil Code (Burgerlijk Wetboek), for both the buyer and the seller with respect to contracts traded within one or more financial markets; (c) counterparty credit risk or CCR: the risk that the counterparty to a transaction could default before the final settlement of the transaction s cash flows; (d) credit valuation adjustment : an adjustment to the mid-market valuation of a portfolio of transactions with a counterparty; (e) cross-product netting: the inclusion of transactions of different product categories within the same netting set pursuant to the rules set out in Section 5.7 for cross-product netting; (f) current exposure: the market value of the transaction or portfolio of transactions within a netting set that would be lost upon the default of the counterparty, assuming no verification is possible in bankruptcy; (g) current market value: net market value, viz. net of all positive and negative market values, of the portfolio of transactions within the netting set with the counterparty; (h) distribution of exposures: the forecast of the probability distribution of market values that is generated by setting forecast instances of negative net market values equal to zero; (i) distribution of market values: the forecast of the probability distribution of net market values of transactions within a netting set for some future date (the forecasting horizon), given the realised market value of those transactions up to the day on which the forecast is made; (j) effective EE (effective expected exposure): the expected value of an exposure at a specific date or the effective value of that exposure at an earlier date, if the latter value is greater; (k) effective EPE (effective expected positive exposure): the weighted average over time of the effective expected exposures over the first year, from the calculation date, or, if all the 80

81 contracts within the netting set mature within that year, over the time period of the longest maturity contract in the netting set, where the weights are the proportion that an individual expected exposure represents of the entire time interval; (l) effective maturity under the internal model method, for a netting set with maturity greater than one year: the ratio resulting from the calculation set out in Annex 5.3; (m) expected exposure (EE): the average of the distribution of exposures at any particular future date before the longest maturity transaction in the netting set matures; (n) expected positive exposure (EPE): the weighted average over time of expected exposures, where the weights are the proportion that an individual expected exposure represents of the entire time interval; (o) general wrong-way risk: the risk that arises when the probability of default (PD) of the counterparty or counterparties is positively correlated with general market risk factors; (p) hedging set: a group of risk positions from the transactions within a single netting set for which only the balance is relevant for determining the exposure value under the Standardised Method referred to in Section 5.5; (q) long settlement transaction: transaction where a counterparty of the financial undertaking undertakes to deliver a security, a commodity, or a foreign exchange amount against cash, other financial instruments or commodities, or vice versa, at a settlement or delivery date that is later than usual as per the market standard for this particular transaction type, or at a settlement or delivery date of more than five business days after the transaction date, whether or not the latter date is the market standard; (r) margin agreement: a contractual agreement or provisions of an agreement under which one counterparty shall supply enforceable collateral to a second counterparty when an exposure of that second counterparty to the first counterparty exceeds a specified level; (s) margin lending transactions: lending transactions in which a financial undertaking extends credit in connection with the purchase, sale, carrying or trading of securities; (t) margin period of risk: the time period from the last exchange of collateral covering a netting set of transactions with a defaulting counterparty until that counterparty is closed out and the resulting market risk is re-hedged; (u) margin threshold: the largest amount of an exposure that remains outstanding until one party has the right to call for enforceable collateral; (v) netting set : a group of transactions for which netting as referred to in Section 127 of Volume 6 of the Dutch Civil Code (Burgerlijk Wetboek) is possible, and which netting is recognised under Chapter 4 and Section 5.7 of this Regulation; (w) one-sided credit valuation adjustment: a credit valuation adjustment that reflects the market value of the credit risk of the counterparty, but does not reflect the market value of the credit risk of the financial undertaking carrying out the adjustment; (x) payment leg: the payment in exchange for a financial instrument or the payment in exchange for another payment, on the contractual basis of an OTC derivative transaction with a linear risk profile; (y) peak exposure: a high percentile of the distribution of exposures at any particular future date before the maturity date of the longest transaction in the netting set; (z) risk-neutral distribution: a distribution of market values or exposures at a future time period where the distribution is calculated using market implied values; (aa) risk position: a risk number that is assigned to a transaction under the Standardised Method referred to in Section 5.5 following a predetermined algorithm; (bb) roll-over risk: the additional exposure that is generated by future transactions and that is equal to the amount by which the expected positive exposure is understated when future transactions are expected to be conducted on an ongoing basis; and (cc) specific wrong-way risk : the risk that arises when the exposure to a particular 81

82 counterparty is positively correlated with the probability of default (PD) of that counterparty due to the nature of the transactions with that counterparty. Section 5.2 General provisions on the calculation of CCR exposure Subsection Choice of method Article 5:2 1. Subject to the provisions of this Section, a financial undertaking shall determine the exposure value for the derivative financial instruments as referred to in Annex B of the Decree, using one of the methods set out in Sections 5.3 to A financial undertaking that does not meet the conditions set out in Article 62(1) of the Decree or Section 1.2 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico), as appropriate, shall be excluded from the use of the method referred to in Section The method referred to in Section 5.4 may not be used for the determination of the exposure value arising from the derivative instruments as referred to in Annex B, point 3 of the Decree. 4. The combined use of the methods referred to in Sections 5.3 to 5.6 may be permitted within a group as referred to in Section 24b of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek), provided that such combined use is carried out on a permanent basis. Such combined use shall not be possible for the individual legal entities that form part of the group. 5. Notwithstanding the provisions of paragraph 4 above, the combined use of the methods referred to in Sections 5.3 and 5.5 may be permitted to the legal entities that form part of the group referred to in Section 24b of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek), where at least one of these methods is used for the application of Article 5:18. Subsection Use of internal model method Article 5:3 Subject to prior consent of De Nederlandsche Bank, a financial undertaking may use the internal model method set out in Section 5.6 for the determination of the exposure value for: (a) contracts involving derivative financial instruments referred to Annex B of the Decree; (b) repurchase transactions; (c) securities or commodities lending or borrowing transactions; (d) margin lending transactions; and (e) long settlement transactions. Subsection Calculation of capital requirements in case of protection via a credit derivative Article 5:4 1. A financial undertaking which purchases credit derivative protection against a non-trading book exposure or against a counterparty credit risk (CCR) exposure may calculate the capital requirement for the hedged asset in accordance with the provisions of Articles 4:91 to 4:93. 2 Subject to prior consent of De Nederlandsche Bank, a financial undertaking may, notwithstanding the provisions of paragraph 1 above, calculate the capital requirement referred to in that paragraph in accordance with the provisions of Article 3:20(1), second sentence and Article 3:83, and it shall set the exposure value for CCR to zero. 82

83 Subsection Exposure value Article 5:5 1. The exposure value for CCR from sold credit default swaps in the non-trading book shall be set to zero, if these swaps are treated as credit protection provided by the financial undertaking and are subject to a capital requirement for credit risk for the full notional amount of the credit protection. 2. Irrespective of the method used, the exposure value for a given counterparty shall at any rate be equal to the sum of the exposure values calculated for each netting set with that counterparty. 3. Subject to the condition that the financial undertaking shall fully collateralise on a daily basis the central counterparty CCR exposures with all participants in its arrangements, for credit risk exposures to central counterparties a CCR exposure value of zero may be attributed to: (a) derivative contracts or repurchase transactions; (b) securities or commodities lending or borrowing transactions; (c) long settlement transactions and margin lending transactions outstanding with a central counterparty and not rejected by that central counterparty; (d) credit risk exposures to central counterparties which result from one of the contracts or transactions set out in subparagraphs (a) to (c) above or from contracts or transactions to be designated by De Nederlandsche Bank; 4. Exposures arising from long settlement transactions may be determined using any of the methods referred to in Sections 5.3 to 5.6, regardless of the method chosen for treating OTC derivatives and repurchase transactions, securities or commodities lending or borrowing transactions, and margin lending transactions. 5. In calculating the capital requirement for long settlement transactions, financial undertakings that use the IRB approach referred to in Chapter 3, may assign the risk weights referred to in Section 2.2 on a permanent basis and irrespective of the materiality of such exposures. 6. The result of the methods referred to in Sections 5.3 and 5.4 may only be used if the notional amount of that result is in real proportion to the risk inherent in the contract. If the condition in the first sentence is not met, the notional amount shall be adjusted to take into account the increased risk resulting from the risk structure of the contract. Section 5.3 Mark-to-market method Article 5:6 1. Under the mark-to-market method, the exposure value per item shall be calculated as the sum of the positive current replacement cost per item and the potential future credit exposure. 2. The current replacement cost shall be determined on the basis of the current market value of contracts with positive values. 3. The value of potential future credit exposure shall be based, regardless of whether the current replacement cost is positive or negative, on the total of the notional principal amounts or on the underlying values, as appropriate, multiplied by the percentages given in table 1 in Annex 5A. 4. If prior approval has been obtained from De Nederlandsche Bank, a financial undertaking may, instead of the percentages given in table 1 in Annex 5A, apply the percentages given in table 2 in Annex 5A for the purposes of calculating the potential future credit exposure in contracts relating to commodities and precious metals other than gold, provided that for calculating the exposure risk in these commodities or precious metals the financial 83

84 undertaking uses the maturity band method referred to in Article 3:40 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). 5. In the case of single-currency floating interest rate swaps, the replacement cost of these swaps may be used to calculate the exposure value instead of the calculation method referred to in paragraph 1 above. Section 5.4 Original exposure method Article 5:7 1. A financial undertaking which, subject to the provisions of Article 5:2, uses the original exposure method, shall multiply the notional principal amounts or the underlying values, as appropriate, of the derivative financial instruments referred to in Annex B to the Decree, by the percentages given in table 1 below that correspond with their nature and maturity. Table 1 Original maturity Interest rate contracts Contracts concerning foreign exchange rates and gold One year or less 0.5% 2.0% Over one year, not 1.0% 5.0% exceeding two years Additional allowance for each additional year 1.0% 3.0% 2. Upon application of the table in paragraph 1 above, the financial undertaking may use residual maturity instead of original maturity in the case of interest rate contracts. Section 5.5 Standardised method Subsection Scope of standardised method Article 5:8 The standardised method shall be used only for traded OTC derivatives and for long settlement transactions, not for securities and commodities financing transactions. Subsection Calculation of exposure value Article 5:9 1. Under the standardised method, the exposure value of the item shall be calculated separately for each netting set. 2. The exposure value, net of collateral, shall be calculated using formula 1 in Annex 5B. 3. For the purposes of the standardised method, only the collateral as referred to in Article 4:27 of this Regulation or Article 3:32 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico), as appropriate, shall be recognised. Subsection Transactions with a linear risk profile 84

85 Article 5:10 1. For the purposes of the calculations set out in the subparagraphs below, a financial undertaking may: (a) disregard the interest rate risk from payment legs with a remaining maturity of less than one year; and (b) treat transactions that consist of two payment legs that are denominated in the same currency, as a single aggregate transaction. The treatment for payment legs applies to the aggregate transaction. 2. Transactions with a linear risk profile, in which equities (including equity indices), gold, other precious metals or other commodities are the underlying financial instruments, shall be mapped to a risk position in the respective underlying financial instrument, precious metal or commodity, and to an interest rate risk position for the payment leg. If the payment leg is denominated in a foreign currency, this payment leg shall additionally be mapped to a risk position in the respective currency. 3. Transactions with a linear risk profile, in which a debt instrument is the underlying instrument, shall be mapped to an interest rate risk position for the debt instrument and to another interest rate risk position for the payment leg. 4. If the underlying debt instrument referred to in paragraph 3 above is denominated in a foreign currency, the debt instrument shall be mapped to a risk position in the respective currency. If the payment leg is denominated in a foreign currency, it shall, without prejudice to paragraph 3 above, also be mapped to a risk position in the respective currency. 5. Transactions with a linear risk profile that stipulate the exchange of payment against payment, shall be mapped to an interest rate risk position for each of the two payment legs. This applies also to forward exchange transactions. 6. If a payment leg is denominated in a foreign currency, that payment leg shall also be included in the calculation of the financial undertaking s proprietary position in the respective currency, such according to the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). 7. The exposure value assigned to a foreign exchange basis swap transaction shall be zero. Subsection Size of risk position Article 5:11 1. Except for debt instruments, the size of a risk position from a transaction with a linear risk profile shall be equal to the effective notional value in euro of the underlying financial instruments, including commodities. 2.For debt instruments and for payment legs, the size of the risk position shall be equal to the effective notional value in euro of the outstanding gross payments (including the notional amount), multiplied by the modified duration of the debt instrument, or payment leg, respectively. 3. The size of a risk position from a credit default swap shall be the notional value of the reference debt instrument multiplied by the remaining maturity of the credit default swap. 4. The size of a risk position from an OTC derivative with a non-linear risk profile (including options and swaptions) shall be equal to the delta equivalent of the effective notional value of the financial instrument that underlies the transaction, except in the case of an underlying debt instrument. 5. The size of a risk position from an OTC derivative with a non-linear risk profile (including options and swaptions), of which the underlying value is a debt instrument or a payment leg, 85

86 shall be equal to the delta equivalent of the effective notional value of the financial instrument or payment leg multiplied by the modified duration of the debt instrument or payment leg, respectively. Subsection Treatment of collateral Article 5:12 1. For the determination of risk positions, collateral received from a counterparty shall be treated as a claim on that counterparty under a derivative contract (long position) that is due on the day of receipt, while collateral posted shall be treated as an obligation to the counterparty (short position) that is due on the day of issue. Subsection Calculation and formulas used Article 5:13 A financial undertaking may use formula 2 set out in Annex 5B to determine the size and sign of a risk position Article 5:14 The risk positions are to be grouped into hedging sets. For each hedging set, the net risk position being the absolute value amount of the sum of the resulting risk positions shall be computed and represented as set out in formula 1 in Annex 5B. Article 5:15 1. Interest rate risk positions from money deposits received from a counterparty as collateral from payment legs and underlying debt instruments, to which according to Article 3:9(3)(d) of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) a maximum capital requirement of 1.6 % applies, shall be grouped into six hedging sets for each currency, as set out in table 1 in Annex 5B. 2. Hedging sets shall be defined by a combination of the criteria "maturity" and "reference interest rates". 3. For interest rate risk positions from underlying debt instruments or payment legs for which the interest rate is linked to a reference interest rate that represents a general market interest level, the remaining maturity shall be the length of the time interval up to the next readjustment of the interest rate. In all other cases, the remaining maturity shall be the remaining life of the underlying debt instrument or, in the case of a payment leg, the remaining life of the transaction. 4. There shall be one hedging set for each issuer of a reference debt instrument that underlies a credit default swap. 5. Interest rate risk positions from money deposits that are posted with a counterparty as collateral shall be grouped into one hedging set for each issuer, unless the counterparty has debt obligations of low specific risk outstanding from underlying debt instruments, to which according to Article 3:9(3)(d) of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) a capital requirement of more than 1.6 % applies. When a payment leg emulates a debt instrument as referred to in the previous sentence of this paragraph, there shall also be one hedging set for each issuer of the reference debt instrument. 6. Risk positions that arise from debt instruments of a certain issuer, or from reference debt instruments of the same issuer that are emulated by payment legs, or that underlie a credit default swap, may be assigned to the same hedging set. 86

87 Article 5:16 1. Underlying financial instruments other than debt instruments shall be assigned to the same respective hedging sets only if they are identical or similar instruments. In all other cases they shall be assigned to separate hedging sets. 2. Similar instruments as referred to in paragraph 1 above shall be, in respect of: (a) equities: instruments issued by the same issuer; (b) equity indices: instruments that are treated by index as if they were issued by a separate issuer; (c) precious metals: instruments of the same metal; (d) an index for precious metals: shall be treated as a separate precious metal; (e) electric power: delivery rights and obligations that refer to the same peak or off-peak load time interval within any 24-hour interval; (f) commodities: instruments in the same commodity; and (g) a commodity index: shall be treated as a separate commodity. Article 5:17 The financial undertaking shall use CCR multipliers (CCRMs) for the different hedging set categories in accordance with the percentages set out in table 2 in Annex 5B. Article 5:18 1. If the financial undertaking cannot determine the delta for transactions with a non-linear risk profile, or the modified duration for debt instruments or payment legs as the underlying value, with the aid of a model that De Nederlandsche Bank has approved for the purposes of determining the minimum capital requirements for counterparty credit risk, the size of the risk positions and the applicable CCRMs shall be determined conservatively and used after prior consent from De Nederlandsche Bank. 2. In cases other than those referred to in paragraph 1 above, De Nederlandsche Bank may require the use of the method set out in Section 5.3, that is, the exposure value shall be determined as if there were a netting set that comprises just the individual transaction. Subsection Requirements with respect to internal procedures Article 5:19 A financial undertaking shall have internal procedures to verify that, prior to including a transaction in a hedging set, the transaction is covered by a legally enforceable netting contract that meets the requirements set out in Section 5.6. Article 5:20 A financial undertaking that makes use of collateral to mitigate its CCR shall have internal procedures to verify that, prior to recognising the effect of collateral in its calculations, the collateral meets the legal certainty standards set out in Articles 4:5, 4:30, 4:61 and 4:65. Section 5.6 Internal model method (IMM) Subsection General provisions Article 5:21 1. A financial undertaking may use the internal model method only if it meets the conditions set out in this Section and if it has obtained prior consent from De Nederlandsche Bank. 87

88 2. The internal model method may be used to calculate the exposure value for the transactions referred to in Article 5:3(a) to (d). In the calculation referred to in the previous sentence, the financial undertaking may also include the transactions set out in Article 5:3(e). Subsection Scope of regulation Article 5:22 1. Notwithstanding the provisions of Article 5:2(1), a financial undertaking may choose not to apply the internal model method to exposures that are immaterial in size and risk. 2. Notwithstanding the provisions of Article 5:2(5), the combined use of the internal model method and one of the methods set out in Sections 5.3 and 5.5 shall, with prior consent of De Nederlandsche Bank, be permitted for immaterial exposures referred to in paragraph 1 above by an individual legal entity within a group as referred to in Section 24B of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek). Subsection Phased implementation Article 5:23 If prior consent has been obtained from De Nederlandsche Bank, a financial undertaking may implement the internal model method sequentially across the different product categories. Without prejudice to the provisions of Article 5:22(2), a financial undertaking may, until this phased roll-out is completed, use the method set out in Section 5.3, or Section 5.5, as appropriate, for the calculation of its other exposure values. Article 5:24 1. A financial undertaking that has obtained permission to use the internal model method shall not revert to the use of the method set out in Section 5.3, or Section 5.5, as appropriate, unless it has obtained permission from De Nederlandsche Bank. 2. If a financial undertaking ceases to comply with the requirements set out in this Section, it shall either present to De Nederlandsche Bank a plan for a timely return to compliance or demonstrate that the effect of non-compliance is immaterial. Subsection Exposure value Article 5:25 1. When the internal model method is used, the exposure value shall be measured, at the level of the netting set, as follows: (a) the model shall specify the forecasting distribution for changes in the market value of the netting set attributable to changes in market variables; and (b) the model shall then calculate the exposure value for the netting set at each future date given the changes in the market variables. 2. For the purposes of subparagraph 1(a) above, the financial undertaking may include eligible financial collateral as referred to in Article 4:27 of this Regulation, or Article 3:32 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling Solvabiliteitseisen voor het marktrisico), as appropriate, in its forecasting distribution, if the quantitative, qualitative and data requirements for the internal model method are met for the collateral. For margined counterparties, a financial undertaking may also capture future collateral movements. 88

89 3. After application of paragraphs 1 and 2 above, the exposure value shall be calculated in accordance with Annex 5C as the product of alpha and effective EPE. Subsection Own estimate of alpha Article 5:26 Notwithstanding the provisions of Article 5:25(3), a financial undertaking may, with prior consent of De Nederlandsche Bank, use its own estimates of alpha in its internal model, provided that: (a) alpha is at least 1.2 and equals the ratio of internal capital from a full simulation of CCR exposure across counterparties (numerator) and internal capital based on EPE (denominator); (b) the figure included in the denominator is determined as if EPE were a fixed outstanding amount; (c) in the numerator, account is taken of material sources of stochastic dependency of distribution of market values of transactions or of portfolios of transactions across counterparties; and (d) account is taken of the granularity of portfolios. Article 5:27 1. For the purposes of Article 5:26, a financial undertaking shall, in its internal model, use an approach to ensure that the numerator and denominator of alpha are calculated in a consistent fashion with respect to the modelling methodology, parameter specifications and portfolio composition. This approach shall be based on the financial undertaking s internal capital approach, be well-documented and also be subject to independent validation. 2. The validation referred to in the second sentence of paragraph 1 above shall take place at least every three months, and more frequently when the composition of the portfolio referred to in the first sentence of paragraph 1 above varies over time. For the purposes of prudential control by De Nederlandsche Bank, the validation referred to in the second sentence of paragraph 1 above shall also comprise an assessment of the model risk. 3. Where appropriate, volatilities and correlations of market risk factors used in the joint simulation of market and credit risk, shall be conditioned on the credit risk factor to reflect potential increases in volatility or correlation in an economic downturn. Subsection Treatment of margin agreement Article 5:28 1. If the netting set is subject to a margin agreement, a financial undertaking shall, in its internal model, use one of the following EPE measures: (a) Effective EPE without taking into account the margin agreement; or (b) the EPE threshold, if positive, under the margin agreement plus an add-on that reflects the potential increase in exposure over the margin period of risk. 2. The add-on referred to in subparagraph 1(b) above shall be calculated as the expected increase in the netting set s exposure beginning from a current exposure of zero over the margin period of risk. This computation shall be based on: (a) a margin period of risk of at least five business days for netting sets consisting only of repo-style transactions subject to daily remargining and daily marking-to-market; or (b) a margin period of risk of ten business days for all other netting sets than those referred to in subparagraph (a) above. 3. If, in its internal model, the financial undertaking takes account of the effects of margining 89

90 when estimating EE, it may, with prior consent of De Nederlandsche Bank, use the model s EE measure directly in the second equation of Annex 5C. Subsection Minimum operational requirements for EPE models Article 5:29 The internal EPE model of a financial undertaking shall meet the operational requirements set out in Subsections a. to e. Subsection a. CCR control Article 5:30 1. The financial undertaking shall have a control unit that is responsible for the design and implementation of its CCR management system, including the initial and on-going validation of its internal model. 2. The unit referred to in paragraph 1 above shall: (a) control the integrity of the input data; (b) produce and analyse reports on the output of the internal model, including at any rate an evaluation of the relationship between measures of risk exposure and credit and trading limits; (c) be independent from units responsible for originating, renewing or trading exposures, be free from influences that may threaten its independence and be adequately staffed; and (d) report directly to the senior management of the financial undertaking. 3. The financial undertaking shall ensure that the operations of the unit referred to in paragraph 1 above are closely integrated into the financial undertaking s day-to-day credit risk management process. It shall also ensure that the output of these operations form an integral part of the process of planning, monitoring and controlling the financial undertaking s credit and overall risk profile. Article 5:31 1. The financial undertaking s CCR management policies, procedures and systems shall be conceptually sound and implemented with integrity. 2. The financial undertaking s risk management policies shall take account of market, liquidity, and legal and operational risks that can be associated with CCR. 3. The financial undertaking shall not enter into contracts with a counterparty without assessing its creditworthiness and without taking due account of settlement and pre settlement credit risk. These risks shall be managed as comprehensively as practicable at the firm-wide level and at the counterparty level, by aggregating exposures to a counterparty with other credit exposures to that counterparty. Article 5:32 1. The financial undertaking s board of directors and senior management shall be actively involved in the CCR control process, to which they shall devote adequate human and financial resources. Senior management shall ensure the reliability of the output of the financial undertaking s internal model, and: (a) shall be aware of the limitations and assumptions of the model used and the impact these can have on the reliability of the output; (b) shall consider the uncertainties of the market environment and operational risks; and (c) shall be aware of how the information referred to in subparagraphs (a) and (b) is reflected in the model. 90

91 2. For the purposes of paragraph 1 above, the daily reports prepared on a financial undertaking s exposures to CCR shall be reviewed by a level of management that in terms of seniority and authority is capable of enforcing both reductions of positions taken by individual credit managers or traders and reductions in the financial undertaking s overall CCR exposure. Article 5:33 1. The financial undertaking s CCR management system shall be used in conjunction with the credit and trading limits included in the internal model. The financial undertaking shall ensure that the credit and trading limits are consistent over time and are well understood by credit managers, traders and senior management. 2. The financial undertaking s measurement of CCR shall include: (a) measuring daily and intra-day usage of credit lines; and (b) measuring the financial undertaking s current exposure gross and net of collateral. 3. At portfolio and counterparty level, the financial undertaking shall calculate and monitor peak exposure or potential future exposure at the confidence interval chosen by it. The financial undertaking shall take account of large and concentrated positions, which shall at any rate include positions that can be categorised by group. Article 5:34 1. As a supplement to the CCR analysis, the financial undertaking shall have a routine and rigorous programme of stress testing in place based on the day-to-day output of its internal risk measurement model. 2. The results of the stress testing referred to in paragraph 1 above shall be reviewed periodically by senior management and shall be reflected in the policies set out in Article 5:31 and in the limits set out in Article 5:33. Where stress tests reveal particular vulnerability to a given set of circumstances, the financial undertaking shall take prompt steps to control these risks appropriately. Article 5:35 1. The financial undertaking shall have a routine in place for complying with a documented set of internal policies, controls and procedures concerning the operation of the CCR control system. 2. The financial undertaking s CCR control system shall be well documented and shall provide an explanation of the empirical techniques used to measure CCR. Article 5:36 1. The financial undertaking shall conduct an independent review of its CCR control system regularly through its own internal auditing process, which shall include both the activities of the business unit referred to in Article 5:51(3) and of the independent control unit referred to in Article 5:30(1). 2. A review of the full CCR control process shall take place at regular intervals and shall address, at a minimum: (a) the adequacy of the documentation of the CCR control system and process; (b) the organisation of the CCR control unit; (c) the integration of CCR measures into daily risk management; (d) the approval process for risk pricing models and valuation systems used by front and back-office personnel; (e) the validation of any significant changes in the CCR measurement process; (f) the scope of CCR captured by the risk measurement model; 91

92 (g) the integrity of the management information system; (h) the accuracy and completeness of CCR data; (i) the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; (j) the accuracy and appropriateness of volatility and correlation assumptions; (k) the accuracy of valuation and risk transformation calculations; and (l) the verification of the model s accuracy through frequent back-testing. Subsection b. Use test Article 5:37 1. The financial undertaking shall use a model that generates a distribution of CCR exposures to calculate effective EPE, and shall ensure that this model is part of a CCR control framework that includes the identification, measurement, management, approval and internal reporting of CCR. This control framework shall include the measurement of usage of credit lines, in the context of aggregating CCR exposures with other credit exposures, and internal capital allocation. 2. The financial undertaking shall closely integrate the distribution of exposures generated by the model referred to in paragraph 1 above into its day-to-day CCR control process. The financial undertaking shall assign an essential role to the resulting exposure output in its credit approval, CCR control, internal capital allocation and corporate governance policies. 3. For the purposes of the previous paragraphs, the financial undertaking shall demonstrate to De Nederlandsche Bank before submitting its application to De Nederlandsche Bank for the use of the model referred to in paragraph 1 above that it has a track record of at least one year in using models that generate a distribution of exposures to CCR. It shall also demonstrate that these models broadly meet the minimum requirements set out in this Subsection. Article 5:38 1. In addition to expected positive exposure (EPE), the financial undertaking shall also measure and manage current exposures. Where appropriate, the financial undertaking shall measure current exposure gross and net of collateral. 2. The use test is satisfied if the financial undertaking uses other CCR measures, such as peak exposure or potential future exposure (PFE), based on the distribution of exposures generated by the same model to compute EPE. 3. The financial undertaking shall have the systems capability to estimate EE daily, unless it demonstrates to De Nederlandsche Bank that its exposures to CCR warrant less frequent calculation. It shall compute EE along a time profile of forecasting horizons that adequately reflects the time structure of future cash flows and maturity of the contracts and in a manner that is consistent with the materiality and composition of the exposures. Article 5:39 1. An exposure shall not only be measured, monitored and controlled over a one-year time horizon, but over the life of all contracts in the netting set. 2. If the exposure rises beyond the one-year horizon, the financial undertaking shall have procedures in place to identify and control the corresponding counterparty risks. 3. The increase in exposure forecast by the measurement referred to in Article 5:38 shall be an input into the financial undertaking s internal capital model. Subsection c. Stress tests 92

93 Article 5:40 1. The financial undertaking shall have in place sound stress testing processes for use in the assessment of capital adequacy for CCR. 2. The output of stress testing referred to in paragraph 1 above shall be compared with the measure of EPE and considered by the financial undertaking as part of the risk assessment, measurement and control processes set out in Article 24A of the Decree. 3. In carrying out stress testing referred to in paragraph 1 above, the financial undertaking shall also identify possible events or future changes in economic conditions that could have unfavourable effects on its credit exposures and ability to withstand such changes. Article 5:41 1. Stress testing referred to in Article 5:40 shall refer to the financial undertaking s CCR exposures as well as to market and credit risk factors. Stress tests of CCR shall consider concentration risk (to a single counterparty or groups of counterparties), correlation risk across market and credit risk, and the risk that liquidating the counterparty s positions could move the market. 2. In carrying out stress testing referred to in paragraph 1 above, the financial undertaking shall also consider the impact on its own positions of the market moves referred to in the second sentence of paragraph 1 above. It shall integrate that impact in its assessment of CCR. Subsection d. Wrong-way risk Article 5:42 1. The financial undertaking shall give due consideration to exposures that give rise to a significant degree of general wrong way risk. 2. The financial undertaking shall have procedures in place to identify, monitor and control cases of specific wrong way risk, from the pre-contractual stage of a transaction up to its final settlement. Subsection e. Integrity of the modelling process Article 5:43 1. The financial undertaking s internal model shall reflect transaction terms and specifications in an appropriate, complete and prudent fashion. 2. The terms and specifications referred to in paragraph 1 above shall at any rate include the following data: (a) contractual notional amounts, (b) maturity, (c) reference assets, (d) type of transaction, i.e. a margin or netting agreement. 3. The transaction terms and specifications shall be entered and maintained in a secure database under the responsibility of the independent control unit referred to in Article 5:30(1). Both the maintenance and the transmission of data on these terms and specifications shall be subject to formal and periodic internal audit. 4. The input into the database shall require the prior approval of a legal expert, especially where qualification of the transaction as a netting agreement is concerned. 5. The financial undertaking shall use formal reconciliation processes between the internal model and the database to verify on an ongoing basis that transaction terms and specifications are being reflected in EPE correctly or at least prudently. 93

94 Article 5:44 1. The internal model shall employ current market data to compute current exposures. 2. When a financial undertaking uses historical data to estimate volatility and correlations, these data shall refer to a period of at least three years, and shall be updated quarterly or more frequently if market conditions warrant. 3. The data referred to in paragraph 2 above shall cover a full range of economic conditions. The price supplied by the appropriate business unit shall be validated by a unit independent from that business unit. 4. The data referred to in paragraph 2 above shall be acquired independently of the business lines, fed into the model in a timely and complete fashion, and maintained in a secure database subject to formal and periodic audit. The financial undertaking shall also have a well-developed data integrity process to clean the data referred to in paragraph 2 above of erroneous or anomalous observations. 5. Notwithstanding the provisions of paragraph 2 above, the financial undertaking may also use proxy market data where no historical data of at least three years are available, if: (a) it identifies in its internal policies which data are to be recognised as suitable proxies; and (b) it demonstrates empirically that the proxies provide a prudent representation of the underlying risk under adverse market conditions. 6. To determine the effect of collateral on changes in the market value of the netting set, the financial undertaking shall rely on its internal model only if it has adequate historical data to capture the volatility of the collateral in that model. Article 5:45 1. The model shall be subject to an internal validation process. 2. The validation process shall be clearly articulated in the financial undertaking s policies and procedures, and shall specify at any rate the kind of testing needed to ensure the integrity of the internal model. The validation process shall also identify conditions under which assumptions are violated and may result in an understatement of EPE. 3. For the purposes of paragraph 1 above, the validation process shall at any rate include a review as to whether the internal model adequately captures CCR. Article 5:46 The financial undertaking shall monitor the model risk set out in Article 5:45(3) and shall have processes in place to adjust its estimate of EPE when this risk becomes significant. The previous sentence shall include at least the following: (a) the financial undertaking shall identify and control its exposures to specific wrong way risks; (b) for exposures with a rising risk profile after one year, the financial undertaking shall compare the estimate of EPE over that year with EPE over the life of the exposure; (c) for exposures with a residual maturity below one year, the financial undertaking shall compare on a regular basis the replacement cost (current exposure) and the realised exposure profile, and shall store data that would allow such a comparison. Article 5:47 A financial undertaking shall have internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by a legally enforceable netting contract that meets the applicable requirements set out in Section 5.7. Article 5:48 94

95 A financial undertaking that makes use of collateral to mitigate its CCR shall have internal procedures to verify that, prior to recognising the effect of collateral in its calculations, the collateral meets the legal certainty standards set out in Chapter 4. Subsection Validation requirements for EPE models Article 5:49 1. Without prejudice to the following paragraphs of this Article, a financial undertaking s EPE model shall at any rate meet the qualitative validation requirements set out in Articles 4:4, 4:5 and 4:7 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling Solvabiliteitseisen voor het marktrisico). 2. Without prejudice to paragraph 1 above, interest rates, foreign exchange rates, equity prices, commodities and other market risk factors shall be forecast over long time horizons for measuring CCR exposure. The output of the forecasting model for market risk factors shall be validated over a long time horizon. 3. Without prejudice to paragraph 1 above, the pricing models used to calculate CCR exposure for a given scenario of future shocks to market risk factors, shall be tested as part of the validation process referred to in Article 5:45. For the purposes of the previous sentence, pricing models for options shall account for the non-linearity of the option value with respect to market risk factors. Article 5:50 1. The EPE model shall capture transaction-specific information in order to aggregate exposures at the level of the netting set. The financial undertaking shall verify that these exposures are assigned to the appropriate netting set within its internal model. 2. The EPE model shall also include the following transaction-specific information to capture the risk-mitigating effect of margining: (a) the current amount of margin; (b) the margin that would be passed between counterparties in the future; (c) the nature of margin agreements (unilateral or bilateral); (d) the frequency of margin calls; (e) the margin period of risk; (f) the minimum threshold of unmargined exposure that the financial undertaking is willing to accept; and (g) the minimum transfer amount. 3. The EPE model shall model the mark-to-market change in the value of the margin agreements referred to in paragraph 2 above that have been posted as collateral, unless these agreements are already governed by the provisions of Chapter 4. Article 5:51 1. As part of the validation process referred to in Article 5:45, static, historical back-testing shall be performed on representative counterparty portfolios. At regular intervals, the financial undertaking shall conduct such back-testing on a number of - actual or hypothetical - representative counterparty portfolios. These representative portfolios shall be chosen based on their sensitivity to the material risk factors and correlations to which the financial undertaking is exposed. 2. If back-testing indicates that the internal model is not sufficiently accurate, De Nederlandsche Bank may revoke the model approval or impose appropriate measures to 95

96 ensure that the model is improved promptly. Pursuant to Articles 23, 23a, 23d and 23e of the Decree, De Nederlandsche Bank may also require additional own funds to be held. Section 5.7 Contractual netting (contracts for novation and other netting agreements) Subsection Definitions with respect to netting Article 5:52 1. For the purposes of this Section, the following terms shall be defined as follows: (a) counterparty: any natural person who or legal entity which is legally authorised to conclude a contractual netting agreement with a financial undertaking; and (b) cross-product netting agreement: a written (umbrella) agreement between a single financial undertaking and a single counterparty which creates a mutual legal obligation in respect of netting across different product categories under several master agreements and other transactions between the said parties. 2. Cross-product netting agreements shall cover mutual netting only. Article 5:53 For the purposes of cross-product netting, products from the following transactions and instruments shall be considered to belong to different product categories: (a) repurchase transactions (repos), reverse repurchase transactions (reverse repos), commodities and securities lending or borrowing transactions; (b) margin lending transactions; and (c) derivative financial instruments referred to in Annex B to the Decree. Subsection Types of netting that are recognised Article 5:54 1. Only the following types of contractual netting may be recognised as risk-mitigating: (a) bilateral contracts for novation between a single financial undertaking and a single counterparty under which mutual claims and obligations are continuously and automatically amalgamated in such a way that a single net amount continuously remains and a single new contract arises that extinguishes former contracts; (b) bilateral netting agreements between a single financial undertaking and a single counterparty; and (c) cross-product netting agreements between a single counterparty and a single financial undertaking, provided that the financial undertaking has received approval from De Nederlandsche Bank to use the internal model method referred to in Section 5.6, and the agreement falls under the scope of that method. 2. Netting across transactions entered by members of a group as referred to in Section 24b of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek) shall not be recognised for the purposes of risk mitigation pursuant to paragraph 1 above. Subsection Conditions for recognition Article 5:55 1. Contractual netting may be recognised as risk-mitigating only under the conditions set out in the following paragraphs. 2. The financial undertaking shall have a contractual netting agreement with its counterparty which creates a single legal obligation covering all included transactions, such that, in the 96

97 event of a counterparty s failure to perform owing to default, bankruptcy, liquidation or any other similar circumstance, the financial undertaking would have a claim to receive or an obligation to pay only the net sum of the positive and negative mark-to-market values of the individual transactions included in the agreement. 3. The financial undertaking shall demonstrate to De Nederlandsche Bank with the aid of written documents that within the applicable rules of law under private international law the agreement meets the provisions of paragraph 2 above. If the applicable law is Dutch law, this shall be demonstrated by means of documentation as referred to in Section 9 of Title 2 of Volume 1 of the Dutch Code of Civil Procedure (Wetboek van Burgerlijke Rechtsvordering). 4. For the purposes of paragraph 3 above, the financial undertaking shall have procedures in place to ensure that the legal validity of its contractual netting is kept under review in the light of possible changes in the applicable law, and the financial undertaking shall maintain the documentation referred to in paragraph 3 above. Article 5:56 1. The effects of contractual netting shall be factored into the financial undertaking s measurement of each counterparty s aggregate credit risk exposure. The financial undertaking shall manage its CCR on the basis of the outcome of the measurement referred to in the first sentence of this paragraph. 2. The credit risk to a counterparty that for the different transactions is determined separately shall be aggregated for each counterparty to arrive at an aggregate risk exposure across all transactions to a single counterparty. This aggregation shall be factored into credit limit procedures and internal capital procedures. Article 5:57 No contract containing a provision which permits a non-defaulting counterparty to make limited payments only, or no payments at all, to the estate of the defaulter, even if the defaulter is a net creditor, may be recognised as risk-reducing. Article 5:58 Without prejudice to the provisions of Articles 5:52 to 5:57, cross-product netting agreements shall only be recognised as risk-mitigating if: (a) the net sum referred to in Article 5:55(2) is the net sum of the positive and negative close out values of the individual bilateral master agreements and of the positive and negative mark-to-market values of the individual other transactions, insofar as the relevant netting agreement covers these agreements and transactions; (b) the written documents referred to in Article 5:55(3) address the validity and legal enforceability of the entire contractual cross-product netting agreement as well as the impact of netting on the material provisions of any included bilateral master agreement; (c) the procedures set out in Article 5:55(4) are covered by a legal opinion; and (d) the financial undertaking continues to comply with the requirements for the recognition of bilateral netting and the requirements for the recognition of credit risk mitigation set out in Chapter 4, as appropriate, with respect to each included individual bilateral master agreement and transaction. Subsection Effects of recognition Article 5:59 Without prejudice to the provisions of Sections 5.5 and 5.6, netting shall only be recognised if the conditions set out in Subsection are met. 97

98 Article 5:60 Without prejudice to the provisions of Section 5.7, netting for the purposes of Sections 5.5 and 5.6 shall be recognised in the manner as set out in the latter Sections. Article 5:61 In the case of contracts for novation, the financial undertaking may weigh the single net amounts rather than the gross amounts involved. Thus, for the purposes of Section 5.3, in: - Article 5:6(2): the current replacement cost, and - Article 5:6(3): the notional principal amounts or underlying values may be obtained taking account of the contract for novation. Article 5:62 For the purposes of Section 5.4, in Article 5:7(1) the notional principal amount may be calculated taking account of the contract for novation. The percentages of table 1 in Article 5:7(1) shall apply. Article 5:63 1. For the purposes of Article 5.6, the current replacement cost for the contracts included in a netting agreement may be obtained by taking account of the actual hypothetical net replacement cost which results from the agreement. In the case where netting leads to a net obligation for the financial undertaking calculating the net replacement cost, the current replacement cost referred to in Article 5:6(2) shall be set at zero. b) For the purposes of Article 5.6, the figure for the potential future credit exposure for all contracts included in a netting agreement may be reduced according to the following formula: PCEred = 0.4 * PCEgross * NGR * PCEgross where: (a) PCEred shall be understood to mean: the reduced figure for potential future credit exposure for all contracts with a given counterparty included in a legally valid bilateral netting agreement; (b) PCEgross shall be understood to mean: the sum of the figures for potential future credit exposure for all contracts with a given counterparty which are included in a legally valid bilateral netting agreement and are calculated by multiplying their notional principal amounts by the percentages set out in table 1; and (c) NGR shall be understood to mean: the net-to-gross ratio. 3. The net-to-gross ratio set out in subparagraph 1(c) above may be calculated either separately or aggregately. The separate calculation computes the quotient of the net replacement cost for all contracts included in a legally valid bilateral netting agreement with a given counterparty (numerator) and the gross replacement cost for all contracts included in a legally valid bilateral netting agreement with that counterparty (denominator). The aggregate calculation computes the quotient of the sum of the net replacement cost calculated on a bilateral basis for all counterparties, taking into account all contracts included in legally valid netting agreements (numerator) and the gross replacement cost for all contracts included in legally valid netting agreements (denominator). Article 5:64 1. If, for the calculation of the net-to-gross ratio, a financial undertaking chooses one of the methods set out in Article 5:63(3), the method chosen shall be used consistently. 2. For the calculation of the potential future credit exposure according to the formula set out 98

99 in Article 5:63(2), perfectly matching contracts included in the netting agreement may be taken into account as a single contract with a notional principal equivalent to the net receipts. 3. Perfectly matching contracts referred to in paragraph 2 above shall be understood to mean: forward foreign exchange contracts or similar contracts in which the notional principal is equivalent to cash flows if the cash flows fall due on the same value date and are fully or partially in the same currency. Article 5:65 1. For the purposes of Article 5:7(1), the following contracts included in a netting agreement may be treated as follows: (a) perfectly matching contracts included in the netting agreement may be taken into account as a single contract with a notional principal equivalent to the net receipts; the notional principal amounts shall be multiplied by the percentages given in table 1 in Article 5:7(1). (b) for all other contracts included in a netting agreement, the applicable percentages may be reduced as indicated in table 2 below: Table 2 Original maturity Interest rate contracts Foreign exchange contracts One year or less 0.35% 1.50% Over one year, not 0.75% 3.75% exceeding two years Additional allowance for each additional year 0.75% 2.25% 2. For the purposes of table 2 above, a financial undertaking may, subject to approval from De Nederlandsche Bank, choose either original or residual maturity. Chapter 6 Securitisation Title 6.1 General provisions Article 6:1 In this Chapter, the following terms shall be defined as follows: (a) ABCP programme (asset-backed commercial paper programme): a programme of securitisations the securities issued by which predominantly take the form of commercial paper with an original maturity of one year or less; (b) clean-up call option: a contractual option for the originator to extinguish the securitisation positions before all of the underlying exposures have been repaid, when the amount of underlying exposures falls below a specified level; (c) excess spread: finance charge collections and other fee income received in respect of the securitised exposures net of costs and expenses; (d) K irb : 8% of the risk-weighted exposure amounts that would be calculated under Articles 69 to 76(3) of the Decree in respect of the securitised exposures had they not been securitised, plus the amount of expected losses associated with those exposures calculated under those Articles; (e) K irbr : the ratio of (a) K irb to (b) the sum of the exposure values of the exposures that have been securitised; 99

100 (f) liquidity facility: a securitisation position arising from a contractual agreement to provide funding to ensure timeliness of cash flows to investors; (g) rated position: a securitisation position which has an external credit assessment by an eligible credit assessment institution; (h) ratings based method: the method of calculating risk-weighted exposure amounts for securitisation positions in accordance with Article 6:31; (i) servicer of a securitisation: the entity responsible for the day-to-day management of the securitised exposures in terms of collection of principal and interest, which is then forwarded to the holders of the securitisation positions; (j) SSPE (securitisation special purpose entity): an entity for securitisation purposes, as referred to in Article 1 of the Decree; (k) supervisory formula method: the method of calculating risk-weighted exposure amounts for securitisation positions in accordance with Article 6:37; (l) unrated position: a securitisation position which does not have an external credit assessment by an eligible credit assessment institution; Article 6:2 A financial undertaking shall apply the provisions of this Chapter for determining the regulatory capital requirements in respect of: (a) credit risks in the non-trading book on securitised exposures or securitisation positions arising from traditional and synthetic securitisations or similar structures with corresponding features, and (b) counterparty credit risk in the trading book on securitisation positions. Title 6.2 Minimum requirements for recognition of significant credit risk transfer and calculation of risk-weighted exposure amounts and expected loss amounts Section Minimum requirements for recognition of significant credit risk transfer Subsection Minimum requirements for a traditional securitisation Article 6:3 1. The originator financial undertaking of a traditional securitisation may exclude securitised exposures from the calculation of risk-weighted exposure amounts and, as relevant, expected loss amounts if significant credit risk associated with the securitised exposures has been transferred to third parties and the transfer complies with the provisions of the Articles 6:4 and 6:5 as well as with the following conditions: (a) the securitised exposures have been put beyond the reach of the originator financial undertaking and its creditors, including in bankruptcy and receivership, as confirmed by qualified legal counsel; (b) the originator financial undertaking does not maintain effective or indirect control over the transferred exposures; (c) the originator financial undertaking has adequately covered the liability for any losses on the securitised exposures and, to that end, it has at least informed the SSPE and the holders of the securitisation positions of the risk profile attaching to the securitised exposures and the SSPE has confirmed that it is aware of and accepts these risks; (d) the originator financial undertaking is under no obligation to repurchase the (risk on the) securitised exposures, which has been laid down in the contract with the SSPE, and of which the holders of securitisation positions have been informed; 100

101 (e) the transfer of the exposures does not contravene the terms and conditions of the underlying credit agreements, and all the necessary permissions for the risk transfer have been obtained; (f) in the event of a rescheduling or renegotiation of the credit agreement, due to a deterioration of the credit quality, the holders of the securitisation positions are subject to the rescheduled or renegotiated terms; (g) the originator financial undertaking does not, after the exposures have been transferred, bear any of the (recurring) costs ensuing from the securitisation, and (h) where payments are routed through it, the originator financial undertaking is under no obligation to remit funds to the SSPE unless and until these have been received. Article 6:4 The transfer shall be to an SSPE, the following conditions having been met: (a) the originator financial undertaking does not have any equity interest in, nor does it have any other form of proprietary interest in or does it exercise policy control over, the SSPE; (b) the SSPE is not affiliated to the originator financial undertaking, and the management of the SSPE is independent of the originator financial undertaking; (c) the name of the SSPE does not include the name of the originator financial undertaking nor does it suggest any connection with it; (d) the holders of the securities issued by the SSPE may sell or pledge these securities without any restriction, and (e) the SSPE is financially independent of the originator financial undertaking. Article 6:5 1. The securitisation documentation shall reflect the economic substance of the transaction. 2. The securitisation documentation shall not contain clauses that require securitisation positions in the securitisation to be improved by the originator financial undertaking, including but not limited to clauses that provide for: (a) altering the underlying exposures or increasing the yield payable to investors in response to a deterioration of the credit quality of the securitised exposures, or (b) increasing the yield payable to holders of securitisation positions in response to a deterioration in the credit quality of the underlying pool. 3. Where there is a clean-up call option, the following conditions shall be satisfied: (a) the clean-up call option is exercisable at the discretion of the originator financial undertaking; (b) the clean-up call option may only be exercised when 10% or less of the original value of the securitised exposures remains unamortised; (c) the clean-up call option is so structured that losses are allocated to credit enhancement positions or other securitisation positions held by investors, and (d) the clean-up call option is not structured to provide credit enhancement. Subsection Minimum requirements for a synthetic securitisation Article 6:6 An originator financial undertaking of a synthetic securitisation may calculate risk-weighted exposure amounts, and, as relevant, expected loss amounts, for the securitised exposures in accordance with the provisions of Articles 6:8 and 6:9, if significant credit risk has been transferred to third parties either through funded or unfunded credit protection and the transfer complies with the following conditions: (a) the securitisation documentation reflects the economic substance of the transaction; 101

102 (b) the credit protection by which the credit risk is transferred complies with the eligibility and other requirements under Articles 80 to 82(3) of the Decree for the recognition of such credit protection, with the proviso that securitisation special purpose entities shall not be recognised as eligible unfunded protection providers; (c) the enforceability of the credit protection in all relevant jurisdictions has been confirmed by qualified legal counsel; (d) the instruments used to transfer credit risk do not contain terms or conditions that: (i) impose significant materiality thresholds below which credit protection is deemed not to be triggered if a credit event occurs; (ii) allow for the termination of the protection due to deterioration of the credit quality of the underlying exposures; (iii) require securitisation positions in the securitisation to be improved by the originator financial undertaking, or (iv) increase the cost of credit protection or the yield payable to holders of securitisation positions in response to a deterioration of the credit quality of the underlying pool; (e) the transfer of the credit risk does not contravene the terms and conditions of the underlying credit agreements, and all the necessary permissions for the risk transfer have been obtained; (f) in the event of a rescheduling or renegotiation of the credit agreement, due to a deterioration of the credit quality, the holders of the securitisation positions are subject to the rescheduled or renegotiated terms, and (g) the originator financial undertaking does not reassume any credit risk in respect of the securitised exposures through the issuance of another credit derivative or in any other way. Subsection Minimum requirements for significant risk transfer Article 6:7 1. Unless De Nederlandsche Bank, on grounds other than those described in this paragraph, holds that a credit risk transfer is not significant, a credit risk transfer to third parties as part of a securitisation shall, for the purposes of Article 6:3 and Article 6:6, be considered significant, if the proportion of the credit risk transferred to third parties is at least commensurate with the proportional reduction of the risk-weighted exposure amounts. 2. The originator financial undertaking shall determine the proportion of the credit risk transferred to third parties as referred to in paragraph 1 above as the ratio of the credit risk transferred to third parties and the original credit risk using a method which is appropriate to the specific securitisation and consistent with the financial undertaking s internal processes. 3. The originator financial undertaking shall determine the proportional reduction of the riskweighted exposure amounts as referred to in paragraph 1 above by comparing the riskweighted exposure amounts for the retained or repurchased securitisation positions after securitisation with the risk-weighted exposure amounts for all securitised exposures as if these exposures had not been securitised. Section Originator financial undertaking s calculation of risk-weighted exposure amounts and expected loss amounts for securitised exposures and treatment of maturity mismatches in synthetic securitisations Article 6:8 1. In calculating risk-weighted exposure amounts for securitised exposures, where the conditions in Article 6:6 are met, the originator financial undertaking of a synthetic securitisation shall, without prejudice to the provisions of Article 6:9, use the relevant 102

103 calculation methodologies set out in this Chapter for the entire pool of exposures forming part of the securitisation. 2. For financial undertakings calculating risk-weighted exposure amounts and expected loss amounts under Articles 69 to 76(3) of the Decree, the expected loss amount in respect of such exposures shall be zero. Article 6:9 1. An originator financial undertaking of a synthetic securitisation shall, for the purposes of calculating risk-weighted exposure amounts, allow for any maturity mismatch between the credit protection by which the tranching is achieved and the securitised exposures, and shall do so in accordance with the provisions of paragraphs 2 and 3 below. 2. The maturity of the securitised exposures shall be taken to be the longest maturity of any of those exposures, subject to a maximum of five years. The maturity of the credit protection shall be determined in accordance with Articles 81(6) and 82(1) of the Decree. 3. An originator financial undertaking shall, when calculating risk-weighted exposure amounts for tranches which have been assigned a risk weight of 1250%, ignore any maturity mismatches. For all other tranches, the maturity mismatch treatment set out in Articles 81(6) and 82(1) of the Decree shall be applied in accordance with the following formula: RW* = [RW(SP) x (t-t*)/(t-t*)] + [RW(Ass) x (T-t)/(T-t*)] where t* = 0.25, and (a) RW* represents the risk-weighted exposure amounts for the purposes of Article 60(1)(a) of the Decree; (b) RW(Ass) represents the risk-weighted exposure amounts for exposures had they not been securitised, calculated on a pro rata basis; (c) RW(SP) represents the risk-weighted exposure amounts calculated in accordance with the provisions of Article 6:8 as if there were no maturity mismatch; (d) T represents the maturity of the underlying exposures, expressed in years, and (e) t represents the maturity of the credit protection, expressed in years. Section Other provisions Subsection Originator financial undertaking s retention of partial exposures Article 6:10 1. An originator financial undertaking shall be allowed to securitise part of an exposure, thus retaining another exposure to the same counterparty ensuing from the same credit agreement, or to securitise an exposure sharing the same security right with a retained exposure to the same counterparty ensuing from a different credit agreement, provided that: (a) the originator financial undertaking and the SSPE have entered into a clear contractual arrangement on the management of the jointly held security rights, and (b) the originator financial undertaking will not, as a consequence of retaining an interest in the credit agreement or the security rights, be liable in any way for any losses in respect of the securitised exposure. 2. An originator financial undertaking shall be allowed to retain a newly created exposure ensuing from a credit agreement under which an existing exposure has already been securitised in full or in part, or to retain a newly created exposure sharing the same security right with an existing securitised exposure, provided that: (a) the conditions set out in subparagraphs 1(a) and (b) above are satisfied; 103

104 (b) the newly created exposure is not used as credit enhancement for the securitisation and does not systematically improve the credit quality of the pool of securitised exposures, and (c) the newly created exposure is granted on market terms and is subject to the normal procedures and criteria for the granting of new credits. Subsection Risk-weighted exposure amounts for a financial undertaking acting as servicer in a securitisation Article 6:11 A financial undertaking acting as servicer in a securitisation shall include the securitised exposures in the calculation of its risk-weighted exposure amounts, unless the securitisation meets the following conditions, both at the time of the risk transfer and afterwards, with the proviso that these conditions only concern the financial undertaking in its capacity as servicer: (a) the servicer in a securitisation has no liability to the creditors or investors, unless it is culpable of gross negligence; (b) the servicer in a securitisation is able to prove that it has sufficiently informed the SSPE and the investors of the fact that it is not liable for any losses; (c) the servicer in a securitisation does not have any equity interest in, nor does it have any other form of proprietary interest in or does it exercise policy control over, the SSPE; (d) the management of the SSPE is able to operate independently of the servicer in a securitisation; (e) the servicer does not, after the risk transfer, bear any costs ensuing from the securitisation other than those stipulated in the service agreement; (f) the servicer in a securitisation is not obliged to make payments to the SSPE in situations where the underlying exposures are not performing; (g) it is possible to reverse non-obligatory payments by the servicer in a securitisation to the SSPE if the original debtor defaults, and (h) the servicer in a securitisation does not in that capacity bear any losses ensuing from interest rate or exchange rate movements. Subsection Originator financial undertaking s repurchase of securitised exposures Article 6:12 An originator financial undertaking in a securitisation which has the possibility to repurchase the securitised exposures in that securitisation before the legal maturity date of the securitisation, shall only be allowed to repurchase the securitised exposures if the repurchase will not lead to a structurally highly adverse decrease in the originator financial undertaking s regulatory capital ratio. Title 6.3 Calculation of risk-weighted exposure amounts for securitisation positions and use of external credit assessments Section Calculation of risk-weighted exposure amounts for securitisation positions Article 6:13 1. The providers of credit protection to securitisation positions shall be considered holders of securitisation positions in the securitisation. 2. Where a securitisation position is subject to funded or unfunded credit protection, the risk weight to be applied to that securitisation position may be modified in accordance with 104

105 Articles 80 to 82(3) of the Decree, read in conjunction with the provisions of the present Chapter. 3. Subject to Articles 94(2), opening sentence, and 94(2)(g) of the Decree, the risk-weighted exposure amount shall, for the purposes of Article 60(1)(a) of the Decree, be included in the financial undertaking s total of risk-weighted exposure amounts. Article 6:14 1. For the purposes of Article 85 of the Decree and of Article 6:13, the risk-weighted exposure amount of a securitisation position shall be calculated by applying, in the manner as described in paragraphs 2 to 5 below and in Titles 6.4, 6.5 and 6.6, the relevant risk weight to the exposure value of the securitisation position. 2. Without prejudice to the provisions of Article 6:13(3): (a) where a financial undertaking calculates risk-weighted exposure amounts in accordance with the standardised approach as referred to in Title 6.4, the exposure value of an on-balance sheet securitisation position shall be its balance sheet value, or (b) where a financial undertaking calculates risk-weighted exposure amounts in accordance with the internal ratings based approach as referred to in Title 6.5, the exposure value of an on-balance sheet securitisation position shall be its balance sheet value gross of value adjustments; 3. Without prejudice to the provisions of Article 6:13(3), the exposure value of an off-balance sheet securitisation position shall be its nominal value multiplied by a conversion figure of 100%, unless otherwise specified in the present Chapter. 4. The exposure value of a securitisation position arising from a credit derivative listed in Annex B to the Decree shall be determined in accordance with the provisions of Chapter 5 of the present Regulation. 5. Where a securitisation position is subject to funded credit protection, the exposure value of that position may be modified in accordance with the requirements referred to in Articles 81(6) and 82(1) of the Decree. 6. Where a financial undertaking has two or more overlapping securitisation positions in a securitisation, it shall, to the extent that these positions overlap, include in its calculation of risk-weighted exposure amounts only the position or portion of a position producing the highest risk-weighted exposure amounts. Section Use of external credit assessments Subsection Requirements for credit assessments by credit assessment institutions Article 6:15 A credit assessment of an eligible credit assessment institution shall only be used for the calculation of risk-weighted exposure amounts under the present Chapter, if: (a) there is no mismatch between the types of payment reflected in the credit assessment and the types of payment to which the financial undertaking is entitled under the contract that has given rise to the securitisation position in question, and (b) the credit assessment is available publicly to the market. Subsection Use of credit assessments by a financial undertaking Article 6:16 105

106 1. A financial undertaking may only nominate one or more eligible credit assessment institutions as referred to in Article 88 of the Decree whose credit assessments it will use in the calculation of its risk-weighted exposure amounts under the present Chapter. 2. Without prejudice to the provisions of paragraphs 4 and 5 below and without prejudice to the provisions of Article 6:17, a financial undertaking shall consistently use credit assessments of nominated credit assessment institutions in respect of its securitisation positions. 3. Without prejudice to the provisions of paragraphs 4 and 5 below, a financial undertaking shall not use one credit assessment institution s credit assessments for its securitisation positions in some tranches and another credit assessment institution s credit assessments for its securitisation positions in other tranches within the same structure, irrespective of whether a credit assessment of the former credit assessment institution is available for the latter tranches. 4. In cases where a securitisation position has two credit assessments by nominated credit assessment institutions, the financial undertaking shall use the less favourable credit assessment. 5. In cases where a securitisation position has more than two credit assessments by nominated credit assessment institutions, the financial undertaking shall use the second most favourable credit assessment or, if the two most favourable credit assessments are equally favourable, one of these two. Article 6:17 1. Where credit protection eligible under Articles 80 to 82(3) of the Decree is provided directly to the SSPE, and that protection is reflected in the credit assessment of a securitisation position by a nominated credit assessment institution, the risk weight associated with that credit assessment may be used. 2. A credit assessment reflecting the credit protection shall not be recognised, if the credit protection is not eligible under Articles 80 to 82(3) of the Decree or if the credit protection is not provided to the SSPE but is applied directly to a securitisation position. Title 6.4 Calculation of risk-weighted exposure amounts under the standardised approach Section Calculation of risk-weighted exposure amounts Subsection Risk weights associated with each credit quality step Article 6:18 1. Without prejudice to the provisions of Article 6:19, the risk-weighted exposure amounts of a rated securitisation position shall be calculated by applying to the exposure value the risk weight associated with the credit quality step in which the credit assessment has been classified in accordance with Article 85(4) and (5) of the Decree, as shown below in tables 1 and 2. Table 1 Securitisation positions with credit assessments other than for the short term Credit quality step and below Risk weight 20% 50% 100% 350% 1250% Table 2 Securitisation positions with short-term credit assessments Credit quality step All other credit assessments 106

107 Risk weight 20% 50% 100% 1250% 2. Without prejudice to the provisions of Sections to 6.4.4, the risk-weighted exposure amount of an unrated securitisation position shall be calculated by applying a risk weight of 1250%. Subsection Financial undertakings acting as originator or sponsor Article 6:19 For a financial undertaking acting as originator or sponsor, the risk-weighted exposure amounts calculated in respect of its securitisation positions may be limited to the riskweighted exposure amounts which would be calculated for the securitised exposures had they not been securitised, subject to the presumed application of a 150% risk weight to all past due items and items belonging to regulatory high risk categories amongst the securitised exposures. Section Treatment of unrated securitisation positions Article 6:20 1. A financial undertaking having an unrated securitisation position may apply the treatment set out in paragraph 2 below for calculating the risk-weighted exposure amount for that position, provided the composition of the pool of securitised exposures is known at all times. 2. If the financial undertaking is able to determine the weighted average risk weight that would be applied to the securitised exposures under Articles 61, 61a, 82(1), 83 and 88 of the Decree by a financial undertaking holding the exposures, it may apply that risk weight, multiplied by a concentration ratio, to the securitisation position. The concentration ratio is equal to the sum of the nominal amounts of all the tranches divided by the sum of the nominal amounts of the tranches junior to or pari passu with the tranche in which the position is held including that tranche itself. The resulting risk weight to be applied to the securitisation position shall not be higher than 1250% or lower than any risk weight applicable to a rated more senior tranche. 3. Where the financial undertaking is unable to determine the risk weights that would be applied to the securitised exposures under Articles 61, 61a, 82(1), 83 and 88 of the Decree, it shall apply a risk weight of 1250% to the securitisation position. Section Treatment of unrated securitisation positions in a second loss tranche or better in an ABCP programme Article 6:21 1. Subject to the availability of a more favourable treatment by virtue of the provisions of Section 6.4.4, a financial undertaking may apply to unrated securitisation positions in an ABCP programme meeting the conditions set out in paragraph 2 below, a risk weight that is the higher of: (a) 100%, or (b) the highest of the risk weights that would be applied to any of the securitised exposures under Articles 61, 61a, 82(1), 83 and 88 of the Decree by a financial undertaking holding the exposures. 2. The risk weight referred to in paragraph 1 above shall be applied only if: 107

108 (a) the securitisation position is in a tranche which is economically in a second loss position or better in the securitisation, with the first loss tranche providing meaningful credit enhancement to the second loss tranche; (b) the securitisation position is of a quality equivalent to investment grade or better; (c) the securitisation position is held by a financial undertaking which does not hold a position in the first loss tranche; (d) the credit enhancement has been determined at the inception of the securitisation and the securitisation contract allows it to increase only if: (i) the securitisation is enlarged with another pool of exposures, and (ii) the additional credit enhancement concerns only the added exposures; (e) the credit enhancement is documented separately from other facilities provided by the financial undertaking and the risks of the credit enhancement are clearly defined; (f) the financial undertaking has sufficiently informed the SSPE and the investors that it is not liable for, and will not bear, losses beyond the terms of the contract, and (g) payment of the fee for the credit enhancement is not subordinate to the first loss tranche or subject to deferral or waiver. Section Treatment of unrated liquidity facilities Subsection Eligible liquidity facilities Article 6:22 For the purpose of determining the exposure value of an unrated securitisation position in the form of certain types of liquidity facilities, the securitisation position shall, when determining the risk-weighted exposure value, be regarded as an eligible liquidity facility, if: (a) the liquidity facility documentation clearly identifies and limits the circumstances under which the facility may be drawn; (b) the facility cannot be drawn so as to provide credit support to cover losses; (c) the facility solely serves to fund temporary differences between incoming and outgoing cash flows and cannot be used to provide permanent or regular funding for the securitisation; (d) repayment of draws on the facility is not subordinate to the claims of investors other than to claims arising in respect of interest rate or currency derivative contracts, fees or other such payments, nor is it subject to waiver or deferral; (e) the facility cannot be drawn after all applicable credit enhancements from which the liquidity facility would benefit are exhausted, and (f) the facility includes a provision that results in an automatic reduction in the amount that can be drawn by the amount of exposures that are in default, or a provision that, where the pool of securitised exposures consists of rated instruments, terminates the facility if the average quality of the pool falls to a credit assessment below investment grade. Article 6:23 1. When the conditions for an eligible liquidity facility as referred to in Article 6:22 are satisfied, the exposure value of a liquidity facility may be determined by: (a) applying a conversion figure of 20% to the nominal amount of a liquidity facility with an original maturity of one year or less, or (b) applying a conversion figure of 50% to the nominal amount of a liquidity facility with an original maturity of more than one year. 2. For the purposes of paragraph 1 above, the risk weight to be applied shall be the highest risk weight that would be applied to any of the securitised exposures under Articles 61, 61a, 82(1), 83 and 88 of the Decree by a financial undertaking holding the exposures. 108

109 Subsection Liquidity facilities that may be drawn only in the event of a general market disruption Article 6:24 In respect of a liquidity facility that may be drawn only in the event of a general market disruption, a conversion figure of 0% may be applied to the nominal amount of the facility, provided that the conditions for an eligible liquidity facility as set out in Article 6:22 are satisfied. Subsection Cash advance facilities Article 6:25 In respect of a cash advance facility that is unconditionally cancellable, a financial undertaking may apply a conversion figure of 0% to the nominal amount of the facility, provided that: (a) the conditions for an eligible liquidity facility as set out in Article 6:22 are satisfied; (b) repayments of draws on the facility are senior to any other claims on the cash flows arising from the securitised exposures; (c) the cash advance is reimbursed from subsequent principal and interest collections or from the available credit enhancement, and (d) in-house procedures are in place at the financial undertaking ensuring that or permitting ascertainment that the credit risk is negligible. Section Recognition of credit risk mitigation on securitisation positions Article 6:26 Where credit protection is obtained on a securitisation position, the calculation of riskweighted exposure amounts may be modified in accordance with Articles 81(6) and 82(1) of the Decree. Section Reduction in risk-weighted exposure amounts Article 6:27 1. In accordance with Article 94(2), opening sentence, of the Decree, in respect of a securitisation position to which a 1250% risk weight applies, financial undertakings may, as an alternative to including the position in their calculation of risk-weighted exposure amounts, deduct the exposure value of the position from tier 1 capital and tier 2 capital. For these purposes, the calculation of the exposure value may reflect eligible funded credit protection in a manner consistent with Article 6: Where a financial undertaking makes use of the alternative indicated in paragraph 1 above, 12.5 times the amount deducted in accordance with that paragraph shall, for the purposes of Article 6:19, be subtracted from the amount specified in Article 6:19 as the maximum riskweighted exposure amount to be calculated by the financial undertakings indicated in that Article. Title 6.5 Calculation of risk-weighted exposure amounts under the internal ratings based approach Section Hierarchy of methods 109

110 Article 6:28 1. For the purposes of Article 85 of the Decree and Article 6:13, the risk-weighted exposure amount of a securitisation position shall be calculated in accordance with the internal ratings based approach as referred to in the present Title. 2. For a rated securitisation position or a securitisation position in respect of which an inferred rating as referred to in Article 6:30 may be used, the ratings based method set out in Article 6:31 shall be used to calculate the risk-weighted exposure amount. 3. For an unrated securitisation position, the supervisory formula method as set out in Section shall be used, except where the internal assessment approach for securitisation positions in an ABCP programme as set out in Section may be used. 4. A financial undertaking other than an originator or sponsor may only use the supervisory formula method with the approval of De Nederlandsche Bank. 5. In respect of unrated securitisation positions for which an inferred rating may not be used, a risk weight of 1250% shall be applied in the case of: (a) an originator or sponsor financial undertaking which is unable to calculate K irb and which has not obtained approval to use the internal assessment approach for securitisation positions in ABCP programmes, and (b) other financial undertakings where they have not obtained approval to use the supervisory formula method or, for their securitisation positions in ABCP programmes, the internal assessment approach. Section Maximum risk-weighted exposure amounts Article 6:29 A financial undertaking which is able to calculate K irb may limit the risk-weighted exposure amounts calculated in respect of its securitisation positions in a securitisation to that which would produce a capital requirement under Article 60(1)(a) of the Decree equal to the sum of: (a) 8% of the risk-weighted exposure amounts which would be produced if the securitised assets had not been securitised and were on the balance sheet of the financial undertaking, and (b) the expected loss amounts of those exposures. Section Ratings based method Subsection Use of inferred ratings Article 6:30 A financial undertaking shall attribute to an unrated securitisation position an inferred rating equivalent to the credit assessment of those rated securitisation positions (the reference positions ) which are the most senior positions which are in all respects subordinate to the unrated securitisation position in question, when the following minimum operational requirements are satisfied: (a) the reference positions are subordinate in all respects to the unrated securitisation position; (b) the maturity of the reference positions is equal to or longer than that of the unrated securitisation position in question, and (c) any inferred rating is updated on an ongoing basis to reflect any changes in the credit assessment of the reference positions. Subsection Risk weights under the ratings based method 110

111 Article 6:31 1. Under the ratings based method, the risk-weighted exposure amount of a rated securitisation position shall be calculated by applying to the exposure value of the position the risk weight associated with the credit quality step in which the credit assessment has been classified in accordance with Article 85(4) and (5) of the Decree as set out in tables 3 and 4, multiplied by Table 3 Securitisation positions other than those with short-term credit assessments Credit Quality Step (CQS) Risk weight A B C 1 7% 12% 20% 2 8% 15% 25% 3 10% 18% 35% 4 12% 20% 35% 5 20% 35% 35% 6 35% 50% 50% 7 60% 75% 75% 8 100% 100% 100% 9 250% 250% 250% % 425% 425% % 650% 650% Below CQS % 1250% 1250% Table 4 Securitisation positions with short-term credit assessments Credit Quality Step (CQS) Risk weight A B C 1 7% 12% 20% 2 12% 20% 35% 3 60% 75% 75% All other credit assessments 1250% 1250% 1250% 2. Without prejudice to the provisions of paragraphs 3 and 4 below, the risk weights in column A of each table shall be applied where the rated securitisation position is in the most senior tranche of a securitisation. When determining whether a tranche is the most senior for these purposes, it is not required to take into consideration amounts due under interest rate or currency derivative contracts, fees due, or other such payments. 3. To a securitisation position which is in the most senior tranche and relative to which any other securitisation position which would receive a risk weight of 7% under paragraph 2 above is subordinate, a risk weight of 6% may be applied, provided that: (a) the financial undertaking shows that this risk weight is justified due to the loss absorption qualities of subordinate tranches in the securitisation, and (b) either the securitisation position has an external credit assessment associated with credit quality step 1 in table 3 or table 4 or the requirements for the use of an inferred rating as referred to in Article 6:30 are satisfied, the reference positions being taken to mean those securitisation positions which are subordinate to the securitisation position in the most senior tranche in a securitisation and which would receive a risk weight of 7% under paragraph 2 above. 4. The risk weights in column C of each table shall be applied where the rated securitisation position is in a securitisation where the effective number of securitised exposures is less than six. In calculating the effective number of securitised exposures, multiple exposures to one obligor shall be treated as one exposure. The effective number of exposures is calculated as: 111

112 ( EAD 2 i i N = 2 EAD i i ) where N represents the effective number of securitised exposures and EAD i represents the sum of the exposure values of all exposures to the i th obligor. In the case of resecuritisation (securitisation of securitisation exposures), the financial undertaking shall look at the number of securitisation exposures in the pool and not at the number of underlying exposures in the original pools from which the underlying securitisation exposures stem. If the portfolio share associated with the largest exposure, C1, is available, the financial undertaking may compute N as 1/C1. 5. The risk weights in column B shall be applied to all other securitisation positions. 6. Credit risk mitigation on securitisation positions may be recognised in accordance with the provisions of Articles 6:42 to 6:44. Section The internal assessment approach for securitisation positions in ABCP programmes Article 6:32 Subject to the prior approval of De Nederlandsche Bank, a financial undertaking may, in accordance with the provisions of Article 6:36, attribute to an unrated securitisation position in an ABCP programme a internally derived rating when the conditions set out in Articles 6:33 to 6:35 are satisfied. Article 6:33 The commercial paper issued from the ABCP programme shall concern rated securitisation positions. Article 6:34 1. The internal assessment approach shall meet the following conditions: (a) the financial undertaking shall satisfy De Nederlandsche Bank that its internal assessment of the credit quality of the securitisation position reflects the publicly available assessment methodology of one or more eligible credit assessment institutions for the rating of securities backed by exposures of the type securitised; (b) the eligible credit assessment institutions whose methodology shall be reflected as required by (a) above, shall include those eligible credit assessment institutions which have provided an external rating for the commercial paper issued from the programme. Quantitative elements such as stress factors used in attributing a particular credit quality to the securitisation position shall be at least as conservative as those used in the relevant assessment methodology of the eligible credit assessment institutions in question; (c) in developing its internal assessment methodology, the financial undertaking shall take into consideration relevant published rating methodologies of eligible credit assessment institutions for the rating of the commercial paper of the ABCP programme. This consideration shall be documented by the financial undertaking and updated on a regular basis in accordance with the provisions of subparagraph (f) below; (d) the financial undertaking s internal assessment methodology shall include rating grades, with an explicitly documented correspondence between such rating grades and the credit assessments of eligible credit assessment institutions; 112

113 (e) the internal assessment methodology shall be used in the financial undertaking s internal risk management processes, including its decision making, management information and internal capital allocation processes; (f) internal or external auditors, an eligible credit assessment institution, or the financial undertaking s internal credit review or risk management function shall perform regular independent reviews of the internal assessment processes and the quality of the internal assessments of the credit quality of the financial undertaking s exposures to an ABCP programme, and (g) the financial undertaking shall track the performance of its internal ratings over time to evaluate the performance of its internal assessment methodology and shall make adjustments, as necessary, to that methodology when the performance of the exposures regularly diverges from that indicated by the internal ratings. 2. The requirement, as set out in subparagraph 1(a) above, for the assessment methodology of the eligible credit assessment institution to be publicly available may be waived by De Nederlandsche Bank where the financial undertaking demonstrates to De Nederlandsche Bank that, due to the specific features of the securitisation, there is as yet no publicly available assessment methodology of an eligible credit assessment institution. Article 6:35 The ABCP programme shall meet the following conditions: (a) the ABCP programme shall incorporate underwriting standards in the form of credit and investment guidelines; (b) the ABCP programme s underwriting standards shall establish minimum asset eligibility criteria, including at any rate criteria that: (i) rule out the purchase of assets that are significantly past due or defaulted; (ii) limit excess concentration to an individual obligor or geographical area, and (iii) limit the tenor of the assets to be purchased; (c) the ABCP programme shall have collection policies and processes that take into account the operational capability and credit quality of the servicer, and the programme shall mitigate the risk for the seller or servicer through various methods; (d) the aggregated estimate of loss on an asset pool that the ABCP programme is considering purchasing must take into account all sources of potential risk, such as credit and dilution risk. If the level of the seller-provided credit enhancement is based solely on credit-related losses, a separate reserve shall be established for dilution risk, if dilution risk is material to the particular pool of exposures. In addition, in determining the required credit enhancement level, the programme shall review several years of historical information regarding losses, arrears, dilutions, and the turnover rate of short-term receivables, and (e) the ABCP programme shall incorporate structural features for example wind-down triggers into the purchase of exposures in order to mitigate potential credit deterioration of the underlying portfolio. Article 6:36 1. The unrated securitisation position shall be assigned by the financial undertaking to one of the rating grades described in Article 6:34(1), under (d). The securitisation position shall be attributed the same derived rating as the credit assessments corresponding to that rating grade as laid down in Article 6:34(1), under (d). 2. Where, at the inception of the securitisation, the derived rating referred to in paragraph 1 above, second sentence, is at the level of investment grade or better, it shall be considered equivalent to an eligible credit assessment by an eligible credit assessment institution for the purposes of calculating risk-weighted exposure amounts. 113

114 Section Supervisory formula method Article 6:37 1. Without prejudice to the provisions of Article 6:41, under the supervisory formula method, the risk weight for a securitisation position shall be the greater of 7% or the risk weight to be applied in accordance with paragraph 2 below. 2. Without prejudice to the provisions of Article 6:41, the risk weight to be applied to the securitisation position shall be that resulting from the supervisory formula set out as formula A in Annex If the exposure value of the largest securitised exposure is no more than 3% of the sum of the exposure values of the securitised exposures, the financial undertaking may, for the purposes of the supervisory formula method referred to in paragraph 2 above, use the simplified inputs set out in formula B in Annex For securitisations involving retail exposures, a financial undertaking may implement the supervisory formula method using the simplifications: h = 0 and v = 0, if the effective number of exposures as referred to in Article 6:31(4) is larger than 500 or if the financial undertaking ascertains that the use of the simplifications does not lead to a material change in the capital requirement. 5. Credit risk mitigation on securitisation positions may be recognised in accordance with Articles 6:42, 6:43, 6:45 and 6:46. Section Liquidity facilities Subsection Applicability of provisions Article 6:38 The provisions of Articles 6:39 to 6:41 shall be applicable for the purposes of determining the conversion figure to be applied to the exposure value of an unrated securitisation position in the form of certain types of liquidity facilities. Subsection Liquidity facilities that may be drawn only in the event of a general market disruption Article 6:39 A conversion figure of 20% may be applied to the nominal amount of a liquidity facility that may only be drawn in the event of a general market disruption and that meets the conditions for an eligible liquidity facility set out in Article 6:22.. Subsection Cash advance facilities Article 6:40 A conversion figure of 0% may be applied to the nominal amount of a liquidity facility that meets the conditions set out in Article 6:25. Subsection Exceptional treatment where K irb cannot be calculated Article 6:41 1. When it is not practical for a financial undertaking to calculate the risk-weighted exposure amounts for the securitised exposures as if they had not been securitised, the financial 114

115 undertaking may, on an exceptional basis and subject to the prior approval of De Nederlandsche Bank, temporarily apply the method described in this Article for the calculation of risk-weighted exposure amounts for an unrated securitisation position in the form of a liquidity facility that meets the conditions for an eligible liquidity facility set out in Article 6:22 or that satisfies the provisions of Article 6: The highest risk weight that would be applied under Articles 61, 61a, 82(1), 83 and 88 of the Decree to any of the securitised exposures had they not been securitised may be applied to the securitisation position represented by the liquidity facility. In addition, for determining the exposure value of the position, the following is applicable: (a) a conversion figure of 50% may be applied to the nominal amount of the liquidity facility if the facility has an original maturity of one year or less; (b) a conversion figure of 20% may be applied if the liquidity facility complies with the conditions in Article 6:39, and (c) in all other cases a conversion figure of 100% shall be applied. Section Recognition of credit risk mitigation in respect of securitisation positions Subsection Funded credit protection Article 6:42 Eligible funded credit protection is limited to the instruments referred to in Articles 80 to 82(3) of the Decree which are eligible for the calculation of risk-weighted exposure amounts under Articles 61, 61a, 82(1), 83 and 88 of the Decree, and recognition is subject to compliance with the relevant minimum requirements set out in the former Articles. Subsection Unfunded credit protection Article 6:43 Eligible unfunded credit protection and unfunded credit protection providers are limited to those which are eligible under Articles 80 to 82(3) of the Decree, and recognition is subject to compliance with the relevant minimum requirements set out in those Articles. Subsection Calculation of capital requirements for securitisation positions with credit risk mitigation Subsection a Ratings based method Article 6:44 Where risk-weighted exposure amounts are calculated using the ratings based method, the exposure value or the risk-weighted exposure amount for a securitisation position in respect of which credit protection has been obtained may be modified in accordance with the provisions of Articles 81(6) and 82(1) of the Decree as they apply for the calculation of risk-weighted exposure amounts under Articles 61, 61a, 82(1), 83 and 88 of the Decree. Subsection b Supervisory formula method full credit protection Article 6:45 1. Where risk-weighted exposure amounts are calculated using the supervisory formula method, the financial undertaking shall determine the effective risk weight of the 115

116 securitisation position by dividing the risk-weighted exposure amount of the position by the exposure value of the position and multiplying the result by In the case of funded credit protection, the risk-weighted exposure amount of the securitisation position shall be calculated by multiplying the funded protection adjusted exposure amount of the position (E*, as calculated under Articles 80 to 82(3) of the Decree for the calculation of risk-weighted exposure amounts under Articles 61, 61a, 82(1), 83 and 88 of the Decree, taking the amount of the securitisation position to be E) by the effective risk weight. 3. In the case of unfunded credit protection, the risk-weighted exposure amount of the securitisation position shall be calculated by multiplying G A (the amount of the protection adjusted for any currency mismatch and maturity mismatch in accordance with the provisions of Articles 81:6 and 82(1) of the Decree) by the risk weight of the protection provider, and adding this to the amount arrived at by multiplying the amount of the securitisation position minus G A by the effective risk weight. Subsection c Supervisory formula method - partial credit protection Article 6:46 1. If the credit risk mitigation covers the first loss or losses on a proportional basis on the securitisation position, the financial undertaking may apply the provisions of Article 6: In other cases the financial undertaking shall treat the securitisation position as two or more positions with the uncovered portion being considered the position with the lower credit quality. For the purposes of calculating the risk-weighted exposure amount for this position, the provisions of Section shall apply mutatis mutandis, subject to the modifications that T shall be adjusted to e* in the case of funded protection and to T-g in the case of unfunded protection, where: (a) e* denotes the ratio of E* to the total notional amount of the underlying pool; (b) E* is the adjusted exposure amount of the securitisation position calculated in accordance with the provisions of Articles 81(6) and 82(1) of the Decree as they apply for the calculation of risk-weighted exposure amounts under Articles 61, 61a, 82(1), 83 and 88 of the Decree; (c) E is the amount of the securitisation position, and (d) g denotes the ratio of the nominal amount of credit protection (adjusted for any currency or maturity mismatch in accordance with the provisions of Articles 81(6) and 82(1) of the Decree) to the sum of the exposure amounts of the securitised exposures. 3. Where paragraph 2 above is applied, the risk weight of the protection provider shall, in the case of unfunded credit protection, be applied to that portion of the securitisation position not falling within the adjusted value of T. Section Reduction in risk-weighted exposure amounts Article 6:47 1. The risk-weighted exposure amount of a securitisation position to which a 1250% risk weight is applied may be reduced by 12.5 times the amount of any value adjustments made by the financial undertaking in respect of the securitised exposures. To the extent that value adjustments are taken into account for this purpose, they shall not be taken into account for the purposes of the calculation indicated in Article 75(3) of the Decree. 2. The risk-weighted exposure amount of a securitisation position may be reduced by 12.5 times the amount of any value adjustments made by the financial undertaking in respect of the position. 116

117 3. As provided in Article 94(2), opening sentence, of the Decree, in respect of a securitisation position to which a 1250% risk weight applies, a financial undertaking may, as an alternative to including the position in the calculation of risk-weighted exposure amounts, deduct the exposure value of the position from its tier 1 capital and tier 2 capital. 4. For the purposes of paragraph 3 above: (a) the exposure value of the position may be derived from the risk-weighted exposure amounts taking into account any reductions made in accordance with paragraphs 1 and 2 above; (b) the calculation of the exposure value of the position may reflect eligible funded protection in a manner consistent with the methodology described in Section 6.5.7; (c) where the supervisory formula method is used to calculate risk-weighted exposure amounts and L < Kirbr and [L+T] > Kirbr, the securitisation position may be treated as two positions with L equal to Kirbr for the more senior of the securitisation positions. 5. Where a financial undertaking makes use of the alternative indicated in paragraph 3 above, 12.5 times the amount deducted in accordance with that paragraph shall, for the purposes of Section 6.5.2, be subtracted from the amount specified in Section as the maximum riskweighted exposure amount to be calculated by the financial undertakings indicated in Section Title 6.6 Additional capital requirements for securitisations of revolving exposures with early amortisation provisions Section Applicability of this Title and exemptions from early amortisation treatment Article 6:48 In addition to the risk-weighted exposure amounts calculated in respect of its securitisation positions, an originator financial undertaking shall calculate a risk-weighted exposure amount in accordance with the method set out in this Title and subject to the provisions of Article 6:49, when it sells revolving exposures into a securitisation that contains an early amortisation provision. Article 6:49 An originator financial undertaking of the following securitisation types is exempt from the additional capital requirement referred to in Article 6:48: (a) securitisations of revolving exposures whereby investors remain fully exposed to all future draws by borrowers so that the risk on the underlying facilities does not return to the originator financial undertaking, not even after an early amortisation event has occurred, and (b) securitisations where any early amortisation provision is solely triggered by events not related to the performance or rating of the securitised assets or the rating of the originator financial undertaking. Section Principles for the calculation of risk-weighted exposure amounts Article 6:50 1. The financial undertaking shall calculate a risk-weighted exposure amount in respect of the sum of the originator s interest and the investors interest. 2. For securitisation structures where the securitised exposures comprise revolving and nonrevolving exposures, the originator financial undertaking shall apply the treatment set out in this Title to that portion of the underlying pool containing revolving exposures. 117

118 Article 6:51 1. If a financial undertaking calculates the risk-weighted exposure amounts using the standardised approach referred to in Title 6.4, it shall apply the provisions of Article 6:50, subject to the provisions of paragraphs 2 to 5 below. 2. The originator s interest is, subject to the provisions of paragraph 3 below, equal to the exposure value of that notional part of a pool of drawn amounts sold into a securitisation, the proportion of which in relation to the amount of the total pool sold into the structure determines the proportion of the cash flows generated by principal and interest collections and other associated amounts which is not available to make payments to those having securitisation positions in the securitisation. 3. To qualify as such, the originator s interest may not be subordinate to the investors interest. 4. Investors interest, as referred to in paragraph 3 above, is understood to be the exposure value of the notional part of the pool of drawn amounts which is not covered by paragraph 2 above. 5. The exposure of the originator financial undertaking associated with its rights in respect of the originator s interest, as referred to in paragraph 2 above, shall not be considered a securitisation position but shall be considered a pro rata exposure to the securitised exposures as if they had not been securitised. Article 6:52 1. If a financial undertaking calculates the risk-weighted exposure amounts using the internal ratings based approach referred to in Title 6.5, it shall apply Article 6:50, subject to the provisions of paragraphs 2 to 5 below. 2. The originator s interest is, subject to the provisions of paragraph 3 below, equal to the sum of: (a) the exposure value of that notional part of a pool of drawn amounts sold into a securitisation, the proportion of which in relation to the amount of the total pool sold into the structure determines the proportion of the cash flows generated by principal and interest collections and other associated amounts which is not available to make payments to those having securitisation positions in the securitisation, and (b) the exposure value of that part of the pool of undrawn amounts of the credit lines, the drawn amounts of which have been sold into the securitisation, the proportion of which to the total amount of such undrawn amounts is the same as the proportion of the exposure value described in subparagraph (a) above to the exposure value of the pool of drawn amounts sold into the securitisation. 3. To qualify as such, the originator s interest may not be subordinate to the investors interest. 4. Investors interest, as referred to in paragraph 3 above, is understood to be the exposure value of the notional part of the pool of drawn amounts not covered by subparagraph 2(a) above plus the exposure value of that part of the pool of undrawn amounts of credit lines, the drawn amounts of which have been sold into the securitisation, not covered by subparagraph 2(b) above. 5. The exposure of the originator financial undertaking associated with its rights in respect of that part of the originator s interest referred to in subparagraph 2(a) above shall not be considered a securitisation position but shall be considered a pro rata exposure to the securitised exposures in the form of drawn amounts as if they had not been securitised, to an amount equal to that referred to in subparagraph 2(a) above. The originator financial undertaking shall also be considered to have a pro rata exposure to the undrawn amounts of 118

119 the credit lines, the drawn amounts of which have been sold into the securitisation, to an amount equal to that referred to in subparagraph 2(b) above. Section Maximum capital requirement Article 6:53 1. For an originator financial undertaking subject to the additional capital requirement referred to in Article 6:48, the total of the risk-weighted exposure amounts in respect of its securitisation positions in the investors interest and the risk-weighted exposure amounts calculated under Article 6:48 shall not be more than the greater of: (a) the risk-weighted exposure amounts calculated in respect of its securitisation positions in the investors interest, or (b) the risk-weighted exposure amounts that would be calculated in respect of the securitised exposures by a financial undertaking holding the exposures as if they had not been securitised, to an amount equal to the investors interest. 2. Deduction of net gains, if any, arising from the capitalisation of future income required under Articles 91(2), 92(2) and (3), and 94(2) of the Decree shall be kept outside the maximum amount referred to in paragraph 1 above. Section Calculation of risk-weighted exposure amounts Article 6:54 1. The risk-weighted exposure amount to be calculated in accordance with Article 6:48 shall be determined by multiplying the amount of the investors interest by the product of the appropriate conversion figure as indicated in Articles 6:55 and 6:56 and the weighted average risk weight that would apply to the securitised exposures if they had not been securitised. 2. An early amortisation provision shall be considered to be controlled where the following conditions are met: (a) the originator financial undertaking has an appropriate capital/liquidity plan in place to ensure that it has sufficient capital and liquidity available in the event of an early amortisation; (b) throughout the duration of the transaction there is a pro rata sharing between the originator financial undertaking s interest and the investors interest of payments of interest and principal, expenses, losses and recoveries based on the balance of receivables outstanding at one or more reference points during each month; (c) the amortisation period is considered sufficient for 90% of the total debt (originator s interest and investors interest) outstanding at the beginning of the early amortisation period to be repaid or recognised as in default, and (d) the speed of repayment is no more rapid than would be achieved by straight-line amortisation over the period set out in subparagraph (c) above. Article 6:55 1. A financial undertaking shall compare the three-month average excess spread level with the excess spread levels at which excess spread is required to be trapped, if: (a) a securitisation is concerned which is subject to an early amortisation provision; (b) a securitisation is concerned of retail exposures which are uncommitted and unconditionally cancellable without prior notice, and (c) the early amortisation is triggered by the excess spread level falling to a specified level. 119

120 2. In cases where the securitisation does not require excess spread to be trapped, the trapping point is deemed to be 4.5 percentage points higher than the excess spread level at which an early amortisation is triggered. 3. The conversion figure to be applied shall be determined by the level of the actual threemonth average excess spread in accordance with table 5, where: (a) Level A refers to levels of excess spread less than % but not less than 100% of the trapping level of excess spread; (b) Level B refers to levels of excess spread less than 100% but not less than 75% of the trapping level of excess spread; (c) Level C refers to levels of excess spread less than 75% but not less than 50% of the trapping level of excess spread; (d) Level D refers to levels of excess spread less than 50% but not less than 25% of the trapping level of excess spread, and (v) Level E refers to levels of excess spread less than 25% of the trapping level of excess spread. Table 5 Securitisations subject to a controlled early amortisation provision Securitisations subject to a non-controlled early amortisation provision 3-month average excess spread Conversion figure Conversion figure Above level A 0% 0% Level A 1% 5% Level B 2% 15% Level C 10% 50% Level D 20% 100% Level E 40% 100% Article 6:56 The application for permission as referred to in Article 86(3) of the Decree to depart from the provisions of Article 6:55, is rejected if the financial undertaking is unable to demonstrate that: (a) in determining the conversion figure, it applies a treatment which approximates that prescribed in Article 6:55 as closely as possible, and (b) the conversion figure reflects a prudent estimate of the additional capital requirement as referred to in Article 6:48. Article 6:57 1. All securitisations other than those referred to in Article 6:55 which are subject to a controlled early amortisation provision of revolving exposures shall be subject to a conversion figure of 90 %. 2. All securitisations other than those referred to in Article 6:55 which are subject to a non-controlled early amortisation provision of revolving exposures shall be subject to a conversion figure of 100 %. 120

121 Chapter 7 Large exposures Section 7.1 Definitions and scope Article 7:1 In this Chapter, the following terms shall be defined as follows: (a) derivatives: the instruments listed in Annex B to the Decree, except those which are assigned a 0% risk weight under Section 5.4 of the present Regulation, and (b) regulatory capital: the regulatory capital referred to in Article 90(1) of the Decree. Section 7.2 Calculation of exposures Article 7:2 1. Where an exposure to a counterparty is directly and unconditionally guaranteed by a third party, or secured by collateral in the form of securities issued by a third party under the conditions laid down in Article 7:8(2)(i), the exposure shall be treated as having been incurred to that third party or guarantor rather than to the counterparty. 2. Where the guarantee referred to in paragraph 1 above is denominated in a currency different from that in which the exposure is denominated, the amount of the exposure shall be calculated in accordance with the provisions of Chapter For the purposes of paragraph 1 above, in the case of a maturity mismatch between the exposure and the protection, Section 4:8 shall apply mutatis mutandis. 4 For the purposes of paragraph 1 above, partial coverage may be recognised, subject to the provisions of Chapter 4. Article 7:3 1. This Article shall only apply to financial undertakings which calculate the capital requirements for their trading-book business in accordance with Chapter 3 or, as appropriate, Chapter 4 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). 2. The total exposure to an individual counterparty or a group of connected counterparties arising on the trading book shall be equal to the sum of: (a) the excess, where positive, of the financial undertaking s long positions over its short positions in all the financial instruments issued by the counterparty or group of connected counterparties in question, the net position in each of the different instruments being calculated in accordance with the provisions of Subsection 3.2 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico); (b) in the case of the underwriting of an issue of debt instruments: the exposure calculated in accordance with the provisions of Subsection 3.5 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico); (c) in the case of unsettled exposures and exposures subject to counterparty risk: the exposure calculated in accordance with the provisions of Subsection 3.8 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). 3. The overall exposure to an individual counterparty or group of connected counterparties shall be equal to the sum of: (a) the total value of the exposures to that counterparty or group of connected counterparties arising on the trading book, as referred to in paragraph 2 above, and 121

122 (b) the total value of the exposures to that counterparty or group of connected counterparties arising on the non-trading book, calculated in accordance with the definition of large exposures as referred to in Article 1 of the Decree. 4. For the calculation referred to in paragraph 3 above, regarding the exposures as referred to in subparagraph 3(a), no credit risk mitigation shall be recognised for regulatory reporting purposes, unless repurchase transactions, reverse repurchase transactions or securities or commodities lending or borrowing transactions are concerned. Article 7:4 For the purposes of the calculation referred to in Article 7:3(2)(b), a financial undertaking shall set up systems to monitor and control its underwriting exposures between the time of the initial commitment and working day one in the light of the nature of the risks incurred in the markets in question. Article 7:5 1. A financial undertaking shall report all large exposures and all other significant risk concentrations to De Nederlandsche Bank. Without prejudice to the provisions of the preceding sentence, the report shall at any rate include the ten largest exposures. 2. Other significant risk concentrations as referred to in paragraph 1 above, are: (a) in the case of exposures ensuing directly from one or more of the activities referred to in Annex I to the recast Banking Directive: 3% of regulatory capital subject to a lower limit of 4,538,000 or 30% of regulatory capital, whichever is the lower; (b) in the case of exposures other than those referred to in subparagraph (a) above: 1% of regulatory capital subject to a lower limit of 1,361, The report referred to in paragraph 1 above need not be submitted for exposures that have been exempted under Article 7:8(2)(a) or (d). 4. The report referred to in paragraph 1 above need only be submitted twice a year for the exposures referred to in Article 7:8(2)(b), (c) and (e), and Article 7:9. 4. Where a financial undertaking invokes the provisions of paragraph 3 or 4 above, it shall keep a record of the grounds underlying its choice for one year after the event, so that De Nederlandsche Bank may establish, where necessary, whether the choice was justified. The period of one year shall be taken to start as from the last day of the quarter in which the report was first dispensed with. 6. A financial undertaking shall analyse its exposures to collateral issuers for possible concentrations and, where appropriate, take action or report any significant findings to De Nederlandsche Bank. Section 7.3 Limits Article 7:6 1. Provided that the immediate reporting obligation as referred to in Article 102(4), first sentence, of the Decree has been fulfilled, a financial undertaking is granted permission to exceed the limits referred to in Article 102(1) and (2) of the Decree, if: (a) the excess arises entirely on the trading book; (b) in respect of the excess, the financial undertaking meets the additional capital requirements referred to in Subsection 3.11 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico); (c) where 10 days or less have elapsed since the excess occurred, the trading-book exposure to the counterparty or group of connected counterparties in question does not exceed 250% of the financial undertaking s regulatory capital; 122

123 (d) any excesses that have persisted for more than 10 days do not exceed 300% of the financial undertaking s regulatory capital, and (e) the value of the exposure referred to in subparagraph (c) above is reduced within one month of the date when the excess first arose to below the limit referred to in Article 102(1) of the Decree. 2. The provisions of paragraph 1 above may be invoked only if the financial undertaking reports to De Nederlandsche Bank every three months all cases where the limit laid down in Article 102(1) of the Decree was exceeded during the preceding three months. For each case in which the limit was exceeded, the amount of the excess and the name of the counterparty or group of connected counterparties in question shall be reported separately. Section 7.4 Exemptions Article 7:7 1. For the purposes of Article 7:2 and Articles 7:8 and 7:9, the term guarantee shall include the credit derivatives recognised under Chapter 4 other than credit linked notes. 2. If a financial undertaking recognises credit protection under Article 7:2 and Articles 7:8 and 7:9, the provisions of Chapter 4 shall apply mutatis mutandis. Article 7:8 1. The provisions of Article 102(1) and (2) of the Decree shall not apply to exposures incurred by a financial undertaking to its parent undertaking, to other subsidiaries of that parent undertaking or to its own subsidiaries, in so far as those undertakings are covered by the consolidated supervision as referred to in Part of the Act. 2. The following exposures are exempted from the application of Article 102(1) and (2) of the Decree: (a) the following asset items which, if unsecured, would be assigned a risk weight of 0% under the provisions of Chapter 2: (1 ) asset items constituting claims on central governments or central banks; (2 ) asset items constituting claims on international organisations or multilateral development banks; (3 ) asset items constituting claims carrying the explicit guarantees of central governments, central banks, international organisations, multilateral development banks or public sector entities, and (4 ) other exposures attributable to, or guaranteed by, central governments, central banks, international organisations, multilateral development banks or public sector entities; (b) asset items constituting claims on and other exposures to central governments or central banks not mentioned in subparagraph (a) which are denominated and, where applicable, funded in the national currencies of the borrowers; (c) asset items constituting claims on regional governments and local authorities or claims on or guaranteed by regional governments and local authorities if such claims would be assigned a risk weight of 0% under the provisions of Chapter 2; (d) the following asset items and other exposures fully secured by collateral issued by or placed with the lending bank or with a bank which is the parent undertaking or a subsidiary of the lending institution, provided that such collateral takes the form of: (1 ) cash deposits, including cash deposits received from credit linked notes issued by the bank or received as part of a settlement as referred to in Section 4.2; (2 ) certificates of deposit; (3 ) debt securities issued by central governments or central banks, international organisations, multilateral development banks, Member States' regional governments, local 123

124 authorities or public sector entities, which securities constitute claims on their issuer which would be assigned a 0 % risk weighting under the provisions of Chapter 2, to the extent that the collateral represents an excess value of at least 12%; (e) asset items constituting claims on and other exposures to banks or investment firms, with a maturity of one year or less, but not constituting such banks or investment firms regulatory capital; (f) bills of trade and promissory notes, with a maturity of one year or less, bearing the signature of another bank; (g) covered bonds as referred to in Annex I, meeting the excess value requirements referred to in subparagraph (d)(3 ) above and subparagraph (i) below; (h) holdings, as referred to in Section 3:268(1) of the Act, in insurance companies up to 40 % of the regulatory capital of the financial undertaking having such a holding; (i) exposures secured by collateral in the form of securities other than those referred to in subparagraph (d)(3 ) above, provided that: (1 ) the securities used as collateral are valued at market price; (2 ) the securities are quoted on a regulated market; (3 ) relative to the secured exposures, the securities have an excess value of 100%, unless: (i) the securities consist of equities, in which case the securities shall have an excess value of 150%, or (ii) the securities consist of debt securities issued by financial undertakings, Member States regional governments or local authorities other than those referred to in subparagraph d(3 ) and, in the case of debt securities issued by multilateral development banks other than those assigned a 0 % risk weight under the provisions of Chapter 2, in which case the securities shall have an excess value of 50%. (4 ) there is no mismatch between the maturity of the exposure and the maturity of the credit protection; if there a mismatch between the maturity of the exposure and the maturity of the credit protection, the collateral shall not be recognised; (5 ) the securities used as collateral do not form part of the financial undertaking s regulatory capital; (j) loans secured by mortgages on residential property or by shares in Finnish residential housing companies, operating in accordance with the Finnish Housing Company Act of 1991 or subsequent equivalent legislation and leasing transactions under which the lessor retains full ownership of the residential property leased for as long as the lessee has not exercised his option to purchase, in all cases up to 50 % of the value of the residential property concerned, provided that: (1 ) the value of the property is calculated in accordance with the provisions of Article 2:29(b), and (2 ) valuation of the property is carried out at least once a year. Article 7:9 1. For the purpose of assessing whether the limits referred to in Article 102(1) and (2) of the Decree are exceeded, a financial undertaking shall assign a weighting of 20 % to the following asset items, provided that such asset items would be assigned a risk weight under Section 2.2 of 20%: (a) asset items constituting claims on Member States' regional governments and local authorities, and (b) asset items constituting exposures to or guaranteed by such governments and authorities. 2. For the purpose of assessing whether the limits referred to in Article 102(1) and (2) of the Decree are exceeded, a financial undertaking shall assign the following weightings to the 124

125 following asset items, irrespective of whether such asset items would be assigned a risk weight of 20% under the provisions of Section 2.2: (a) 20% for asset items constituting claims on or other exposures to banks or investment firms, with a maturity of more than one year but not exceeding three years; (b) 50% for asset items constituting claims on banks or investment firms, with a maturity of more than three years, provided that such claims: (1 ) consist of debt securities issued by a bank; (2 ) these debt securities are traded on a regulated market, and (3 ) these exposures do not form part of that bank s regulatory capital. Chapter 8 Transitional and final provisions Article 8:1 1. Notwithstanding the provisions of Annex 1, covered bonds issued before 31 December 2007 shall be eligible for treatment in accordance with Article 2:40 until their final maturity. 2. Until 31 December 2010, the limit of 20% referred to in Annex 1(1)(e), for senior units issued by French Fonds Communs de Créances or equivalent securitisation entities shall not apply to the extent that for such securities a credit assessment is available from a nominated credit assessment institution which is the most favourable assigned by that credit assessment institution to covered bonds. Article 8:2 Until 31 December 2010, the LGD value referred to in Article 3:44(1)(c), may be replaced by an LGD value of , if: (a) assets as defined in Annex 1 collateralising the bonds are all eligible for credit quality step 1 in accordance with the provisions of Chapter 2 of the present Regulation; (b) if assets as defined in Annex 1(1), under (d) and (e), are used as collateral, the maximum limits laid down under each of these letters, 10% of the nominal amount of the outstanding issue. (c) assets as defined in Annex 1(1), under (f), are not used as collateral, or (d) the covered bonds have a credit assessment by a nominated credit assessment institution and the credit assessment institution classes these bonds in the most favourable category of credit assessments assigned by the credit assessment institution to covered bonds. Article 8:3 A financial undertaking which, pursuant to Article V(3) of the Decree implementing the Basel II Capital Accord (Besluit implementatie kapitaalakkoord Bazel 2) leaves Subsection 10.1c of the Decree out if consideration, shall apply the Solvency Regulation on Securitisation (Regeling inzake solvabiliteit bij securitisatie) until 1 January Article 8:4 A bank, investment firm or clearing institution which applies Article VIII(5) of the Decree implementing the Basel II Capital Accord (Besluit implementatie kapitaalakkoord Bazel 2) shall apply the provisions under Section 20(3) of the Act on the Supervision of the Credit System 1992 (Wet toezicht kredietwezen 1992) or, as appropriate, Sections 1 to 7 of the Regulations on Prudential Supervision of the Securities Trade 2002 (Nadere regeling prudentieel toezicht effectenverkeer 2002), as they were in force prior to the date of entry into force of the present Regulation and if not included in Chapter 10 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). 125

126 Article 8:5 1. The following instruments are repealed: (a) Policy rule for indexation method for determining the forced-sale value of the mortgage portfolio (Beleidsregel indexatiemethode ter bepaling van executiewaarde hypotheekportefeuille); (b) Policy rule on credit derivatives (Beleidsregels kredietderivaten); (c) Regulation on deductions from capital (Regeling Vermogensaftrek). 2. The Solvency Regulation on Securitisation (Regeling inzake solvabiliteit bij securitisatie) shall be repealed effective 1 January Article 8:6 This Regulation shall enter into force on 1 January Article 8:7 This Regulation shall be cited as the Supervisory Regulation on Solvency Requirements for Credit Risk (Regeling solvabiliteitseisen voor het kredietrisico). This Regulation and the appurtenant explanatory notes shall be published in the Staatscourant (Government Gazette). De Nederlandsche Bank N.V. /s/ A.. Schilder, Executive Director /s/ D.E. Witteveen, Executive Director Annex 1 Definition of covered bonds 1. The assets collateralising covered bonds are the following: (a) exposures to or guaranteed by central governments in the European Union or by central governments, central banks, multilateral development banks and international organisations that qualify for credit quality step 1; (b) exposures to or guaranteed by public sector entities, regional governments and local authorities in the European Union or by public sector entities, regional governments and local authorities that are risk-weighted as exposures to central governments or central banks in accordance with Articles 2:8 and 2:9 and Article 2:12, respectively; (c) subject to the provisions of paragraph 3 below, exposures to financial undertakings that qualify for credit quality step 1, provided that the total exposure of this kind excluding exposures caused by transmission of payments by obligors in respect of loans secured by real estate to holders of covered bonds shall not exceed 15 % of the nominal amount of the outstanding covered bonds of the issuing financial undertaking. (d) loans secured by residential real estate or shares in Finnish residential housing companies as referred to in Article 2:29 up to the lesser of the principal amount of the liens combined with any prior liens and 80 % of the value of the pledged properties; (e) subject to the provisions of paragraph 4 or paragraph 5 below, exposures secured by senior units issued by French Fonds Communs de Créances or by equivalent securitisation entities governed by the laws of a Member State securitising residential real estate exposures; 126

127 (f) loans secured by ships but only where the liens combined with any prior liens are below 60% of the value of the pledged ship. 2. For the purposes of paragraph 1 above, collateralised includes situations where the assets as described in paragraph 1 above are exclusively dedicated in law to the protection of the bond-holders against losses. 3. Notwithstanding the provisions of subparagraph 1(c) above, exposures to financial undertakings in the European Union with a maturity not exceeding 100 days may also serve as collateral if they qualify for credit quality step Subparagraph 1(e) above shall be applied only if at least 90% of the securities listed there are composed of mortgages that are combined with any prior liens up to the lesser of the principal amounts due under the senior units, the principal amounts of the liens, and 80% of the value of the pledged properties. Where such senior units do not exceed 20% of the nominal amount of the outstanding issue, they shall also qualify for credit quality step 1. Exposures caused by transmission and management of payments of the obligors of, or liquidation proceeds in respect of, loans secured by pledged properties of the senior units or debt securities shall not be comprised in calculating the 90% limit. 5. Furthermore, subparagraph 1(e) above shall be applied only if at least 90% of the securities listed there are composed of mortgages that are combined with any prior liens up to the lesser of the following amounts: the principal amounts due under the senior units, the principal amounts of the liens, and 60% of the value of the pledged properties. Where such senior units do not exceed 20% of the nominal amount of the outstanding issue, they shall also qualify for credit quality step 1. Exposures caused by transmission and management of payments by the obligors of, or liquidation proceeds in respect of, loans secured by pledged properties of the senior units or debt securities shall not be comprised in calculating the 90% limit. Annex 2A Tables of the risk weights to be assigned to exposures Table A Risk weights based on credit assessments by credit assessment institutions (in %) Credit quality step Central governments and central banks Regional governments and local authorities Financial undertakings (maturity > 3 months) Financial undertakings (maturity 3 months) Corporates Specific short-term exposures to financial undertakings and corporates Collective investment undertakings (CIUs) Table B Risk weights based on credit assessments by export credit insurance agencies (%) Minimum export insurance premium (MEIP) Risk weight Annex 2B List of regional governments and local authorities assigned the same risk weight as their central government 127

128 The Netherlands Provinces Municipalities Water boards Joint boards of an administrative nature Other European Union Member States Regional governments and local authorities that have been included by the national supervisory authority for financial undertakings in the list of regional governments and local authorities assigned the same risk weight as their central government. Other countries Regional governments and local authorities that have been included by the national supervisory authority for financial undertakings in the countries listed in Annex 2E in the list of regional governments and local authorities assigned the same risk weight as their central government. Annex 2C List of multilateral development banks attracting a 0% risk weight (a) International Bank for Reconstruction and Development (b) International Finance Corporation (c) Inter-American Development Bank (d) Asian Development Bank (e) African Development Bank (f) Council of Europe Development Bank (g) Nordic Investment Bank (h) Caribbean Development Bank (i) European Bank for Reconstruction and Development (j) European Investment Bank (k) European Investment Fund (l) Multilateral Investment Guarantee Agency (m) International Finance Facility for Immunisation (n) Islamic Development Bank Annex 2D Classification of off-balance-sheet items 1. Full risk: (a) Guarantees having the character of credit substitutes (b) Credit derivatives (c) Acceptances (d) Endorsements on bills not bearing the name of another financial undertaking (e) Transactions with recourse (f) Irrevocable standby letters of credit having the character of credit substitutes (g) Assets purchased under outright forward purchase agreements (h) Forward forward deposits (i) The unpaid portion of partly-paid shares and securities, and (j) Asset sale and repurchase agreements as defined in Article 1 of the Decree. 128

129 2. Medium risk: (a) Documentary credits issued and confirmed (b) Guarantees not having the character of credit substitutes and other warranties and indemnities (including tender, performance, customs and tax bonds) (c) Irrevocable standby letters of credit other than those set out in subparagraph 1(f) above, not having the character of credit substitutes (d) Undrawn credit facilities with an original maturity of more than one year (e) Note issuance facilities (NIFs) and revolving underwriting facilities (RUFs). Medium/low risk: (a) Documentary credits in which underlying shipments act as collateral and other self-liquidating transactions (b) Undrawn credit facilities with an original maturity of up to and including one year which may not be cancelled unconditionally at any time or because of deterioration in a borrower's creditworthiness. Low risk: (a) Undrawn credit facilities which may be cancelled unconditionally at any time or because of deterioration in a borrower's creditworthiness, and (b) Retail credit lines if the terms and Dutch consumer protection legislation permit the financial undertaking to cancel them. Annex 2E List of countries with equivalent supervision For the purposes of Articles 2:5, 2:9, 2:13 and 2:45, the following countries operate supervisory practices and arrangements which are equivalent to those in the European Union: - United States; - Canada; - Japan; - Republic of Korea; - Hong Kong; - Singapore; - Australia; - New Zealand, and - Switzerland. Annex 3 Formulas and tables for computing risk-weighted exposure amounts and expected loss amounts for the application of the IRB A. Formulas I. Formulas for Article 3:20 Formula 1: Correlation factor for central governments and central banks, financial undertakings and corporates Correlation (R. = 129

130 0.12 ( 1 EXP ( 50 * PD ))/( 1 EXP ( 50) ) [ 1 ( 1 EXP ( 50 * PD ))/( 1 EXP ( 50 ))] EXP(x) denotes e x * Formula 2: Maturity adjustment for central governments and central banks, banks and investment firms and corporates Maturity factor (b) = ( *ln(PD)) 2 Formula 3: Risk weight for central governments and central banks, banks and investment firms and corporates Risk weight (RW) = (LGD* N[(1 R) 0.5 * G(PD) + (R/(1 R)) 0.5 * G(0.999)] PD * LGD)* (1 1.5 * b) 1 * (1 + (M 2.5) * b) * 12.5 * 1.6 N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x). G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N (x)= z). Formula 4: Risk-weighted exposure amount for central governments and central banks, banks and investment firms and corporates Risk-weighted exposure amount = RW exposure value If PD = 0: Risk-weighted exposure amount = 0 If PD = 1: (a) Risk-weighted exposure amount = 0 for financial undertakings applying foundation IRB (b) Risk-weighted exposure amount = maximum of 0 and 12.5*(LGD EL BE ) for financial undertakings applying advanced IRB Formula 4a: Risk-weighted exposure amount adjusted for double default effect Risk-weighted exposure amount = RW * exposure value * (( *PDpp) PDpp = PD of the protection provider RW is calculated using formula 3 for the PD of the obligor and the LGD of a comparable direct exposure to the protection provider. The maturity factor (b) is calculated using the lower of the PD of the protection provider and the PD of the obligor. Formula 5: Correlation factor for small corporates assigned to the corporates class Correlation (R) = 0.12 ( 1 EXP ( 50 * PD )) / ( 1 EXP ( 50 )) [ 1 ( 1 EXP ( 50 * PD ))/ ( 1 EXP ( 50) )] 0.04 * ( 1 ( S 5) / 45) * 130

131 In this formula, S is expressed as total annual sales in millions of euro, where 5 million <= S <= 50 million. Reported sales of less than 5 million are treated as if they were equivalent to 5 million. II. Formulas for Article 3:24 Formula 6: Correlation factor for retail exposures Correlation (R) = 0.03 ( 1 EXP ( 35 * PD )) / ( 1 EXP ( 35 )) [ 1 ( 1 EXP ( 35 * PD ))/( 1 EXP ( 35 ))] Formula 7: Risk weight for retail exposures * Risk weight (RW): LGD * N [(1 R) 0.5 * G(PD) + (R/(1 R)) 0.5 * G(0.99)] PD * LGD) * 12.5 * 1.06 Formula 8: Risk-weighted exposure amount for retail exposures Risk-weighted exposure amount = RW exposure value If PD = 1: Risk-weighted exposure amount = maximum of 0 and 12.5 * (LGD EL BE ) III. Formula for Article 3:27 Formula 9: Risk-weighted exposure amounts for equity exposures Risk-weighted exposure amount = RW exposure value where the risk weight (RW) can take on different values: (i) 190% for non-exchange-traded equity exposures that the financial undertaking can demonstrate are assigned to sufficiently diversified portfolios; (ii) 290% for exchange-traded equity exposures; (iii) 370% for all other equity exposures. IV. Formula for Article 3:33 Formula 10: Risk-weighted exposure amounts for other non-credit-obligation assets Risk-weighted exposure amount = 100% exposure value except when the exposure is a residual value in which case it should be determined each year and be calculated as follows: l/t * 100% * exposure value t denotes the remaining number of years of the lease contract term. For remaining terms of less than one year, the value 1 is used for t. V. Formulas for Article 3:35 Formula 11: Expected loss 131

132 Expected loss (EL) = PD LGD Formula 12: Expected loss amount Expected loss amount = EL exposure value For exposures of which the risk-weighted exposure amount has been calculated using formula 4a, EL is equal to 0. VI. Formulas for Article 3:57 Formula 13: Expected loss amounts for positions under the simplified risk weight approach Expected loss amount = EL exposure value where the following values apply for expected loss (EL): (i) 0.8% for non-exchange-traded equity exposures that have been assigned to sufficiently diversified portfolios; (ii) 0.8% for exchange-traded equity exposures; (iii) 2.4% for all other equity exposures. Formula 14: Expected loss for positions under the PD/LGD approach Expected loss (EL) = PD LGD Formula 15: Expected loss amount for positions under the PD/LGD approach Expected loss amount = EL exposure value VII. Formulas for Article 3:38 Formula 16: Expected loss for dilution risk Expected loss (EL) = PD LGD Formula 17: Expected loss amount Expected loss amount = EL exposure value VIII. Formulas for Article 3:46 Formula 18: M for exposures subject to a cash flow schedule M = MAX{1; MIN{ t t t * CF / CF ; 5}} t t where CFt denotes the cash flows (principal, interest payments and fees) contractually payable by the obligor in period t. Formula 18a: M for exposures for which, in accordance with Chapter 5, Section 5.6, financial undertakings calculate the exposure value using an in-house model 132

133 M = MIN tk 1 year k = 1 EffectiveE tk 1 year k = 1 E k * t k EffectiveE * df E k k + maturity tk > 1 year * t k EE * df k k * t k * df k ;5 where df k is the risk-free discounting factor for the future period t k and the other symbols are defined as in Chapter 5, Section 5.6. B. Tables I. Table for Article 3:21 Table 1 Remaining category 1 category 2 category 3 category 4 category 5 maturity Less than 2.5 years 50% 70% 115% 250% 0% At least 2.5 years 70% 90% 115% 250% 0% II. Table for Article 3:36 Table 2 Remaining category 1 category 2 category 3 category 4 category 5 maturity Less than 2.5 years 0% 0.4% 2.8% 8% 50% At least 2.5 years 0.4% 0.8% 2.8% 8% 50% Annex 4A Formulas to be used for the calculation of risk-weighted exposure amounts and expected loss amounts for the purposes of credit risk mitigation Explanation of signs used in formulas ( ) = the sum of... = the absolute value of... max ( ) = the maximum of Formula 1a for Article 4:9(1) and Article 4:39(1) Calculation of E* in on-balance sheet netting and under the financial collateral comprehensive method: E* = max {0, [E VA - C VAM ]} where E VA is the volatility-adjusted exposure amount (see formula 1c), and C VAM is the volatility-adjusted value of the collateral (see formula 1b), further adjusted for any maturity mismatch (see formula 10). Formula 1b for Article 4:39(1) Calculation of the volatility-adjusted exposure amount as referred to in formula 1a: 133

134 E VA = E x (1+H E ), and in the case of OTC derivative transactions E VA = E where E is the exposure value as it would be determined if the exposure was not collateralised, and H E is the volatility adjustment appropriate to the exposure (E). Formula 1c for Article 4:39(1) Calculation of the volatility-adjusted value of the collateral as referred to in formula 1a: C VA = C x (1-H C -H FX ) where C VA is the volatility-adjusted value of the collateral; C is the value of the securities borrowed, purchased or received or the cash borrowed or received in respect of each such exposure; H C is the volatility adjustment appropriate for the collateral, and H FX is the volatility adjustment appropriate for a currency mismatch. Formula 2 for Article 4:9(3) and Article 4:40(3) Calculation of the adjusted LGD based on E* to be used under the foundation IRB approach: LGD* = LGD x (E*/E) where LGD is the loss-given-default that would apply to the exposure if the exposure was not collateralised; E is the exposure value as it would be determined if the exposure was not collateralised, and E* is de exposure value as calculated in accordance with formula 1a. Formula 3 for Article 4:12(1) Calculation of E* in accordance with the supervisory volatility adjustments approach or the own estimates volatility adjustments approach for repo-style transactions and capital marketdriven transactions under a master netting agreement: E* = max {0, [( (E) - (C)) + ( net position in each type of security or commodity x H sec ) + ( E fx x H fx )]} where: E* is the fully adjusted exposure value; E is the exposure value for each separate exposure under the agreement that would apply in the absence of credit protection; C is the value of the securities or commodities borrowed, purchased or received or the cash borrowed or received in respect of each such exposure; (E) is the sum of all Es under the agreement; (C) is the sum of all Cs under the agreement; H sec is the volatility adjustment appropriate to a particular type of security or commodity and is applied to the absolute value of the net position in the securities or commodities of that type; 134

135 H fx is the foreign exchange volatility adjustment and is applied to the absolute value of the net position in each currency other than the settlement currency of the master netting agreement; E fx is the net position (positive or negative) in a given currency other than the settlement currency of the agreement and is calculated as follows: E fx = (the total value of securities or commodities denominated in that currency lent, sold or provided under the master netting agreement plus the amount of cash in that currency lent or transferred under the agreement) minus (the total value of securities or commodities denominated in that currency borrowed, purchased or received under the agreement plus the amount of cash in that currency borrowed or received under the agreement), and the net position in each type of security or commodity is the total value of the securities or commodities of that type lent, sold or provided under the master netting agreement less the total value of securities or commodities of that type borrowed, purchased or received under that agreement. Formula 4 for Article 4:12(2) Calculation of E* in accordance with the VaR method for repo-style transactions and capital market-driven transaction under a master netting agreement : E* = max {0, [( E - C) + (output of the VaR model)]} where E is the exposure value for each separate exposure under the agreement that would apply in the absence of the credit protection; C is the value of the securities borrowed, purchased or received or the cash borrowed or received in respect of each such exposure; (E) is the sum of all Es under the agreement, and (C) is the sum of all Cs under the agreement. Formula 5 for Article 4:39(2) Calculation of the volatility adjustment where the collateral consists of a number of recognised items: H = a H i i i where a i is the proportion of an item to the collateral as a whole, and H i is the volatility adjustment applicable to that item. Formula 6 for Article 4:46(2) Calculation of the adjusted volatility adjustment if a financial undertaking uses a shorter or a longer liquidation period than the minimum liquidation period: = H M H N T M / T N where H M is the volatility adjustment under the minimum liquidation period; H N is the volatility adjustment based on the liquidation period T N ; T M is the minimum liquidation period, and 135

136 T N is the liquidation period used by the financial undertaking. Formula 7 for Article 4:50 Calculation of the adjusted volatility adjustment if the frequency of revaluation is less than daily: H = H M N R + ( TM 1) T M where H is the volatility adjustment to be applied; H M is the volatility adjustment where there is daily revaluation; N R is the actual number of business days between two revaluations, and T M is the minimum liquidation period for the type of transaction in question. Formula 8 for Article 4:93(1) Calculation of the adjusted nominal value of the credit protection: G* = G x (1-H fx ) where G is the nominal amount of the credit protection (adjusted for the absence, if any, of restructuring as a credit event), and H fx is the volatility adjustment for any currency mismatch between the credit protection and the underlying credit obligation. Formula 9 for Article 4:93(4) Calculation of the risk-weighted exposure amounts if the protected amount is less than the exposure value and both portions are of equal seniority: RWA = (E-G A ) x r + G A x g where RWA is the risk-weighted value of the exposure; E is the exposure value; G A is the value of G* as calculated in accordance with formula 8 and further adjusted for any maturity mismatch as specified in Section 4.9; r is the risk weight of exposures to the obligor as specified under the standardised approach, and g is the risk weight of exposures to the protection provider as specified under the standardised approach. Formula 10 for Article 4:99(1) Adjustment of the adjusted value of the collateral to reflect maturity mismatch: C VAM = C VA x (t-t*)/(t-t*) where C VA is the volatility-adjusted value of the collateral; 136

137 t is the number of years remaining to the maturity date of the credit protection calculated in accordance with Subsection 4.9.2, or the value of T, whichever is the lower; T is the number of years remaining to the maturity date of the exposure calculated in accordance with Subsection 4.9.2, or five years, whichever is the lower; t* = 0.25, and C VAM is C VA, further adjusted for maturity mismatch and is to be included in formula 3 for the calculation of the fully adjusted value of the exposure (E*) as set out in Articles 4:42 and 4:43. Formula 11 for Article 4:99(3) Adjustment of the adjusted value of the guarantee/credit protection to reflect maturity mismatch: G A = G* x (t-t*)/(t-t*) where G* is the amount of the protection adjusted for any currency mismatch; see formula 8; G A is G* adjusted for any maturity mismatch; t is the number of years remaining to the maturity date of the credit protection calculated in accordance with Subsection 4.9.2, or the value of T, whichever is the lower; T is the number of years remaining to the maturity date of the exposure calculated in accordance with Subsection 4.9.2, or five years, whichever is the lower; t* = 0.25, and G A is then taken as the value of the protection. Annex 4B Tables to be used for the calculation of risk-weighted exposure amounts and expected loss amounts for the purposes of credit risk mitigation Table 1 for Article 4:42 Standard volatility adjustments under the supervisory volatility adjustments approach: Credit quality step with which the credit assessment of the debt security is associated Residual maturity Volatility adjustments for debt securities issued by entities described in Article 4:22(b) Volatility adjustments for debt securities issued by entities described in Article 4:22(c) 20-day liquidation period (%) 10-day liquidation period (%) 5-day liquidation period (%) 20-day liquidation period (%) 10-day liquidation period (%) 5-day liquidation period (%) 1 1 year >1 5 years > 5 years year >1 5 years > 5 years year N/A N/A N/A >1 5 years N/A N/A N/A > 5 years N/A N/A N/A 137

138 Table 2 for Article 4:42 Standard volatility adjustments under the supervisory volatility adjustments approach: Credit quality step with which the credit assessment of a short-term debt security is associated Volatility adjustments for debt securities issued by entities described in Article 4:22(b) with short-term credit assessments 20-day liquidation period (%) 10-day liquidation period (%) 5-day liquidation period (%) Volatility adjustments for debt securities issued by entities described in Article 4:22(c) with short-term credit assessments 20-day liquidation period (%) 10-day liquidation period (%) 5-day liquidation period (%) Table 3 for Article 4:42 Standard volatility adjustments under the supervisory volatility adjustments approach: Other collateral or exposure types 20-day liquidation period (%) 10-day liquidation period (%) 5-day liquidation period (%) Main index equities, main index convertible bonds Other equities or convertible bonds listed on a recognised exchange Cash Gold Table 4 for Article 4:42 Standard volatility adjustments under the supervisory volatility adjustments approach: Volatility adjustment for currency mismatch 20-day liquidation 10-day liquidation 5-day liquidation period (%) period (%) period (%) Table 5 for Article 4:70(2) Table with applicable LGDs for additional types of collateral under the foundation IRB approach: LGD* for senior claims or contingent claims Required minimum collateralisation level of the exposure Senior Non-senior C* C** Short-term receivables 35% 65% 0% 125% Residential real 138

139 estate/commercial real estate 35% 65% 30% 140% Other collateral 40% 70% 30% 140% Annex 5A Mark-to-Market Method: - calculation of exposure value; - calculation of potential future credit exposure Table 1 For the calculation of potential future credit exposure on the basis of notional principal amounts or underlying values Residual maturity Interest rate contracts Contracts concerning foreign exchange rates or gold Contracts concerning equities Contracts concerning precious metals except gold Contracts concerning commodities other than precious metals One year or less 0% 1% 6% 7% 10% Over one year, not exceeding five years 0.5% 5% 8% 7% 12% Over five years 1.5% 7.5% 10% 8% 15% The following provisions shall apply to the calculation: (1) The potential credit risk need not be calculated for exposures in so-termed floating/floating interest rate swaps. (2) Contracts which do not fall within one of the five categories indicated in this table shall be treated as contracts concerning commodities other than precious metals. (3) For contracts with multiple exchanges of principal, the percentages have to be multiplied by the number of remaining payments still to be made under the contract. (4) For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset such that the market value of the contract is zero on these specified dates, the residual maturity would be equal to the time until the next reset date. In the case of interest rate contracts that meet these criteria and have a remaining maturity of over one year, the percentage shall not be lower than 0.5%. Credit derivatives The exposure value of the potential credit risk of a total return swap credit derivative or of a credit default swap derivative shall be determined by multiplying the notional amount of the credit derivative by one of the following percentages: (a) 5% if the reference obligation, provided that it constituted a direct risk to the financial undertaking, would have qualified as a qualifying item, or (b) 10% if the reference obligation, provided that it constituted a direct risk to the financial undertaking, would not have qualified as a qualifying item. For the present purposes, qualifying items are understood to be positions in debt securities as referred to in Article 3:9(3)(a) to (d), and Article 3:9(4)(a) to (e), of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). 139

140 However, where a credit default swap is concerned, a financial undertaking for which the risk inherent in the swap represents a long position in the underlying asset may, for the purposes of the calculation of potential future credit risk, use a percentage of 0%, unless the credit default swap involves close-out in the event of insolvency of the entity for which the risk inherent in the swap represents a short position in the underlying asset, even if there is no default in respect of the underlying value. Where the credit derivative affords protection for the n th default under a number of underlying obligations, the applicable percentage from those listed above shall be determined on the basis of the obligation with the n th lowest credit quality. The obligation with the n th lowest credit quality is determined by the question whether the underlying obligation, provided that it constituted a direct risk for the financial undertaking, would have qualified as a qualifying item. Table 2 Optional, to calculate potential future credit exposure on the basis of the notional principal amounts or underlying values, subject to the conditions set out in Article 5:6(4) Table 2 Residual maturity Precious metals (except gold) Base metals Agricultural products (softs) Other, including energy products One year or less 2% 2.5% 3% 4% Over one year, not exceeding five years 5% 4% 5% 6% Over five years 7.5% 8% 9% 10% Annex 5B Standardised Method For the purposes of Articles 5:9, 5:13, 5:14, 5:15(1) and 5:17. Formula 1 as referred to in Articles 5:9(2) and 5:14: Formula 1 Exposure value = β * max CMV CMC; RPTij RPClj * CCRMj l j i where CMV = current market value of the portfolio of transactions within the netting set with the counterparty, that is, where: CMV = CMC l l where CMVi = current market value of transaction i; CMC = current market value of the collateral assigned to the netting set, that is, where: CMC = l where CMC l 140

141 CMCl = current market value of collateral l; i = index designating the transaction; l = index designating the collateral; j = index designating the hedging set category. These hedging sets correspond to risk factors for which risk positions of opposite sign can be offset to yield a net risk position on which the exposure measure is then based; RPTij = risk position from transaction i with respect to hedging set j; RPClj = risk position from collateral l with respect to hedging set j; CCRMj = CCR multiplier set out in table 2 with respect to hedging set j; ß = 1.4. Collateral received from a counterparty has a positive sign; Collateral posted to a counterparty has a negative sign. Formula 2 as referred to in Article 5:13: A. For all instruments other than debt instruments: effective notional value, or delta equivalent δ V notional value = ρref δ ρ where Pref = price of the underlying instrument expressed in euro: V = value of the financial instrument (in the case of an option this is the option price and in the case of a transaction with a linear risk profile this is the value of the underlying instrument itself); P = price of the underlying instrument expressed in the same currency as V; B. For debt instruments and the payment legs of all transactions: effective notional value multiplied by the modified duration, or delta equivalent in notional value multiplied by the modified duration δ V δ r where: V = value of the financial instrument (in the case of an option this is the option price and in the case of a transaction with a linear risk profile this is the value of the underlying instrument itself or of the payment leg, respectively); r = interest rate level. If V is denominated in a currency other than the euro, the derivative must be converted into euro by multiplication with the relevant exchange rate. In respect of Article 5:15(1): The risk positions are to be grouped into hedging sets. For each hedging set, the net risk position is calculated (this is the absolute amount of the sum of the resulting risk positions) and is represented by: i RPT ij RPClj l in formula 1 set out under 1 above. 141

142 Table 1 Government referenced interest rates Non-government referenced interest rates Maturity <= 1 year <= 1 year Maturity >1 <= 5 years >1 <= 5 years Maturity > 5 years > 5 years For Article 5:17: Table 2 Hedging set categories CCRM 1. Interest rates 0.2% 2. Interest rates for risk positions from a reference debt instrument that underlies a credit default swap and to which a capital requirement for the specific position risk of 1.6%, or less, applies under Article 1:10 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) of De Nederlandsche Bank 0.3% 3. Interest rates for risk positions from a debt instrument or reference debt instrument to which a capital requirement of more than 1.6% applies under Article 1:10 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) of De Nederlandsche Bank 0.6% 4. Foreign exchange (FX) 2.5% 5. Electric power 4% 6. Gold 5% 7. Equity 7% 8. Precious metals (except gold) 8.5% 9. Other commodities (excluding precious metals and electric power) 10% 10. Underlying instruments of OTC derivatives that are not in any of the above categories 10% Annex 5C For the internal model method For the purposes of Articles 5:25, 5:26 and 5:28: The exposure value shall be calculated as the product of alpha times effective expected positive exposure (effective EPE): Exposure value = α Effective EPE (1) where: - alpha (α ) is 1.4, but in special cases De Nederlandsche Bank may, in consultation with the financial undertaking concerned, set a higher factor; - effective EPE is calculated by estimating expected exposure (EEt) as the average exposure at future date t, where the average is taken across possible future values of the exposure as a result of changes in relevant market risk factors. The internal model estimates EE at a series of future dates t1, t2, t3 Effective EEs are calculated recursively as: 142

143 Effective EEtk = max(effective EEtk-1; EEtk) (2) where: the current date is denoted as t0 and effective EEt0 equals current exposure. In this regard, effective EPE is the average effective EE during the first year of future exposure. If all contracts in the netting set mature within one year, EPE is the average of expected exposure until all contracts in the netting set mature. Effective EPE is calculated as a weighted average of effective EEs: min(1 year; maturity ) EffectiveE PE = EffectiveEE tk * tk (3) k = 1 where: the weights tk = tk tk-1 allow for the case when future exposure is calculated at dates that are not equally spaced over time. Expected exposure or peak exposure is calculated based on a distribution of exposures that accounts for the possible non-normality of the distribution of exposures. Financial undertakings may, for each counterparty, use a measure that is more conservative than α multiplied by effective EPE as calculated in accordance with the above equation. Effective maturity under the internal model method, for a netting set with a maturity greater than one year, is the ratio of the sum of expected exposure over the life of the transactions in the netting set discounted at the risk-free rate of return divided by the sum of expected exposure over one year in a netting set discounted at the risk-free rate. This effective maturity may be adjusted to reflect roll-over risk by replacing expected exposure with effective expected exposure for forecasting horizons under one year. Annex 6 to Section 6.5.5, providing for the supervisory formula and simplified inputs Formula A (supervisory formula) for Article 6:37(2) The risk weight for a securitisation position to be applied under the supervisory formula method is: 12.5 x (S[L+T] S[L]) / T where: x when x Kirbr S [ x ] = ω(kirbr x)/kirbr Kirbr + K[x] K[Kirbr] + ( d Kirbr/ ω )( 1 e ) when Kirbr < x where: 143

144 h c v f g a b d = = = ( ELGD v + Kirbr = 1 h (1 c ) c = f = = = 1 (1 Kirbr g c g (1 K [ x ] = (1 τ = 1000, and ω = 20. Kirbr (1 /(1 c ) h ) ((1 / 1 h ) Kirbr 2 ELGD c h ) (1 Beta 2 Beta ) ) N Kirbr + [ x ; + N (1 [ Kirbr 0.25 Kirbr ) Kirbr (1 h ) τ ; a, b ]) x (1 a, b ]) + Beta ELGD [ x ; a v ) Kirbr + 1, b ] c ). In these expressions, Beta [x; a, b] refers to the cumulative beta distribution with parameters a and b evaluated at x. T (the thickness of the tranche in which the securitisation position is held) is measured as the ratio of (a) the nominal amount of the tranche to (b) the sum of the exposure values of the exposures that have been securitised. For these purposes, the exposure value of a derivative instrument listed in Annex B to the Decree shall, where the current replacement cost is not a positive value, be the potential future credit exposure calculated in accordance with Chapter 5 of the present Regulation. Kirbr is the ratio of (a) K irb to (b) the sum of the exposure values of the exposures that have been securitised. Kirbr is expressed in decimal form (e.g. K irb equal to 15% of the pool would be expressed as Kirbr of 0.15). L (the credit enhancement level) is measured as the ratio of the nominal amount of all tranches subordinate to the tranche in which the securitisation position is held to the sum of the exposure values of the exposures that have been securitised. Capitalised future income shall not be included in the measured L. Amounts due by counterparties in respect of derivative instruments listed in Annex B to the Decree that represent tranches more junior than the tranche in question, may be measured at their current replacement cost (without the potential future credit exposures) in calculating the enhancement level. N is the effective number of exposures calculated in accordance with Article 6:31(4). ELGD, the exposure-weighted average loss-given-default, is calculated as follows: ELGD = LGDi EADi i i EAD i where LGD i represents the average LGD associated with all exposures to the i th obligor, where LGD is determined in accordance with Articles 69 to 76 of the Decree. In the case of resecuritisation, an LGD of 100% shall be applied to the securitised positions. When default risk and dilution risk for purchased short-term receivables are treated in an aggregate manner 144

145 within a securitisation (that is, there is a single reserve or overcollateralisation is available to cover losses from either source), the ELGD input shall be constructed as a weighted average of the LGD for credit risk and 75% of the LGD for dilution risk. The risk weights shall be the stand-alone capital charges for credit risk and dilution risk respectively. Formula B (simplified inputs) for Article 6:37(3) For the purposes of the supervisory formula method, the simplified inputs are as follows: (1) LGD = 50%, and (2) N is equal to either C C N = C C m 1 m 1 1 Cm + max{1 m 1, 0} or N = 1/ C 1. 1 C m is the ratio of the sum of the exposure values of the largest m exposures to the sum of the exposure values of the exposures securitised. The level of m may be set by the financial undertaking. Explanatory notes General The present Regulation serves to implement: - Article 61(5) and (6) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (Chapters 2 and 5 of the present Regulation); - Articles 69 to 76 of the Decree on Prudential Rules for Financial Undertakings(Besluit prudentiële regels Wft) (Chapter 3 of the present Regulation); - Articles 80 to 87 of the Decree on Prudential Rules for Financial Undertakings(Besluit prudentiële regels Wft) (Chapters 4 and 6 of the present Regulation), and - Articles 102(3) and 105(4) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (Chapter 7 of the present Regulation). More in particular, the present Regulation serves to implement: - Article 110(3) of the Banking Directive (Article 7:5 of the present Regulation); - Articles 112 to 118 of the Banking Directive (Chapter 7 of the present Regulation); - Annex III to the Banking Directive (Chapter 5 of the present Regulation); - Annexes VI to X of the Banking Directive (Chapters 2 to 4 and 6 of the present Regulation), and - Articles 28 to 32 of the Capital Adequacy Directive (Chapter 7). Chapter 1 contains general provisions which apply to Chapters 2 to 7. Section 1.1 contains the general definitions. The definitions which relate to just a single Chapter can be found in the Chapter concerned. Section 1.2 contains provisions regarding the indexation method from the Credit System Supervision Manual (Handboek Wtk) under 4011 b2 (Policy rule for indexation method for determining the forced-sale value of the mortgage portfolio). Chapter 8 provides for the transitional regime (Articles 8:1 to 8:4), the repeal of existing regulations (Article 8:5), a regulation regarding entry into force (Article 8:6) and the short title of the Regulation (Article 8:7). 145

146 Structure of the Regulation and of the explanatory notes In the implementation of the provisions of the Directives and of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), the structure of these regulations has been departed from in cases where this benefits the transparency and clarity of the present Regulation. For each of the Chapters 2 to 7, the explanatory notes include a correlation table to enhance clarity. General and article-specific explanatory notes and, where applicable, a section on the administrative costs are given for each Chapter. When preparing the articles, the explanatory notes and the sections on administrative costs, De Nederlandsche Bank has duly allowed for the relevant instructions and frameworks. For instance, the wording of the articles and the explanatory notes is in line with the Instructions for Regulations (Aanwijzingen voor de regelgeving) (Government Gazette (Staatscourant) 2004, 213), because, pursuant to Instruction 4, these instructions must also be observed by independent public sector entities, such as De Nederlandsche Bank. Of particular importance is Instruction 214, which states that explanatory notes must not be used to impose further rules. The explanations and the examples contained in these explanatory notes do not, therefore, have the status of generally binding rules. The explanatory notes serve to explain and elucidate and seek to provide guidance to the supervised financial undertakings in their day-to-day implementation of the Regulation. In cases where the explanatory notes might be interpreted in a manner contrary to the system, the letter or the spirit of the Articles, it stands to reason that the Articles prevail. Definitions Chapter 1 (Article 1:1) contains definitions of terms used in various Chapters. This serves to prevent these definitions from being included in the Regulation more than once. For some frequently used or special terms, no definitions are given. Cases in point are probability of default, loss given default and recast Banking Directive. These and similar terms have been defined in Article 1 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). Because of the hierarchy between that General Administrative Order and the present Regulation, the definitions contained in the Decree also hold for the present Regulation. Administrative costs General Administrative costs are defined as the costs incurred by the business sector in order to comply with the information requirements ensuing from public sector legislation and regulation. This definition is to be found on page 8 of the report Meten is weten (To measure is to know) of the Interdepartmental Project Management Administrative Costs (Interdepartementale projectdirectie administratieve lasten (IPAL)). In terms of the present Regulation, this means that the following must be ascertained: - the costs (burden) - for the financial undertakings covered by the present Regulation (business sector) 1 - ensuing from the obligations contained in the present Regulation (legislation and regulation) - issued by De Nederlandsche Bank (public sector) - for the provision of information (information requirements). 1 The point here is a calculation of the maximum administrative costs rather than the actual costs. Not all enterprises covered by the relevant regulations and legislation will in actual practice be faced with all the information requirements, since the actual administrative costs depend on the choices made by the financial undertakings themselves. 146

147 Within the framework of the above definition, this section on administrative costs enlarges on the comparable section of the Bill on the implementation of the Basel II Capital Accord (Wetsvoorstel implementatie Kapitaalakkoord Bazel 2) 2 and of the Decree on the implementation of the Basel II Capital Accord (Besluit implementatie Kapitaalakkoord Bazel 2) 3. Just as the section on administrative costs in the Decree on the implementation of the Basel II Capital Accord (Besluit implementatie Kapitaalakkoord Bazel 2) constitutes an elaboration of the section on administrative costs in the Bill on the implementation of the Basel II Capital Accord (Wetsvoorstel implementatie Kapitaalakkoord Bazel 2), so the present section constitutes an elaboration of the section on administrative costs in the Decree on the implementation of the Basel II Capital Accord (Besluit implementatie Kapitaalakkoord Bazel 2). This system follows from the fact that the secondary legislator may not overstep the boundaries of the framework of the primary legislator and that the supervisory authority must remain within the confines of the framework set by the secondary legislator. These explanatory notes detail to what extent the total amount of administrative costs of over 13 million is due to the capital requirements and general information requirements under the present Regulation. In this context, it should be noted first of all that De Nederlandsche Bank has also prepared two additional regulations involving administrative costs. These are the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) (whose share in the total amount of administrative costs is 56,835) and the Supervisory Regulation on Solvency Requirements for Operational Risk (Regeling solvabiliteitseisen voor het operationeel risico) (whose share in the total administrative costs is 367,200) Hence, on aggregate, an amount of 424,035 out of the total of 13 million is accounted for by these two Regulations. Second, it should be noted that the calculation of the administrative costs resulting from the change in reporting frequencies (also under the Regulation on Solvency Requirements for Credit Risk) is discussed separately in the explanatory notes to the Supervisory Regulation on Reporting Forms for Financial Undertakings (Regeling staten financiële ondernemingen Wft). Finally, the administrative costs of over 13 million are also accounted for by the Decree on the implementation of the Basel II Capital Accord (Besluit implementatie Kapitaalakkoord Bazel 2) of the Ministry of Finance. The net share of the administrative costs accounted for by the Supervisory Regulation on Solvency Requirements for Credit Risk is 6,812,187.50, or close on 7 million. The relevant obligations consist of elaborations of the administrative costs of 9.8 million for solvency supervision as calculated in the explanatory memorandum to the Bill on the Implementation of the Basel II Capital Accord (Wetsvoorstel implementatie kapitaalakkoord Bazel 2) and 4.3 million in respect of the supply of (other) information. Because the supply of information to De Nederlandsche Bank always relates to the Bank s supervision of the financial undertakings which must supply this information, these costs of close on 7 million cannot be realistically broken down into a share for solvency supervision and one for information supply, as was done in the explanatory memorandum referred to above. The administrative cost savings total 3,725,000. The calculation of this amount has been based on the numbers of financial undertakings and the hourly rates referred to in the Bill on the Implementation of the Basel II Capital Accord (Wetsvoorstel implementatie Kapitaalakkoord Bazel 2) (Parliamentary Papers II, 2005/2006, 30672, no. 3, p. 13, second paragraph). 2 Parliamentary Papers II, 2005/2006, 30672, no. 3, pp Decree on the implementation of the Basel II Capital Accord (Besluit implementatie Kapitaalakkoord Bazel 2), as integrated into the Decree on Prudential Rules for Financial Undertakings ( Besluit implementatie kapitaalakkoord Bazel 2 ). 147

148 Schematic representation of administrative costs The information requirements, as provided for in the various Chapters of the Supervisory Regulation on Solvency Requirements for Credit Risk, which give rise to administrative costs are identified in the table below. They are all either information requirements relating to solvency supervision or general information requirements. The calculation of the administrative costs and an explanation are given in the section following the table. Article Decrease in costs Increase in costs Essence of the obligation and, where necessary, explanation Chapter 1 1,975,000 59,250 1:8 Validation requirement in the context of the indexation method not applicable Abolition of the requirement to conduct a re-appraisal Chapter 2 1,750, ,350 2:11(2) 2,925 Essence of the requirement: to show that a central government guarantee is available for a certain exposure. Explanation: The administrative costs of 2,925 relate to each individual exposure for which the financial undertaking can show that there is a central government guarantee 2:45(3) 1,425 (annually for each CIU) 88 and 88a of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) At least 1,680,000 or at least 70,000 At least 20,000 and at most 300,000 Annual report by a CIU on its business for the purpose of the calculation of an average risk weight for the CIU by a financial undertaking Essence of the requirement: application for recognition of a credit assessment institution by that institution itself or by the bank(s) wishing to use that institution s ratings. Explanation: the saving of at least 1,680,000 applies when the credit assessment institution submits the application itself. The saving of at least 70,000 applies when two or more banks submit a joint application for recognition of one and the same credit assessment institution Chapter 3 657,900 3:2 See the notes Essence of the requirement: the provision of information in the context of the application for permission to use the IRB. Explanation: The administrative costs all ensue from Article 3:2. The other information requirements relate solely to part of these overall costs 3:6(1) See the notes Separate recording of a certain category of exposures 3:12 and 3:14 See the notes Provision of information in the context of phased introduction of the IRB 3:44(3) and 3:45(4) See the notes Requirement to provide evidence in the context of the application of the LGD approach under the foundation IRB approach 3:50(1) See the notes Requirement to provide evidence in the context of the 3:63, opening sentence See the notes PD/LGD approach for positions in equities Requirement to provide evidence in the context of the calculation of the amount of dilution risk-weighted assets and off-balance sheet items 3:63(e) See the notes Documentation requirement in respect of internal rating system 3:64(4) See the notes Documentation of rating systems 3:65 See the notes Documentation of rules for assigning obligors or 148

149 transactions to a rating system if more than one such system is used 3:68(4) See the notes Reasoning underlying classification of exposures into grades or pools 3:69(6) See the notes Documentation of rules regarding replacement of objective inputs and outputs by subjective appraisal 3:70 See the notes Various requirements to provide evidence when using statistical models 3:76(6) See the notes Documentation requirement when estimates are used other than those included in the internal rating system 3:79(4)(d) See the notes Documentation of the basis for the link between internal ratings and the scales used by a credit assessment institution See the notes General documentation requirements 3:88(2) See the notes Requirement to provide evidence in the context of the validation of IRB systems 3:84(4) to (7) See the notes Various documentation requirements for bought shortterm trade receivables 3:86(2) See the notes Documentation requirement for reasoning underlying construction of VaR models 3:88(2), (7) and (9) See the notes Documentation requirements in respect of internal rating model for positions in equities 3:90(7) and (9) See the notes Documentation requirement for officer in charge of credit risk management Chapter 4 790,020 4:15 See the notes Requirement to provide evidence of the soundness and integrity of the risk management system 4:19(1) See the notes Requirement to provide evidence of the predictive power of VaR models 4:25(e) See the notes Requirement to provide evidence of sufficient market liquidity for debt instruments as referred to in Article 4:25 4:31 See the notes Documentation requirement in the context of the admission as collateral of the financial instruments referred to in Article 4:22 4:54 See the notes Documentation requirement in respect of repo-style transactions 4:61(d) See the notes Documentation requirement in the context of the admission as collateral of short-term receivables 4:64(b) See the notes Requirement to provide evidence of non-significant difference when realising collateral 4:66(e) See the notes Documentation requirement in the context of the admission as collateral of physical collateral 4:74(2)(b) See the notes Requirement to provide evidence of the liquidity of the instruments referred to in Article 4:74(1) 4:79(2)(b) See the notes Requirement to provide evidence of the interaction between the strategy in respect of the use of guarantees and the company-wide risk management processes 4:80(2)(a) See the notes Requirement to provide evidence for the application of a longer period for payment 4:82(1)(b) See the notes Documentation requirement in the context of the admission as collateral of guarantees or credit derivatives Chapter 5 758,565 5:30(2)(b) See the notes Reporting requirement for the control unit 5:31(1) See the notes Documentation of management policies and CCR procedures 5:33 See the notes Documentation of transaction limits 5:35(2) See the notes Documentation of the CCR management system 149

150 5:43(3) See the notes Documentation of transaction terms and specifications 5:44 See the notes Input data for the internal model 5:45(2) See the notes Documentation of the validation process 5:55(3) See the notes Requirement to provide evidence in respect of netting agreement (compliance with Article 5:55(2)) Chapter 6 4,153, :3(c) and (d) See the notes Information requirements regarding risk profile and repurchase obligation in respect of the securitisation 6:5(1) and (2) See the notes Documentation regarding the securitisation 6:6(a) See the notes Documentation regarding the securitisation 6:11(b) See the notes Servicer s obligation to provide evidence 6:21(2)(e) See the notes Documentation of credit enhancement 6:21(f) See the notes Obligation to provide information on liability for losses 6:22(a) See the notes Documentation of liquidity facility 6:31(3)(a) See the notes Requirement to provide evidence when applying a 6% risk weight to certain securitisation positions 6:34(a) See the notes Requirement to provide evidence about the correspondence between the internal rating and the rating of an external credit assessment institution 6:34(d) See the notes Documentation requirement regarding the correspondence between the internal rating and the rating of an external credit assessment institution 6:34(g) See the notes Tracking and evaluating the performance of the internal rating system 6:34(2) See the notes Requirement to provide evidence as part of procedure for obtaining a waiver 6:35 See the notes Compulsory data for ABCP programme 6:37(4) See the notes Requirement to provide evidence for the application of the supervisory formula method to securitisations of retail exposures 6:56 See the notes Requirement to provide evidence for the application as referred to in Article 86 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) Chapter 7 87,360 7:5 See the notes Reporting obligation for significant findings from analysis of exposures to collateral issuers for possible concentrations 7:7(2) See the notes Reporting obligation for excesses over the limits under Article 82 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) Calculation of administrative costs Administrative costs are calculated on the basis of the so-termed standard cost model. Under this model, the aggregate administrative burden (in quantitative terms) ensuing from a certain piece of regulation is equal to the outcome of the following formula: P (rate * time) * Q (number of enterprises * frequency) The calculations required under the formula are based on the answers to the following questions: (a) What is the number of acts ensuing from a certain information requirement? (b) What is the time required to perform these acts? (c) What are the rates for the performance of these acts? (d) How many enterprises (that is, financial undertakings) have to perform these acts? (e) What is the frequency with which these acts must be performed? In terms of the information requirements identified above, this produces the following results. 150

151 Notes on administrative costs pursuant to Chapter 1 Article 1:8 (a) The acts required for validation consist of the two steps referred to in Article 1:9, namely: (i) calculation of Qi, and (ii) comparing the average value of Qi to 1. (b) As it may be assumed that each bank has computer systems to perform these acts, it may also be assumed that, for each dwelling in the portfolio, the two steps can be performed within five minutes. (c) In the explanatory memorandum to the Bill on the Implementation of the Basel II Capital Accord (Wetsvoorstel implementatie Kapitaalakkoord Bazel 2), the costs of implementing the provisions from the Banking Directive were set at 90 per hour for banks. (d) The indexation method may be used by each bank (from small to very large), that is, by a total of 79 banks. (e) The valuation using the indexation method must be performed at least once every three years (Article 1:8(1), first sentence). Assuming that all banks will use the indexation method and assuming a minimum residential mortgage portfolio of 100 dwellings (as referred to in Article 1:8(3)), the administrative costs for a period of three years are: ( 90 * 1/12 hour) * (79 banks * frequency 100 dwellings) = 59,250 Section 1.2 Pursuant to the capital adequacy rules under Basel I, a risk weight of 50% is assigned to loans secured by mortgages on non-commercial real estate (that is, residential property), up to an amount equal to 75% of the value obtained from a recent appraisal. A recent appraisal is understood to be an appraisal made at the time when the mortgage loan was granted, increased or renewed. 4 This rule implies that a new appraisal a so-termed reappraisal must be made on each occasion when a mortgage loan is granted, increased or renewed. However, it should be noted that, for an existing portfolio, the value of the collateral may be estimated using the indexation method set out in Section 1.2, instead of relying on a re-appraisal for each individual dwelling. Annex VI, Part 9.1 of the Banking Directive contains provisions about the valuation of real estate which differ from those referred to above, which involve re-appraisal. These provisions have been implemented in Subsection of the present Regulation. The new rules for the valuation of real estate provide that a 35% risk weight for noncommercial real estate is only possible if at least the minimum requirements regarding the monitoring of the value of the real estate, as referred to in Articles 4:57 and 4:58, and the valuation rules under Article 4:59 have been observed. The principal minimum requirement is that the property valuation shall be reviewed by an independent valuer when information indicates that the value of the property may have declined relative to general market prices. Moreover, the value of the property must be monitored regularly, that is, at least once a year for commercial real estate and at least once every three years for residential property, and more frequently if the market is subject to significant changes in conditions. However, in the latter case, use may be made of statistical methods, so that the services of a valuer are not needed. Hence, the Banking Directive does not stipulate that a new appraisal must be performed on each occasion when a mortgage loan is granted, increased or renewed. 4 For the exact formulation, reference is made to the Credit System Supervision Manual (Handboek Wtk), under

152 In conformity with the provisions of the Banking Directive, the obligation to perform a re-appraisal has not been taken over in the new rules. This leads to a significant decrease in (administrative) costs, since an appraisal involves about 250 on average. Hence, the termination of the obligation in its present form leads, for each bank or investment firm, to a cost saving of at least 250 for each eligible dwelling. The total cost saving is: 250 * 79 banks * a minimum of 100 dwellings in the portfolio = 1,975,000 Notes on administrative costs pursuant to Chapter 2 Article 2:11(2) (a) One act: the submission of evidence of a central government guarantee. (b) At most one hour: writing a covering letter or explanatory memorandum and sending it to the supervisory authority. (c) 90 per hour or 75 per hour, respectively. 5 d) All banks which are covered by the present Regulation and wish to avail themselves of the option provided for in this Article, being at most 43 small and 22 medium-sized banks. 6 (e) Once for each eligible exposure of a bank. The administrative costs apply to each exposure for which a central government guarantee is available and in respect of which a financial undertaking wishes to be eligible for the special 0% risk weight under Article 2:11(2). If it is assumed that all small banks (which are expected to apply the standardised approach) have a single exposure for which a central government guarantee is available, the administrative costs are: ( 90 * 0.5 hour) * (65 banks * frequency 1 exposure) = 2,925 Article 2:45(3) (a) All required acts form part of the preparation of an annual report. It may be expected that the required data are available within the financial undertaking and that, at most, they must be adapted and verified by an internal auditor before being included in the annual report. 7 (b) At most 15 hours by an internal auditor. (c) 95 (rate for an internal auditor). (d) All CIUs in respect of which financial undertakings wish to avail themselves of the option provided for in this Article. As there is no insight into the number of CIUs in respect of which Article 2:45(3) will be applied, the calculation shown here concerns just one CIU. (e) Once a year. The relevant administrative costs per annum are: ( 95 * 15 hours) * (1 CIU * frequency 1) = 1,425 5 See the Explanatory Memorandum to the Bill on the Implementation of the Basel II Capital Accord (Wetsvoorstel implementatie kapitaalakkoord Bazel 2), Parliamentary Papers II, 2005/2006, 30672, no. 3, p See the Explanatory Memorandum to the Bill on the Implementation of the Basel II Capital Accord (Wetsvoorstel implementatie kapitaalakkoord Bazel 2), Parliamentary Papers II, 2005/2006, 30672, no. 3, p See the Explanatory Memorandum to the Bill on the Implementation of the Basel II Capital Accord (Wetsvoorstel implementatie kapitaalakkoord Bazel 2), Parliamentary Papers II, 2005/2006, 30672, no. 3, pp. 15 and

153 Articles 88 and 88a of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) The principal difference between Basel I and Basel II lies in the introduction, in the calculation of the capital requirements, of the possibility to use the ratings of rating agencies (denoted in the recast Banking Directive as external credit assessment institutions, or ECAIs). Such use of the ratings of a certain ECAI is subject to approval by the supervisory authority. Once approval has been obtained, the ECAI must be monitored periodically. In order to be able to perform the test and the subsequent monitoring, the supervisory authority requires information from the ECAI; this involves administrative costs. An effort has been made to keep these new costs as low as possible. First, the recast Banking Directive provides for the possibility of the supervisory authority taking over the assessment of a fellow supervisory authority from another EU Member State without conducting an independent test. Second, it has been agreed within the CEBS that the European supervisory authorities may conduct joint tests of ECAIs which are active in more than one EU Member State. Third, De Nederlandsche Bank permits applications for recognition of ECAIs to be channelled through the Netherlands Bankers Association (Nederlandse Vereniging van Banken), so that the information need be provided only once (instead of separately by each applying bank). Meanwhile, the joint European supervisory authorities have started testing three internationally operating ECAIs. Until 12 October 2006, De Nederlandsche Bank had received one application from an ECAI wishing to operate specifically on the Dutch market. Application by an ECAI An application by a large international ECAI is expected to cost somewhere between 70,000 and 350,000. These costs are incurred in the EU only once, instead of 25 times in each individual Member States. The cost saving entailed by the combined application for Europe is thus at least 1,680,000. The rating agencies estimate that their own monitoring of compliance with the recognition (or with the conditions imposed as part of the recognition) will involve somewhere between 20,000 and 300,000 per annum. Application by a bank Channelling an application for recognition of an ECAI through the Netherlands Bankers Association (Nederlandse Vereniging van Banken) also leads to cost savings. It is expected that the standardised approach will be used by 65 banks. If two banks wish to use the ratings of one and the same ECAI, the cost saving is at least 70,000. If three banks wish to use the ratings of one and the same ECAI, the cost saving is at least twice that amount, that is, 140,000. Consequently, the aggregate administrative costs pursuant to Chapter 2 are: 2,925 1,425 (annual costs) 300,000 (at most) 304,350 The savings total: 1,680,000 70,000 (at least) 1,750,

154 Notes on administrative costs pursuant to Chapter 3 The various information requirements provided for in Chapter 3 are all marked by the same structure: a financial undertaking wishing to use the IRB approach must submit an application to De Nederlandsche Bank including the information referred to in Article 3:2. This concerns the following: (1) formal application for use of internal rating systems; (2) general description of IRB implementation; (3) risk management framework; (4) overview of rating systems; (5) impact of transition to IRB approach on capital adequacy; (6) self-assessment of compliance with regulations. It is estimated that such an application takes about 200 hours for each bank or investment firm. If it is assumed that the IRB approach will be used solely by the large and very large banks and investment firms (and on the basis of the hourly rates from the baseline measurement), the administrative costs involved are: ( 90 * 200 hours) * (14 banks * 1 application) = 252,000 ( 75 * 200 hours) * (24 investment firms * 1 application) = 360, ,000 When the application is submitted, the internal rating system must be ready. Constructing and maintaining an internal rating system is beyond the scope of the definition of administrative costs. Information requirements are only included in those Articles under which a financial undertaking must provide information to De Nederlandsche Bank. Distilling this information from the internal rating system is considered a normal filing act taking on average 0.5 hour for each information requirement. Assuming that the IRB approach will be used solely by the large financial undertakings, the administrative costs pursuant to Chapter 3 are: ( 90 * 0.5 hour) * (14 banks * 30 information requirements) = 18,900 ( 75 * 0.5 hour) * (24 investment firms * 1) = 27,000 45,900 All banks and investment firms wishing to use the IRB approach are expected to submit an application for partial use of an IRB system. The appurtenant administrative costs are explained in the explanatory notes to the Policy Rule on Partial Use of the Standardised Approach under the IRB Approach (Beleidsregel partieel gebruik van de standaardbenadering onder de IRB). The aggregate administrative costs pursuant to Chapter 3 of the present Regulation are at least 657,900. Notes on administrative costs pursuant to Chapter 4 The information requirements pursuant to Chapter 4 relate to various documentation requirements and requirements to provide evidence in respect of the admission of certain financial instruments as collateral for the purposes of credit risk mitigation. This concerns the provision of information by financial undertakings which either use the standardised approach in combination with the foundation IRB (medium-sized institutions) or apply the advanced IRB, that is, a total of at most 36 banks (medium-sized to large) and 24 investment firms (large). The above acts (the provision of information) are restricted to distilling information from systems or recording information; the information concerned is available throughout. 154

155 Distilling and recording information are normal filing acts which (at the hourly rates used by the Ministry of Finance in its baseline measurement) give rise to the following administrative costs: For banks: - which are eligible for using the standardised approach in combination with the foundation IRB (small and medium-sized banks): ( 90 * 0.5 hour) * (65 banks * 11 information requirements) = 32,175; - which use the foundation IRB (medium-sized banks): ( 90 * 0.5 hour) * (22 medium-sized banks * 11) = 10,890; - which use the advanced IRB (large to very large banks): ( 90 * 0.5 hour) * (14 large to very large banks * 11) = 6,930, making a total of 49,995. For investment firms: - which are eligible for using the standardised approach (whether or not in combination with the foundation IRB) (small investment firms): ( 75 * 0.5 hour) * (177 investment firms * frequency 11) = 730,125; - which use the advanced IRB (large investment firms): ( 75 * 0.5 hour) * (24 large investment firms * frequency 11) = 9,900, making a total of 790,020. Notes on administrative costs pursuant to Chapter 5 For controlling the so-termed counterparty credit risk, financial undertakings must have an internal risk management system with the appurtenant management policies, transaction limits, controls and reporting obligations. The costs ensuing from the provisions of Chapter 5 largely concern the construction and maintenance of that system. As already observed in the notes to Chapter 3, these costs do not form part of administrative costs. The provision of information from the CCR management system (as required under Article 5:55(3)) is a normal filing act which (at the hourly rates used by the Ministry of Finance in its baseline measurement) gives rise to the following administrative costs: ( 90 * 0.5 hour) * (79 banks * frequency 8) = 28,440 ( 75 * 0.5 hour) * (177 investment firms * frequency 8) = 730, ,565 The total administrative costs are: 758,565. Notes on administrative costs pursuant to Chapter 6 Chapter 6 provides for various documentation requirements and requirements to provide evidence in respect of the admission of certain forms of securitisation for the mitigation of certain credit risks. The documentation requirements relate tot normal file management as referred to in the Filing Act 1995 (Archiefwet 1995) for the materially most significant characteristics of a securitisation. The requirements to provide evidence are limited to the provision of information from the financial undertaking s internal (securitisation) filing system. Recording information in a filing system and distilling information from a rating system are normal filing acts which (at the hourly rates used by the Ministry of Finance in its baseline measurement) give rise to the following administrative costs: ( 90 * 0.5 hour) * (79 banks * frequency 15 information requirements) = 47,

156 ( 75 * 0.5 hour) * (201 investment firms * 15) = 113, The provision of written evidence that certain standards are met will usually take more time than distilling information from existing filing systems. In respect of a limited analysis, the calculation has been based on 4 hours for the preparation of written evidence, while in respect of an extensive analysis, it has been based on 8 hours. This means that the additional administrative costs are as follows: ( 90 * 12 hours) * (79 * 15) = 1,279,800 ( 75 * 12 hours) * (201 * 15) = 2,713,500. The total administrative costs are: 4,153,762,50. Notes on administrative costs pursuant to Chapter 7 The two reporting requirements under Articles 7:5 and 7:6 of the present Regulation are not subject to strict and formal rules, such as reporting using a special form. Excesses over the limits may be reported by letter; preparing such a letter may be expected to take at most 2 hours. This involves the following (maximum) administrative costs (assuming that all banks, investment firms and clearing institutions are eligible for the regulation included in Chapter 7, and assuming the figures from the baseline measurement): Pursuant to Article 7:5 For banks and clearing institutions: ( 90 * 2 hours) * (76 financial undertakings * frequency once for each excess) = 13,680; For investment firms: ( 75 * 2 hours) * (200 financial undertakings * frequency once for each excess) = 30,000. Pursuant to Article 7:6 For banks and clearing institutions: ( 90 * 2 hours) * (76 financial undertakings * frequency once for each excess) = 13,680 per quarter; For investment firms: ( 75 * 2 hours) * (200 financial undertakings * frequency once for each excess) = 30,000 per quarter. Hence, the total administrative costs are: 87,360. The present Regulation was submitted in draft form to the Advisory Committee on Administrative Costs (Adviescollege toetsing administratieve lasten) on 17 October The Committee decided not to select the draft Regulation for further scrutiny. Chapter 1 General For the purposes of Subsection and of Article 4:58 of the present Regulation, financial undertakings must have an insight into the value of real estate. After all, if they have not, they are unable to assess whether such real estate can be used as collateral to secure underlying exposures. In this context, financial undertakings may rely on the indexation method for residential property as provided for in the Policy rule for indexation method for determining the forced-sale value of the mortgage portfolio (Credit System Supervision Manual (Handboek Wtk), under 4011 b2). This policy rule offers an advantage in that the need for an individual appraisal by a valuer is reduced. In Section 1.2, the policy rule has been included without any substantive changes. The indexation method offers a practical solution to the appraisal of the forced-sale 156

157 value of residential property in those cases where individual appraisals constitute a problem, for instance because of the size of the residential mortgage portfolio. It should be noted, however, that the use of the indexation method does not stand in the way of individual appraisals. Explanatory notes to individual Articles Article 1:1(q) Pursuant to the explanatory memorandum to the Mark-to-Market Decree (Besluit actuele waarde), market value is understood to be the value of an asset or off-balance sheet item, excluding costs of purchase. This also clarifies the difference from the concept of realisable value, which relates to the value of an asset or off-balance sheet item after deduction of any costs of purchase. Article 1:4 When using an indexation method, a financial undertaking is allowed to calculate a revaluation factor based on index monitoring per portfolio segment, which must be applied to all residential property in the portfolio segment concerned. The revaluation factor is determined by the value change in the index chosen, after application of a haircut. Since, under this method, the value change is not based on the value change in the undertaking s own portfolio, the reliability of the indexed forced-sale values must be ascertained on the basis of a periodic sample. Application of the indexation method is subject to a number of conditions: reliability, prudence, consistency and verifiability. The requirement of prudence implies, for instance, that any real rights or rights of use in respect of residential property must be duly allowed for in the determination of the forced-sale value. Cases in point are the creation of a real right (usufruct) or a right of use (right of continued tenancy) in respect of residential property. In such cases, the property must be assigned a lower forced-sale value than that ensuing from the indexation method. Article 1:5 When adjusting the forced-sale value of residential property using indexation, care must be taken to avoid that indexation only takes place in years when or in respect of objects where the forced-sale value is expected to have increased. The indexation method is therefore only permitted if it is applied at regular intervals (e.g. once quarterly or semi-annually, but at least once annually) and to the entire portfolio. The following categories of residential property are exempt from the provision that the indexation method must be applied to all dwellings in the portfolio: - dwellings for which mortgage loans have been granted under government guarantee. This category is exempt from the portfolio approach, since the loans concerned are not subject to the 50% risk weight and the forced-sale value is irrelevant to the determination of the credit risk; - dwellings where the total of mortgages is lower than or equal to 25% of the most recently known individually appraised forced-sale value. Dwellings in this category are exempt from the portfolio approach as their low loan-to-value ratio renders it improbable that revaluation of these dwellings will affect the credit risk weight. A financial undertaking may yet opt to include these categories in the indexation method, provided that it pursues a consistent policy in this regard: the indexation should cover either all or no dwellings in a given category. This consistent policy is necessary to warrant the 157

158 reliability of the validation. As regards dwellings with a very high value, the financial undertaking has no option. This top-end category is explicitly excluded from the indexation method, as the dwellings concerned usually possess unique features which largely determine the price movements for these objects. This uniqueness rules out the application of an indexation method. After all, an indexation method is based on the price movements of similar dwellings. An absolute or relative threshold value above which the indexation method may not be used is not specified. This threshold value may differ for each financial undertaking and region and also depends on the coverage of the available indices. Hence, financial undertakings should make a wellconsidered decision regarding application of the indexation method to residential property at the top end of the market; this decision should also allow for the coverage of the available indices. Article 1:6 Pursuant to Article 1:11, a return to individually appraised forced-sale values should be possible. To this end, these values must always be available and must, hence, never be overwritten by the estimated values based on the indexation method. In addition to the results of the validation test required under Article 1:10, differences between the value estimated using the indexation method and the value determined on the basis of an individual reappraisal on account of natural wastage are indicators of the reliability of the results of the portfolio approach used, and must therefore be recorded. Article 1:7 Developments in the housing market may vary widely from one region to the next. For a proper determination of the forced-sale value of the collateral on the basis of an indexation method, these regional differences must be duly allowed for. To this end, all dwellings in the mortgage portfolio must be subdivided into portfolio segments, providing for at least a regional breakdown. The index used must be subdivided accordingly. It is noted that further segmentation, e.g. by region and type of dwelling, combined with appropriate indices, may be expected to make for a more reliable indexation and, consequently, for a higher upward value adjustment on the basis of the validation test described in Article 1:8. The portfolio segmentation must not be based on the ratio between the loans and the forced-sale values of the dwellings. Further segmentation by loan-to-value ratios within a region (or by category of dwelling) is not permitted. This restriction does not rule out that there may be structural loan-to-value patterns by region (or type of dwelling). In addition, it is not permitted to move residential property from one portfolio segment to another. These restrictions are necessary to warrant the reliability of the validation test and to secure a prudent application of the indexation method. Major changes in the composition of the portfolio segments, e.g. as a result of substantial securitisation transactions, may prompt De Nederlandsche Bank to request the financial undertaking concerned to undertake an interim validation of the indexation method. Article 1:8 As the index change is not based on the value change in the financial undertaking s own portfolio, the reliability of the indexed forced-sale values must be ascertained on the basis of a periodic sample. This must be done prior to the first application of the indexation method and, subsequently, at least once every three years. If prompted by specific circumstances, De Nederlandsche Bank may request a financial undertaking to perform an interim validation. Examples of such circumstances are a dramatic fall in house prices or a substantial portfolio change. 158

159 The validating sample must be drawn at random from the portfolio segment to be revalued. This implies that it is irrelevant whether or not a dwelling was appraised or sold in the current year. This is of importance for the reliability of the results. A financial undertaking must be able to demonstrate that the sample was in fact drawn at random. The validating sample must consist of at least 100 dwellings. With due observance of this minimum, a financial undertaking may itself determine the size of the sample. It is noted in this context that a sample containing more than the minimum number of dwellings has a smaller confidence interval and, hence, leads to a revaluation factor that is closer to the average rise. Consequently, it may be preferable to use a larger sample. Financial undertakings must set the size of the sample in advance, since otherwise the sample would not be random. Article 1:9 The test has been formulated in such a way that the financial undertaking must demonstrate with 99% confidence that the indexation method chosen has not led to overestimation of the average value of the collateral. In practice, this means that the lower limit of the 99% confidence interval is the critical limit, which the test statistic must not exceed for the method to qualify as prudent. Using the sample observations as a basis, the financial undertaking calculates the average of Qi (Qg) and the standard deviation of Qi (SQg). If the sample distribution of Qi is a normal distribution, the test statistic may be determined as follows: (Qg-1)/(SQi/ N). Only if the test statistic is smaller than may the indexation method be considered prudent. If the test statistic is in excess of the lower limit of the 99% confidence interval, the financial undertaking must decrease the forced-sale value of all dwellings in the portfolio by the factor referred to in Article 1:10, which is based on the ratio of the sample average to the lower limit of the 99% confidence interval. A financial undertaking must verify whether the distribution of the quotients from the sample meets the assumption of normality. If the distribution of the quotients in the sample prevents reliable validation, the financial undertaking must normalise the sample results and conduct a new validation test on the basis of normalised values. A test for normality may, for instance, be made using a histogram and a Jarque-Bera test. If the distribution of the quotients in the sample prevents reliable validation and prudent application of the indexation method, for instance because overvaluations are relatively much more frequent than undervaluations, the financial undertaking must normalise the sample results and perform the validation test on the basis of normalised values. One example of normalisation is log-normal transformation. Log-normal transformation is a method by which the average of the natural logarithms of the quotients (lnqg) and the standard deviation of the natural logarithms of the quotients (SlnQ) are determined from the sample observations. The test statistic then becomes LnQg/(SlnQ/ n). Article 1:10 Depending on the ratio of Q o99% to Qg, this adjustment will be either an upward or a downward revaluation. Upward revaluations to the lower limit of the 99% confidence interval are permitted, downward revaluations are compulsory. If the sample distribution of Qi is a normal distribution, factor k which must be applied to the dwellings in the indexed residential mortgage portfolio is determined by the formula (1-2,33*SQi/ N)/Qg. The determination of the correction factor is elucidated below by several examples. The examples also show the effects of a larger-than-minimum sample and a smaller standard deviation of the quotients as a result of proper segmentation and the selection of appropriate indices. 159

160 Example a Let the quotients be normally distributed and let Q g be Based on the standard deviations of the quotients in the sample of 0.65 and a sample size of 100, the Q g which corresponds to the lower limit of the confidence interval (Qg o99% ) equals On the basis of this validating sample, it cannot be concluded with 99% confidence that the indexation method has not led to overestimation of the forced-sale value. From this ratio it follows that factor k is (= /0.95). Hence, the indexed forced-sale value of all dwellings covered by the indexation method must be adjusted by this factor. Example b Equal to example a above, but now the sample size is 1,000 dwellings. It follows that Qg o99% equals On the basis of this validating sample, it can be concluded with 99% confidence that the indexation method has not led to overestimation of the forced-sale value in the indexed portfolio. From the Qg o99% /Qg ratio it follows that factor k is (= /0.95). Hence, the indexed forced-sale value of all dwellings covered by the indexation method may be adjusted by with this factor. Example c Equal to example a above, but now the standard deviation of the quotients in the sample is As a consequence, Q o99% equals On the basis of this validating sample, it cannot be concluded with 99% confidence that the indexation method has not led to overestimation of the forced-sale value in the indexed portfolio. From the Q o99% /Qg ratio it follows that factor k is (= /0.95). Hence, the indexed forced-sale value of all dwellings covered by the indexation method must be adjusted by this factor. Example d Equal to example a above, but now the standard deviation of the quotients in the sample is 0.35 and the sample size is 1,000 dwellings. As a consequence, Q o99% equals On the basis of this validating sample, it can be concluded with 99% confidence that the indexation method has not led to overestimation of the forced-sale value in the indexed portfolio. From the Q o99% /Qg ratio it follows that factor k is (= /0.95). Hence, the indexed forced-sale value of all dwellings covered by the indexation method may be adjusted by this factor. Article 1:11 Adjustment of the forced-sale value of dwellings in the mortgage portfolio on the basis of the indexation method must lead to a reliable and prudent estimate of the forced-sale value of the dwellings in the mortgage portfolio and the associated credit risk. In addition, the indexation method must be applied and validated in an unequivocal, sound and verifiable manner. If, for instance on the basis of the validation described in Articles 1:9 and 1:10, the differences referred to in Article 1:6 or the overall manner in which a financial undertaking applies the indexation method, De Nederlandsche Bank is of the opinion that the principles set out in Article 1:4(a) and (b), are not complied with, it may require the financial undertaking to use individual appraisals instead of the indexation method for the weighting of mortgage loans. Failure of the indexation method to lead to prudent results may also be due to relatively special or temporary (market) developments. In such cases, it may be sufficient (for the time being) to make a downward adjustment to the indexed forced-sale values. Hence, a lack of prudent results need not in all cases lead to termination of the possibility to use the 160

161 indexation method. Chapter 2 General Chapter 2 explains how financial undertakings must assign risk weights to exposures in order to arrive at a measurement of credit risk. For many exposure classes, the Chapter permits the use of either fixed risk weights or risk weights determined by external credit assessments. Chapter 2 consists of three Sections. Section 2.1 only contains definitions. Section 2.2 (Risk weights) addresses the risk weights for the various exposure classes. Section 2.3 (Use of credit assessments from credit assessment institutions for the determination of risk weights) contains more detailed provisions for the use of external credit assessments, for instance in cases where more than one credit assessment is available for a certain exposure. Section 2.3 addresses the distinction between credit assessments of obligors and those of new issues and that between long-term and short-term credit assessments. Chapter 2 applies to all financial undertakings insofar as they do not rely on a method underlain by an internal ratings-based approach for the measurement of credit risk. For facilities for credit risk mitigation, reference is made to Chapter 4. Credit assessments Financial undertakings may rely on solicited and unsolicited credit assessments. However, external credit assessments, prepared by a credit assessment institution, may only be used for the calculation of minimum capital requirements if De Nederlandsche Bank has recognised such assessments as being eligible for this purpose. It is important to distinguish between eligible and nominated credit assessment institutions: only credit assessment institutions recognised as eligible by De Nederlandsche Bank can be nominated by a financial undertaking if it wants to use external credit assessments to calculate the minimum capital requirements. The Decree on the Implementation of the Basel II Capital Accord (Besluit implementatie kapitaalakkoord Bazel 2) provides for the conditions which must be satisfied for the credit assessments of a certain credit assessment institution to be used for solvency test purposes. The Decree also describes the method for translating the credit assessments into risk weights (known as mapping). The conditions and the procedure for recognition as well as the mapping method have been elaborated by the Committee of European Banking Supervisors (CEBS) in a document published on the CEBS website on 20 January When assessing credit assessment institutions, De Nederlandsche Bank will rely on these conditions, this procedure and this method. A financial undertaking wishing to use credit assessments of one or more credit assessment institutions must submit an application to De Nederlandsche Bank for recognition of the credit assessment institution(s) concerned. Applications must contain the information listed in the Common basis application pack attached to the CEBS document referred to above. De Nederlandsche Bank will consider applications submitted by supervised financial undertakings. Joint applications may be submitted through the Netherlands Bankers Association (Nederlandse Vereniging van Banken). Applications from credit assessment institutions will also be considered, provided that one financial undertaking supervised by De Nederlandsche Bank to be specifically named in the application has indicated that it will use the credit assessments of the credit assessment institution concerned if it is recognised as eligible. Applications must be addressed to: 8 under Publications, entitled CEBS Guidelines on the Recognition of External Credit Assessment Institutions. This document is also available on 161

162 De Nederlandsche Bank NV Supervisory Policy Department Postbus AB Amsterdam Explanatory notes to individual Articles Article 2:1(d) Article 366 of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek) defines tangible assets as follows: (a) land and buildings, including land and buildings used by the financial undertaking for its own operations; (b) technical and other plant; (c) machinery; (d) technical and administrative equipment; (e) prepayments, and (f) fixed assets under construction. Administrative equipment refers to the full range of administrative support of a financial undertaking, and more specifically to software and hardware required for secretarial and administrative work, if not covered by one of the other items. Article 2:3(1) For an explanation of the Arrangement on Guidelines for Officially Supported Export Credits, reference is made to the website of the OECD ( Article 2:8 This Article concerns regional governments and local authorities which embody the same risk as their central governments because they can levy taxes and specific regulations are in place limiting the probability of default. The list of the regional governments and local authorities concerned is contained in Annex 2B to the present Regulation. Article 2:9 Financial undertakings may submit a reasoned request to De Nederlandsche Bank to apply a lower risk weight. The countries whose supervisory practices and arrangements are equivalent to those in the European Union are listed in Annex 2E to the present Regulation. Article 2:11 Article 2:11 constitutes an elaboration of the scope for national discretion offered under point 15 of Part 1 of Annex VI to the recast Banking Directive. For the purposes of this Article, public sector entities established in the Netherlands at least include: - the state universities; - the municipal university of Amsterdam; - the special universities in Amsterdam, Nijmegen and Tilburg, and - the teaching hospitals affiliated with these universities. Article 2:15(1) For the purposes of Article 2:15(1), the following organisations are regarded as multilateral development banks: 162

163 - the Inter-American Investment Corporation; - the Black Sea Trade and Development Bank, and - the Central American Bank for Economic Integration. Article 2:17 Article 2:17 is meant especially for certain Italian leasing companies which do not form part of a bank but are subject to the prudential supervision of the Banca d Italia. It stands to reason that the Article also covers other financial undertakings in similar circumstances. Equivalent expresses that it has been demonstrated that the prudential requirements for these financial undertakings are in conformity with the Banking Directive and the Capital Adequacy Directive of the European Union. Articles 2:18(3) and 2:25 For the purposes of Articles 2:18 and 2:25, the central government of the country where the financial undertaking (or the corporate, respectively) has its registered office shall be understood as follows: - if the financial undertaking or corporate is an independent legal entity: the central government of the country where the financial undertaking or corporate has its registered office; - if the financial undertaking or corporate is not an independent legal entity: the central government of the country where the parent company has its registered office. Article 2:20 See the explanatory notes to Article 2:26. Article 2:21 Article 2:21 constitutes an elaboration of the scope for national discretion offered under point 85 of Part 1 of Annex VI to the recast Banking Directive. Financial undertakings wishing to apply the preferential risk weight must be able to identify the funding of the exposures concerned. Article 2:22 This Article supplements Article 94 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). Article 2:26 This Article relates to short-term exposures for which a specific credit assessment is available. It therefore refers to issue ratings, which exist for certificates of deposit and commercial paper, among other securities. This is in contrast to issuer ratings that relate to various exposures to a given obligor. Short-term exposures to financial undertakings with an issuer rating intended specifically for short-term exposures, but where no issue rating is available, are covered by Article 2:20. Article 2:27 For the purposes of Article 2:27(a), a financial undertaking may prepare an in-house guideline setting out what it takes a small or medium-sized entity to be. The major criterion in this regard is that exposures to small or medium-sized entities are not managed on an individual basis. In the absence of such an in-house guideline, a small or medium-sized entity may be taken to be an entity with annual sales not in excess of 1 million. 163

164 The provisions of Article 2:27(b), are meant as a measure of the granularity of the retail portfolio. This portfolio should consist of a significant number of individual exposures with similar characteristics. A significant number is regarded as being at least 500. The maximum total amount owed of 1 million, as referred to in Article 2:27(c), is to be distinguished from the maximum annual sales of likewise 1 million, as referred to above in the explanatory notes to Article 2:27(a). The present value of minimum lease instalments may be assigned a risk weight of 75%, provided that all conditions set out in this Article are satisfied. Article 2:29 For the purposes of Article 2:29, the owner shall also be taken to mean the economic owner (whether a natural person or otherwise) in the case of a personal investment company. Article 2:30(a), (d) and (e) The requirement set out in subparagraph (a) does not rule out situations where purely macroeconomic factors have an adverse effect on both the value of the real estate and the payment behaviour of the borrower. Subparagraph (d) details the requirement that the value of the real estate has to be considerably higher than the amount of the exposure in order to be eligible for a risk weight of 35%. De Nederlandsche Bank maintains the standard that the exposure must be 75% or less of the forced-sale value. If the exposure is more than 75% of the forced-sale value, the excess is regarded as part of the retail portfolio (75% risk weight), provided the terms of Article 2:27 are met. Banks are expected to have an in-house method in place to monitor compliance with the requirements set out in subparagraph (e). Article 2:31 The principle to be observed when applying an indexation method is that the method should produce a reliable and prudent estimate of the forced-sale value of the residential property in the portfolio. In addition, the method must be applied in a clear, consistent and verifiable way. These principles have been worked out in greater detail in the indexation method referred to in Section 1.2. Article 2:32 In principle, this Article only applies to non-residential real estate in the Federal Republic of Germany. Financial undertakings may, however, submit a reasoned request to assign a risk weight of 50% to non-residential real estate in other Member States of the European Union as well. Article 2:33 The risk weight is applied to the nominal exposure less the collateral and less specific provisions. Article 2:36 This concerns investments also known as venture capital (under (a)) or private equity (under (b)) and regarded as particularly high-risk (the risk weights of ordinary equities of financial undertakings and corporates are set at 100% in Articles 2:22 and 2:53(c), respectively). Pursuant to Article 61(5)(c) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), De Nederlandsche Bank has power to set a risk weight of 150% for other items as well. For the time being, De Nederlandsche Bank only sets a risk weight of 150% under this power for exposures to obligors whose external credit assessment 164

165 has been revoked. This may be departed from if the financial undertaking demonstrates that the credit assessment was not revoked because of the obligor s credit quality. Article 2:37 The risk weight is applied to the nominal exposure less specific provisions. This Article ensures that high-risk items assigned a weighting of 150% pursuant to Article 2:36 and with specific value adjustments are treated in the same way as past due items (Article 2:33). This serves to prevent a double charge (provisioning plus a higher risk weight) for high-risk items. Article 2:39 Article 2:39 ensures that covered bonds not collateralised by assets listed in Annex 1 are still eligible for the preferential risk weighting pursuant to Article 2:40, provided they are issued before 31 December This concerns covered bonds meeting the definition of Article 22(4), first and second paragraphs, of Directive 85/611/EEC. The definition includes the following four criteria: - the bonds must have been issued by a credit institution which has its registered office in a Member State; - that credit institution must be subject by law to special public supervision (in that Member State) designed to protect bond-holders; - the sums deriving from the issue of these bonds must be invested by that credit institution in conformity with the law in assets which, during the whole period of validity of the bonds, are capable of covering claims attaching to the bonds; - the assets in which these sums are invested must, in the event of failure of the issuing credit institution, be used on a priority basis for the reimbursement of the principal and payment of the accrued interest. Article 2:44 This Article will only be applied in exceptional cases and does not imply that De Nederlandsche Bank monitors all existing CIUs. Articles 2:45 to 2:48 These Articles state the conditions (Article 2:45) under which and the ways (Articles 2:46, 2:47 and 2:48) in which financial undertakings may apply the principle of looking through when determining the risk weight of exposures to CIUs. For the purposes of Article 2:45(2)(a) and (b), De Nederlandsche Bank verifies on a case-by-case basis whether the supervision in the country of origin of the CIU is equivalent to supervision in the European Union and whether the cooperation with the supervisory authority in the country concerned is sufficiently ensured. If a CIU from a country that is not a Member State of the European Union has been recognised by another supervisory authority in the European Union as being acceptable in accordance with Article 2:45(2)(a), De Nederlandsche Bank may use that recognition without performing an assessment of its own. The third party that a financial undertaking may rely on under Article 2:48 must be independent of the CIU. The criteria used for testing independence are similar to those for testing credit assessment institutions (see the CEBS document referred to in the General Notes to this Chapter). Article 2:49 165

166 If, for instance, a sale and repurchase transaction in Dutch central government bonds is concluded with a foreign bank, the risk weight of the Dutch central government applies and the risk weight of the foreign bank is ignored. An outright forward purchase is an uncovered forward purchase. Article 2:50 This Article states how the risk weight is determined of the protection offered by a financial undertaking to another party against default of its debtors by means of a credit derivative. The Article mainly concerns credit derivatives which simultaneously offer protection on several exposures and which pay out after a number of defaults specified in the contract (basket products). The risk weight may be determined in either of two ways: based on a credit assessment by an eligible credit assessment institution if one is available, or otherwise on the basis of the fixed risk weights as determined in Section 2.2. In the latter case, the financial undertaking must itself determine the risk-weighted exposure amount. To this end, the financial undertaking must first determine the risk-weighted exposure amounts of all individual exposures under the contract and rank these risk-weighted exposure amounts by magnitude. Subsequently, the n-1 exposures with the lowest risk-weighted amounts are ignored and the risk-weighted amounts of the remaining exposures are added up. This may be illustrated as follows: in the case of a credit derivative offering protection for, say, 25 exposures with the contract paying out on the 5th default, the risk-weighted exposure amounts for all 25 exposures must be determined. The lowest four risk-weighted exposure amounts are then ignored. The risk weights of the remaining 21 items are added up, subject to a maximum of 1250%. Finally, the sum of these risk weights is multiplied by the total nominal amount for which the credit derivative offers protection to obtain the riskweighted exposure amount. Article 2:52 Cash in process of collection includes cheques to be cleared, securities coupons and redemptions of bonds, mortgage bonds and similar items which are payable and collectible around the date of the calculation of the risk-weighted exposure amount. Article 2:53(a) This includes real estate on the balance sheet of the financial undertaking. Real estate and mortgages not on the balance sheet of the financial undertaking but serving as collateral for exposures of the financial undertaking are addressed in Articles 2:28 to 2:32. Article 2:56 This Article serves to prevent, for instance, a credit assessment for senior debt from being used as an indicator of the overall creditworthiness of an obligor in a situation where that obligor also has junior debts. Article 2:58 This Article concerns issue ratings. See the explanatory notes to Article 2:26. Article 2:61 If no separate credit assessment by an eligible credit assessment institution is available for exposures denominated in a foreign currency, but there is a credit assessment which applies specifically to exposures denominated in the national currency, the exposures denominated in foreign currency are treated as exposures for which no credit assessment by an eligible credit assessment institution is available, as set out in Section

167 Annex 2B The lists of regional governments and local authorities of EU Member States that have been included by the national supervisory authority for financial undertakings in the list of regional governments and local authorities assigned the same risk weight as their central government are published on the website of the Committee of European Banking Supervisors ( Chapter 3 General The IRB Chapter covers all the requirements that relate specifically to the application of the IRB approach. The Chapter consists of five Sections. The first Section contains the definitions that specifically apply to Chapter 3. Section 3.2 subsequently sets out the general provisions under which financial undertakings may use their internal ratings-based systems to calculate the capital requirements for credit risk. It also addresses the classification of all exposures into a set number of classes and the possibility of a phased roll out of the IRB approach. Sections 3.3, 3.4 and 3.5 specify the structure of the methodology that financial undertakings must apply to determine the capital requirements for credit risk. Section 3.3 sets out the provisions on determining the risk-weighted exposure amounts and expected loss amounts, such as the risk curves that financial undertakings must use for specific types of exposure. Section 3.4 then sets out the way in which the input parameters PD, LGD and M must be determined for the various risk curves and Section 3.5 states how financial undertakings must determine the input parameter exposure value for various types of exposure. Section 3.6 sets out the minimum requirements that financial undertakings rating systems and estimates of the input parameters must meet to be used for determining the capital requirements. It specifies, among other things, the structure of the rating system, data requirements, quantification of the input parameters, validation of the IRB methods and internal control for the application of the IRB approach. Explanatory notes to individual Articles Article 3:1 (c) (finance of income-producing real estate) Examples of the real estate covered by this method of funding are offices, shopping centres, factories, hotels, houses and flats. Repayments are met from rent, lease income or sale of the real estate. (e) (object finance) Examples of the assets covered by this method of funding are ships, aircraft and railway wagons. These assets also serve as collateral for the loan. (f) (project finance) Examples of this method of funding are: - financing infrastructure projects, and - financing certain production facilities. (g) (rating system) 167

168 IT systems form a significant part of a financial undertaking s rating system, but a rating system is more than just the IT systems. It also includes all the controls, data collection and other methods and processes for assessing credit risk and classifying obligors and exposures into grades or pools (rating) and the quantification of certain estimates. Article 3:2 A financial undertaking must submit a request for approval to De Nederlandsche Bank to use the IRB approach for calculating the capital requirements for credit risk. De Nederlandsche Bank will formally handle such a request if, in its opinion, it has received sufficient information from the financial undertaking. In the explanatory notes to the application form for using an internal ratings-based system, De Nederlandsche Bank sets out the information to be provided by the financial undertaking before De Nederlandsche Bank can deal with a formal request. This information must consist of: (1) formal application to use internal ratings-based systems; (2) general description of the implementation of the IRB approach; (3) risk management framework; (4) list of rating systems; (5) capital adequacy impact of moving to the IRB approach; (6) self-assessment of compliance with supervisory regulations. A financial undertaking will initially supply only the above information to De Nederlandsche Bank. After assessing this information, De Nederlandsche Bank will request more detailed information for all or some of the internal ratings-based systems. De Nederlandsche Bank operates on the principle that a financial undertaking must not be faced by an unnecessary administrative burden in providing the requested information. Consequently, where possible, a financial undertaking may use already available internal documentation. Besides, internal documentation provides greater insight into the financial undertaking s internal treatment of specific subjects than memoranda written especially for De Nederlandsche Bank. If De Nederlandsche Bank requests information that a financial undertaking has already sent to it at an earlier stage, a mere reference to that information will, of course, suffice and the information need not be submitted again. A financial undertaking s internal documentation will not always be immediately usable (readable) in its existing form for the supervisory authorities. Hence, when compiling the application package, the financial undertaking must, if necessary, make the documentation suitable for assessment by De Nederlandsche Bank. This may, for example, be done by adding pointers which guide De Nederlandsche Bank and possibly also foreign supervisory authorities through the documentation and which set out the links between the different documents. If the financial undertaking fails to do this, the assessment may be delayed and, in view of the tight deadlines, this could be a risk to timely implementation. If the financial undertaking s request is regarded as a joint application on behalf of all entities within the EU under Article 129 of the recast Banking Directive, De Nederlandsche Bank will handle the request in line with Article 129 and the procedural guidelines from the Committee of European Banking Supervisors (CEBS). Article 3:3 To prevent capital arbitrage, combined use of the different methods is not allowed, except where this follows from explicit exemptions for the IRB approach or the phased roll out of the IRB approach. Exceptions are situations where a financial undertaking applies the foundation IRB approach. The financial undertaking must use this approach in combination with the advanced IRB approach for the class referred to in Article 71(1)(d) of the Decree on 168

169 Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (exposures to individuals and small and medium-sized entities, also known as the retail portfolio ) as there is no foundation method for this class in the supervisory regulations. In addition, the financial undertaking is allowed to treat the subclass specialised lending exposures permanently in accordance with the foundation IRB approach, even if the financial undertaking rolls out the advanced IRB approach for other classes. Articles 3:4 to 3:10 Financial undertakings must assign their exposures to the various classes in order to apply the IRB approach correctly for calculating the capital requirements. These classes are generally in line with the portfolios that financial undertakings also use in their internal risk management processes: (a) governments; (b) banks and investment firms; (c) corporates; (d) retail; and (e) equities. There are two further classes: (f) securitisation positions; and (g) other assets. Within the corporates class, four specialised lending subclasses can be distinguished: project finance, object finance, commodities finance and finance of income-producing real estate. The retail portfolio also differentiates between exposures secured by real estate (mortgages), qualifying revolving exposures (including credit cards) and other exposures. As various formulas and various minimum requirements apply to the various classes, it is important that financial undertakings develop procedures for assigning all their exposures to one of these classes in an accurate and consistent manner. Financial undertakings must take reasonable steps to monitor the 1 million limit referred to in Article 3:7(2) for lending to small and medium-sized enterprises (SMEs). De Nederlandsche Bank allows some flexibility with respect to this limit to prevent that financial undertakings have to build completely new information systems to achieve perfect compliance. This is because it will be difficult to be completely sure of the total exposure to a group of associated SMEs treated in the retail class on a consolidated basis as this would require individual amounts to be uniquely identifiable, and this is often not practical in a retail portfolio. De Nederlandsche Bank will, therefore, expect a financial undertaking to monitor the said limit for each autonomously operating entity. In the opinion of De Nederlandsche Bank, monitoring at the autonomously operating entity level is a good middle way. After all, within such an entity, the total exposure across the various retail subclasses to a single counterparty possibly consisting of several associated entities, should be known, certainly if a counterparty is concerned whose exposures would be adding up to a total of 1 million. Another aspect of monitoring the 1 million limit is the convergence of lending to the SME and its owner or owners. In principle, in monitoring the limit, a financial undertaking is expected to include commercial exposures which are formally granted to the owners, but which in material terms are of a commercial nature, such as specific business facilities. If there are facilities which have a primarily non-commercial nature, such as residential mortgages, the financial undertaking need not include them in its monitoring of the 1 million limit. 169

170 Furthermore, De Nederlandsche Bank also accepts that, if the limit is exceeded, the corporate rating system will not be applied immediately and in full, but that only the corporate curve will be used to calculate the capital requirements. De Nederlandsche Bank would only allow this temporarily, however. If an SME exposure systematically exceeds 1 million, a bank must, from the viewpoint of proper risk management, also be using the corporate rating system for that SME exposure. With respect to the assignment of exposures to the retail portfolio, Article 3:7(1)(c) and (d) stipulates that exposures must be part of a significant number of similarly managed exposures and may not be managed individually, as is the case for exposures to corporates. These conditions are a result of the fact that input variables need not be determined individually in the retail portfolio, but the average value may be taken for the group in which they are included. It is important that these groups are sufficiently homogeneous in terms of input variables for risk weight (EL or PD and LGD). If an exposure is actually managed individually in the same way as corporates, there can be no retail treatment using group values. The financial undertaking must treat such exposures in accordance with the class referred to in Article 71(1)(c) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (exposures to corporates) and determine the values for the input variables individually. In the context of the retail portfolio, Article 3:8(2) details the requirements for the treatment of revolving credits. These requirements are two-fold. Firstly, there are requirements on the individual exposures themselves: only to individuals (exposures to SMEs do not qualify), revolving, unsecured, immediately cancellable and not exceeding 100,000. Undrawn credit lines may be regarded as credit lines that can be cancelled unconditionally if the financial undertaking is allowed to cancel them under the relevant terms and conditions to the extent that such is permitted by consumer protection laws and related legislation. Secondly, there are requirements on the group as a whole. These mainly address the fact that the use of the low correlation factor of 0.04 must be in line with the underlying risks of the subportfolio. A key aspect here is the volatility of loss rates, especially within the low PD bands. The financial undertaking must be able to demonstrate this to De Nederlandsche Bank. Treatment as a qualifying revolving exposure must be in line with the underlying risk characteristics of the subportfolio. The financial undertaking will assess the volatility of the loss rates of all qualifying revolving subportfolios separately as well as the aggregated qualifying revolving portfolio, and relate this volatility to that of the other subclasses in the retail portfolio. If a revolving exposure does not meet these requirements, it must be assigned to other retail exposures. Equities not included in the trading book are assigned to the class referred to in Article 71(1)(e) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). Article 3:9 provides that in addition to equities, other positions may be assigned to the equity class. These are indirect equity exposures, such as equity derivatives not included in the trading book, but also debt exposures which have the economic substance of equities, such as exposures with such a degree of subordination that in an economic sense they can be regarded as equity, for instance tier-1 debt instruments issued by other financial undertakings. Exposures which are not subordinated, but whose economic characteristics are equivalent to those of equities must also be assigned to the equity class. Examples are debt instruments whose redemption can be postponed indefinitely ( perpetual loans ) and debt instruments paid out in a predetermined or unspecified number of shares ( convertibles ) where the conversion terms of the convertibles and market conditions play a role in whether the debt instruments should be regarded as equities. Article 3:11 170

171 Pursuant to Article 76 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), financial undertakings may continue to treat specific exposures under the standardised approach. These include state-guaranteed exposures and state-reinsured guarantees. In the latter case, the conditions set out in Article 4:83 must be met. Articles 3:12 to 3:15 If a financial undertaking wishes to apply the IRB approach, it is expected to do this for its entire business, unless particular exposures are explicitly exempted from the IRB approach. However, financial undertakings may be allowed to adopt a phased roll out of the IRB approach. Articles 3:12 to 3:15 set out the conditions under which such a phased roll out is permitted. Article 3:12 stipulates that a financial undertaking adopting a phased roll out must prepare a plan ahead of the IRB roll out stating how it will roll out the IRB approach throughout the organisation. The roll-out plan must indicate for which business units and at what time, the capital requirements in accordance with the IRB approach will be calculated. The roll-out plan will also outline which activities in specific business units must still be carried out by the financial undertaking before it can move to calculating the capital requirements in accordance with the IRB approach. Pursuant to the recast Banking Directive, the supervisory authority must approve the roll-out plan. The roll-out plans of financial undertakings will, by definition, require a case-by-case assessment. If the financial undertaking is of the opinion that the roll out in a specific business unit or class has been completed, it must obtain explicit approval from De Nederlandsche Bank to calculate the capital requirements for that specific unit in accordance with the IRB approach. To this end, the financial undertaking must provide, along with its formal request, up-to-date information on the solvency impact and self-assessment as referred to in Article 3:2(1)(d) and (e). It is evident that the same requirements apply as those to the other units already under the IRB approach. In view of the fact that rolling out the IRB approach will be a significant and complex event, it is important that the financial undertaking manages the roll out with a project-based approach and that the roll out is controlled by the financial undertaking s senior management. A roll-out plan must be prepared carefully and realistically. On the basis of the plan, the project structure and the proposed deployment of people and resources, the expectation must be warranted that the financial undertaking can complete the roll out within the three-year period referred to in Article 3:13. A financial undertaking may also opt to move via the foundation IRB approach to the advanced IRB approach. In that second step, the financial undertaking is allowed another maximum period of three years to progress from one approach to the other. However, a financial undertaking that starts in the foundation IRB approach may only progress to the advanced IRB approach if it has fully completed the foundation IRB roll out. These provisions do not imply that a financial undertaking which opts directly for the advanced IRB approach will have a roll-out period of six years. Another significant criterion in assessing a roll-out plan is that the velocity and completeness of the IRB roll out are not determined exclusively by the rationale for capital requirements. As stated in Article 3:13(1)(d), pillar 2 applies in full during the roll-out period. De Nederlandsche Bank may impose a supplementary capital requirement to rectify a shortfall in capital resulting from a delayed roll out. To prevent that, within that period, a very rapid roll out across low risk business units (with a potentially high decrease in capital requirements) is combined with an unnecessarily slow roll out across high risk business units (with a potentially high increase in capital requirements), Article 3:13(2) specifies that in case of a phased roll out of the IRB approach in the corporates class, the IRB approach must also be rolled out directly across the subclasses 171

172 for specialised lending. This requirement arises from the provisions of the Basel Accord. It has already been stipulated in the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) that, upon its implementation, the IRB approach must be rolled out at the same time on the equity class. In addition to these provisions, De Nederlandsche Bank will assess, among other things, whether the roll out aims for a given frequency and pace supported by risk management and operational considerations. Article 3:14 stipulates that, for all exposures on which financial undertakings propose to apply the IRB approach under the roll-out plan, they must, from the start of the roll out, collect at least the information that is relevant for the application of the IRB approach. This will be conducive to the realisation of a roll out within three years and encourages risk-based management. In addition, cumulative requirements are imposed on histories of data. These ensure that some of this information comes from internal sources (and is thus more appropriate for the situation of the specific bank). Therefore, at the start of the IRB roll out for all business units and exposure classes included in the roll out, a financial undertaking must have a compliant definition of default as well as a system to establish and document default, LGD and conversion factors. Article 3:14(2) addresses the publication of comparative figures during the phased roll out. This paragraph ensures that, after roll out, the financial undertaking will also publish comparative figures during periods of extension of the IRB approach. Article 3:15 indicates that the actual roll out may be affected by future events such as changes in the risk profile of existing exposures or markets, the development of new markets, the origination of mergers and acquisitions, about which the financial undertaking must forthwith notify De Nederlandsche Bank. Articles 3:16 to 3:18 As stated in the explanatory notes to Articles 3:4 to 3:10, under the IRB approach all exposures are assigned to various classes which have different risk curves. Article 3:16 lists the Articles in which these risk curves are specified. A specific aspect of the determination of risk-weighted exposure amounts is the treatment of purchased receivables. The risk-weighted exposure amounts for these exposures are first calculated for the credit risk (the risk that the underlying obligor cannot or will not pay). Depending on the ultimate obligor of the receivable, these receivables are assigned to the class referred to in Article 71(1)(c) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (exposures to corporates) or to the class referred to in Article 71(1)(d) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (retail exposures). Besides risk-weighted exposure amounts for the credit risk, risk-weighted exposure amounts must also be calculated for the dilution risk associated with such exposures (the risk that the underlying obligors do not have to pay the full amount). The dilution risk is not in fact a direct credit risk. It is the risk that an amount receivable is reduced in value through cash or non-cash credits to the obligor, such as discounts for accelerated payment or for substandard quality or even for the return of goods. These two specific aspects have slightly different treatments, set out in specific Articles. As an alternative to the specific treatment of purchased receivables, financial undertakings may, if they have full recourse for default or dilution losses to the seller of the purchased receivables, treat the exposures as collateralised exposures. Article 3:17 provides that the risk-weighted exposure amounts are calculated using the input parameters applicable to the exposure concerned. The input parameters are the probability of default (PD), loss given default (LGD), maturity (M) and the exposure value, and are determined on the basis of the provisions of Sections 3.4, 3.5 and 3.6. There are three 172

173 exceptions to the use of these input parameters. The first exception concerns the exposures assigned to the subclasses referred to in Article 3:6. This is the supervisory slotting method in which financial undertakings may use specific criteria for assigning simplified risk weights to the exposures in these subclasses. The second exception is the treatment of equity exposures. There are three methods for determining the risk-weighted exposure amounts for equity exposures: the PD/LGD approach, the simplified risk weight approach and the method in which financial undertakings apply an internal models approach. The latter two methods are not based on the above input parameters for determining the risk-weighted exposure amounts for equity exposure. The last exception is the determination of the risk-weighted exposure amounts for other assets, for which the simplified risk weight approach is used. Article 3:18 addresses the fact that financial undertakings using the foundation IRB approach may not apply their own estimates of LGD and conversion factors for exposures referred to in Article 71(1)(a) to (c) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). Instead, they must use the values prescribed in this Regulation. Article 3:19 Not only risk-weighted exposure amounts, but also expected loss amounts are relevant to the determination of capital requirements. Pursuant to Articles 92(2)(d) and 94(2)(f) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), a financial undertaking must add up all expected loss amounts and subtract them from the appropriate value adjustments and provisions. A negative result (shortfall) will be deducted from the financial undertaking s regulatory capital. A positive result (excess) may, up to a certain extent, be added to the financial undertaking s regulatory capital (see the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft)). The exact methodology for calculating the expected loss amount depends on the class the exposure is assigned to. Reference to the specific Articles is made in Article 3:19. The methodology for exposures to central governments and central banks, financial undertakings and corporate and retail exposures are set out in Articles 3:35 and 3:36. The expected loss amounts for exposures in the equity exposure class are determined in accordance with Article 3:37. The expected loss amounts for the dilution risk of purchased receivables are set out in Article 3:38. As has already been provided by Article 75(3) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), the expected loss amount for exposures assigned to the class referred to in Article 71(1)(g) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (other assets) will be zero. Article 3:20 Article 3:20 specifies which formulas are used to determine risk-weighted exposure amounts. The same IRB formulas will apply to exposures assigned to the classes of central government and central banks, financial undertakings and corporates. These formulas are set out in Annex 3. The IRB formulas are based on the Asymptotic Single Risk Factor model in which, using certain assumptions and subject to the risk characteristics of the institution-specific portfolio, the loss amount is determined for a situation that is expected to occur with a probability of 1 in This loss amount is converted into a risk weight which subsequently gives rise to the risk-weighted exposure amount. First, a correlation factor is calculated in accordance with the PD of the exposure, ranging from 0.12 for a high PD to 0.24 for a low PD for the classes of central governments and central banks, financial undertakings and corporates. The rationale behind this PDdependent variation of the correlation factor is that in the case of low creditworthiness (high PDs) there is, in particular, an idiosyncratic credit risk and thus a low interdependence of 173

174 credit risks. Exposures with high creditworthiness have a large interdependence and thus a high correlation. Subsequently, a maturity factor is calculated. The maturity factor is aimed at increasing the risk-weighted exposure amount in proportion to the maturity of the exposure, thereby reflecting the risk of a change in creditworthiness during the period for which the capital requirements are calculated (migration risk). This is higher for longer running exposures. The maturity factor declines vis-à-vis the PD, which demonstrates that the impact of the risk of declining creditworthiness over the maturity of the exposure is less for exposures with a lower creditworthiness than for exposures with a high creditworthiness. The formula for the risk weight has four elements. In the first element: LGD*N{(1-R) - 0,5 *G(PD)+(R/(1-R)) 0,5 *G(0,999)} a potential loss is calculated on the basis of the PD and LGD of the exposure that attaches to the limit of the 99.9% confidence interval, in line with a loss in a situation that statistically occurs once in a thousand times. In the second element: - PD*LGD this potential loss is adjusted for the expected loss in current circumstances, so that the risk weights, and thus the capital requirements, are based only on the unexpected loss, viz. that part of the potential loss that exceeds the current expected loss. In the third element: (1-1.5*b)-1 *(1+(M-2.5)*b) the risk weight is increased to incorporate the downgrade risk. Two further factors are applied in the final element: *12.5*1.06, with the first factor aiming to move from capital requirements to risk weights. The second is the multiplier, so chosen that the overall level of capital in the banking system should remain stable. The risk-weighted exposure amount for an exposure is determined by multiplying the exposure value by the risk weight applicable to the given exposure. There are two specific cases in which the IRB formulas do not work mathematically: if PD is equal to 0 and if PD is equal to 1. In either case, the formula produces no result. It has therefore been stipulated that if the PD is zero, the risk weight will be zero as there is no probability of default. There are two possibilities for a PD of 1, depending on the type of IRB approach applied. If a financial undertaking applies the foundation IRB approach, the risk weight is zero. The rationale behind this is that in the event of default there is no uncertainty about the possible loss for this specific exposure as the loss has already occurred. If a financial undertaking applies the advanced IRB approach, the risk weight will be zero unless the best estimate of the expected loss in the event of default in current circumstances (ELBE), as determined in accordance with the provisions of Article 3:81(8), is higher than the LGD. In that case, the risk weight is 12.5 times the difference between the LGD and the ELBE; i.e. the entire difference is required to be held as regulatory capital. If credit protection has been received for an exposure, and such protection meets the specific requirements set out in Chapter 4, the financial undertaking may take into account the double default effect. This means that in calculating the risk-weighted exposure amounts, the financial undertaking may consider the effect that a default of both the obligor and the protection provider is less likely than a default of either one of them. To reflect this effect in the risk-weighted exposure amounts, the financial undertaking may reduce the risk weights of the exposures that meet the relevant conditions in accordance with formula 4A in Annex 3. Paragraph 2 provides that financial undertakings may use a modified correlation formula for exposures to corporates which are assigned to the corporates class and where the total annual sales of the consolidated group of which the corporate forms part, are less than 50 million. In this formula, the correlation factor not only varies with the PD but also with the total annual sales of the consolidated group of which the corporate forms part. Where sales are not a relevant indicator of size, for example, with a start-up business, total assets should be used as an indicator. For these corporates, the correlation varies from 0.08 for a high PD to 0.20 for a low PD, depending on the size of the business. The condition imposed here (annual group sales of less than 50 million) indicates that the modified correlation 174

175 formula is intended for small corporates and not for lending to large corporates. The idea behind this is that the credit risks of small corporates show less interdependence than the credit risks of large corporates. For a proper application of these provisions, financial undertakings must have internal processes in place to ensure that formula 5 will only be used for corporates where the total annual sales of the consolidated group of which the corporate forms part, are less than 50 million and that this formula will not inadvertently be used for lending to large corporates. This also applies to lending where exposures are structured as exposures to special-purpose vehicles. If such a special-purpose vehicle forms part of a corporate where consolidated annual sales exceed 50 million, the modified correlation formula may not be used because the relevant requirements are not met. Article 3:21 Article 3:21 deals with the calculation of risk-weighted exposure amounts using the supervisory slotting method for specialised lending exposures. A special method has been developed for this exposure class which, as in the standardised approach, allocates risk weights to exposures on the basis of a number of risk characteristics. The reason for this special method is that the Basel Framework, while it was being developed, showed that especially with these exposures, financial undertakings were having problems drawing up their own estimates of PD, LGD and exposure value. To be able to apply the supervisory slotting method for specialised lending exposures, financial undertakings must distinguish in this subclass between project finance, object finance, commodities finance and finance of income-producing real estate. It may occur that an exposure is assigned to the specialised lending subclass because it meets the relevant conditions but is not covered by the definitions of the listed types of specialised lending. This could be the case, for example, if the funding is for a project where there are no physical assets but where the other conditions are met. In that case, the exposure is regarded as project finance for the purposes of the IRB approach. The supervisory slotting method must be applied to each part of the subclass and not, therefore, to each exposure. Hence, it may occur that a financial undertaking uses the ordinary IRB method for project finance and object finance, and the supervisory slotting method for commodities finance and finance of income-producing real estate. If the remaining maturity is 2.5 years or more, but the characteristics of the exposure are substantially more positive than would be normal for the relevant class, the financial undertaking may reduce the risk weights to be allocated to classes 1 and 2 to 50% and 75%, respectively. This aligns the risk weights for these two classes with the risk weights for loans with a maturity of less than 2.5 years. Paragraph 3 provides that, in assigning risk weights using four criteria, financial undertakings must assess whether the credit quality of the exposure is strong, good, satisfactory or weak. These qualifications correspond with the classes included in tables I and II in Annex 3. The qualification strong corresponds with class 1, good with class 2, satisfactory with class 3 and weak with class 4. Class 5 is for defaulted exposures. The assessment criteria are financial strength, political and legal environment, transaction or asset characteristics and strength of the sponsor and developer, including any public-private partnership income stream or security package. The Basel Accord provides further details of these criteria which are set out in the table in Annex 1 to this explanatory memorandum. As agreed by the Committee of European Banking Supervisors, De Nederlandsche Bank provides these criteria as a guide for financial undertakings opting for operationalisation of the assessment criteria listed in Article 3:21. The table sets out which aspects are significant for financial undertakings and which characteristics these aspects should have in order to arrive at the assessment strong, good, satisfactory or weak. 175

176 Different assessment aspects are given for the different factors set out in the tables. These aspects correspond with the nature of the lending and risk management at financial undertakings. For example, in project finance, the financial strength factor must be assessed partly against market conditions, such as the number of suppliers and comparative advantages of the borrower compared with competitors. In commodities finance, the financial strength factor mainly addresses the degree of over-collateralisation. Article 3:22 If a financial undertaking has purchased receivables from third parties, for example through factoring activities, the credit risk is determined mainly by the creditworthiness of the underlying obligors included in the pool of purchased receivables. If the financial undertaking does not treat such exposures as collateralised exposures, the risk-weighted exposure amounts for pools of purchased receivables will be determined in accordance with the characteristics of the underlying obligors. To this end, the financial undertaking must meet a number of minimum requirements listed in Article 3:84. These requirements focus, among other things, on safeguarding the effective ownership and control of the cash remittances from the exposures and on the effective monitoring of the credit risk in the pool. The underlying obligors may be counterparties assigned to the class referred to in Article 71(1)(c) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (corporates) or the class referred to in Article 71(1)(d) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (retail). The risk parameters for corporates are, in principle, set at the individual obligor level (bottom-up) in accordance with the requirements set out in Section 3.6 for risk quantification of exposures to corporates. If, however, the bottom-up determination proves too burdensome for the financial undertaking because, for example, the pool of purchased receivables has been purchased temporarily in preparation for securitisation, the financial undertaking may use the top-down approach, in which the risk parameters are determined for the pool as a whole, in accordance with Article 3:42 and the requirements set out in Section 3.6 for quantifying the risk of retail exposures. To this end, however, the pool of receivables must meet the same conditions as those applying to purchased retail receivables and no single receivable in the pool may exceed 100,000. The financial undertaking must look to the weighted average sales of the entities in the underlying pool to determine whether, in that case, the modified correlation formula may also be used. It may occur that the selling party grants credit protection for the purchased receivables. This may take several forms, for instance through a selling price that is lower than the nominal value of the exposures (discount) or through other collateral protecting the financial undertaking against first losses in the pool. Unlike the usual treatment in accordance with the provisions of this Chapter, these positions may also be treated as first-loss positions in accordance with the provisions of the Securitisation Chapter. In that case, the supervisory formula method, as described in Section 6.5.5, will be used for calculating the risk weight of the purchased receivables owned by the bank itself, whereby for Kirb, the PD, LGD and EL will then be calculated for the original exposures, without credit protection. Article 3:23 Article 3:23 specifies the determination of risk-weighted exposure amounts for sold credit protection whereby protection is simultaneously provided on several exposures and payment will be triggered after a specific number of defaults as defined in the contract (basket products) has occurred. Paragraph 1 stipulates that if the product has a credit assessment from an external credit assessment institution, the relevant risk weights set out in the Securitisation Chapter must be applied. 176

177 If no credit assessment from an external credit assessment institution is available, the financial undertaking must determine the risk-weighted exposure amount itself. To this end, the financial undertaking first determines the risk-weighted exposure amount of all exposures under the contract and arranges them by size. The n-1 number of exposures with the lowest risk-weighted exposure amounts are then ignored and the risk-weighted exposure amounts of the remaining exposures are added up. This may be illustrated as follows: in the case of a credit derivative providing protection for, say, 25 exposures with the contract paying out on the 5th default, the risk-weighted exposure amount for all 25 exposures must first be ascertained. The four lowest risk-weighted exposure amounts are then ignored and the risk weights of the remaining 21 items are added up. The sum of the expected loss amount is multiplied by 12.5 and the risk-weighted exposure amount determined in the above-described manner is maximised at the nominal amount of the protection provided by the credit derivative multiplied by Article 3:24 For the determination of the risk-weighted exposure amounts for retail exposures, the same structure and background applies as for the exposures to central governments and central banks, financial undertakings and corporates. There are, however, two differences. Firstly, the correlation factors are different and, secondly, no account is taken of the downgrade risk. Each of the subclasses has its own correlation factor. The correlation factors of exposures secured by real estate and of qualifying revolving exposures do not vary with the PD and are 0.15 and 0.04, respectively. The correlation factors for the other exposures assigned to this class do, however, depend on the PD and range from 0.03 at a high PD to 0.16 at a low PD. These correlation factors reflect the fact that the credit risks of retail exposures have a lower interdependence compared with exposures to, for instance, large corporates. Within the class of retail exposures, credit risks of mortgage exposures show the greatest interdependence and those of revolving credits the least. As in determining the risk-weighted exposure amounts for the credit risk of retail exposures no allowance is made for the risk that creditworthiness declines during the period for which the capital requirements are calculated (downgrade risk), financial undertakings do not need to make calculations with respect to maturity (M) or maturity adjustment when it determines the risk-weighted exposure amounts. There is no specific provision for the situation where PD is equal to zero. The reason is that such a situation is, by definition, impossible. After all, the minimum PD is For the situation where PD is equal to 1, a provision applies which is in line with the treatment of exposures to central governments and central banks, financial undertakings and corporates under the advanced IRB approach. The double default effect also applies to exposures to small and medium-sized entities: if credit protection has been received for an exposure, and such protection meets the specific requirements set out in Chapter 4, the financial undertaking may take into account the effect of double default. To reflect this effect in the risk-weighted exposure amounts, the financial undertaking may reduce the risk weights of the exposures that meet the relevant conditions in accordance with formula 4a in Annex 3. Article 3:25 As stated in the explanatory notes to Article 3:22, there are specific provisions on determining the risk-weighted exposure amounts for the credit risk of a pool of purchased receivables. As the credit risk is determined mainly by the creditworthiness of the underlying obligors in the pool of purchased receivables, the risk-weighted exposure amounts for such pools are, therefore, determined in accordance with the characteristics of the underlying obligors. 177

178 To this end, the minimum requirements set out in Article 3:84 must be met, as is the case for the pools of commercial receivables. These requirements focus on safeguarding the effective ownership and control of the cash remittances from the exposures and on the effective monitoring of the credit risk in the pool. Additional requirements apply to pools with retail receivables, which relate to the origin and creation of the exposures and diversity in the pool. These additional requirements are needed to allow the correct operation of the top-down approach. In the top-down approach, the risk parameters are determined for the pool of receivables as a whole, in accordance with the requirements set out in Section 3.6 for the risk quantification of retail exposures. As is the case with commercial receivables, it may occur that the selling party grants credit protection for the pool of retail receivables. In that case, unlike the usual treatment in accordance with the provisions of this Chapter, these positions may also be treated as firstloss positions in accordance with the provisions of the Securitisation Chapter. If there are mixed pools, the financial undertaking must either classify the pool by risk curve or apply the risk weight function that gives the highest capital requirements. Article 3:26 There are three methods for determining the risk-weighted exposure amounts for equity exposures: the simplified risk weight approach, the method where financial undertakings apply an internal models approach and the PD/LGD approach. An exception to this is formed by equity positions in ancillary services undertakings. In the recast Banking Directive an ancillary services undertaking is defined as un undertaking whose principal activity consists in owning or managing property, managing data-processing services, or any other similar activity which is ancillary to the principal activity of one or more financial undertakings. Such positions are allocated a simplified risk weight of 100% in line with the treatment of other non-credit obligation assets. It is important to restrict the operation of this Article to undertakings which indeed operate as internal ancillary services providers (for a group of financial undertakings or otherwise) and which do not act for third parties on a commercial basis, in which case there would be a higher commercial risk that does not justify the low weight of 100%. Article 3:27 The simplest approach for determining the risk-weighted exposure amounts for equity exposures is the simplified risk weight approach, in which the risk-weighted exposure amount is calculated by multiplying the exposure value by a prescribed risk weight. There are three risk weights: 190% for non-exchange traded equity exposures in sufficiently diversified portfolios, 290% for exchange traded equity exposures, and 370% for all other equity exposures. The risk weight of 190% is intended mainly for private equity and venture capital portfolios, through which financial undertakings invest in a large number of small start-up businesses. Although the risk of small start-up businesses is higher individually than that of established businesses, the risk across the entire portfolio may be lower because of portfolio diversification. To be eligible for application of the 190% risk weight, the equities must therefore form part of a sufficiently diversified portfolio of equity holdings that are, in effect, managed as a diversified portfolio. It is subject to judgment whether or not a portfolio is sufficiently diversified. A financial undertaking must be able to demonstrate that its portfolio is sufficiently diversified, for instance by providing information on geographical and sectoral diversification and past portfolio losses. If the portfolio is not sufficiently diversified, the risk weight of 370% applies. Paragraph 2 provides that the risk weight may be determined in accordance with the net position. This means that if an offsetting short position is entered into for a specific long 178

179 position, the risk weight may be determined on the resulting position. The hedge must, however, be explicitly designated and the remaining maturity must be at least one year. If there are any maturity mismatches, i.e. the remaining maturity of the position regarded as a hedge is less than the remaining maturity of the hedged position, the rules set out in Section 4.9 will apply in full, with the additional requirement that the remaining maturity of the position regarded as a hedge must be at least one year. A further requirement, included in paragraph 3, is that a short position not entered into as a hedge must be treated as if it were a long position. Finally, paragraph 4 provides that any unfunded credit protection, being guarantees and credit derivatives, may also be recognised when determining the risk-weighted exposure amounts for equity exposures. For these purposes, the same provisions apply as for determining the risk mitigation effect on credit exposures in accordance with Article 4:91(3) and (4), last sentence. This leads to the substitution of the risk weight in accordance with formula 9 in Annex 3 by the risk weight of the protection provider under the IRB approach. The financial undertaking then determines the PD of the guarantor and the risk weight for this guaranteed equity exposure by applying the values for LGD and M (see Article 3:52) in accordance with the PD/LGD approach. The minimum values of PD under this approach will also apply (see Article 3:49). Article 3:28 The internal models approach is based on the use of VaR methods subject to the 99 th percentile, one-tailed confidence interval of the difference between quarterly returns on the positions and an appropriate risk-free rate computed over a long-tem period, multiplied by There are specific minimum requirements for the development and application of VaR methods in the banking book, in particular with respect to quantification. These requirements are set out in Article 3:86. As stipulated in the recast Banking Directive, the risk-weighted exposure amounts at the level of the individual equity exposures may not be lower than a specific floor. This floor is calculated from the minimum risk-weighted exposure amount required under the PD/LGD approach based on the minimum value of PD set out in Article 3:49(2)(a) (0.0009), the LGD value set out in Article 3:50 (0.65 or 0.9) and the value of M as set out in Article 3:51 (five years), and the corresponding expected loss amount (Article 3:37) multiplied by In this application, the floor for the internal models approach is equal to the lowest of the floors that must be used in the PD/LGD approach: the risk-weighted exposure amount for an equity exposure of 100 must, under the internal model method, never be below (for positions in non-exchange traded equities where the financial undertaking can demonstrate that they are included in sufficiently diversified portfolios and where a lower risk weight is justified by historical figures) or (for other equity exposures). Financial undertakings have the latitude to ensure pragmatically that this requirement is met. A possible application of this requirement is explained in the example below: Example: Suppose an equity portfolio consists of 20 different issuers: E1, E2, E3, E4,, E20. the corresponding VaR is calculated for each issuer on a solo basis: VaR (E1),, VaR (E20), and compared with the floor; suppose that VaR(E1) and VaR(E2) are lower than the floor; hence the floor applies to these exposures; the risk weight for the other exposures may be determined from the portfolio VaR, excluding exposures E1 and E2. 179

180 Finally, paragraph 4 provides that any unfunded credit protection, being guarantees and credit derivatives, may be recognised in the internal models approach when determining the risk weighted exposure amounts for equity exposures. As this involves an internal models approach, this recognition of unfunded protection is not subject to the provisions of Chapter 4. The provisions of Article 3:45 on the treatment of the effect of guarantees and credit derivatives under the advanced IRB approach and the minimum requirements set out in Article 3:83 for assessing the effect of guarantees and credit derivatives do not apply in full to VaR models, either. These provisions and requirements are only relevant if they concern the legal aspects of guarantees and credit derivatives. The financial undertaking itself must develop a consistent and explainable method of determining the effect of unfunded credit protection on equity exposures. Article 3:29 Provisions with respect to Chinese Walls are a complicating factor when applying the PD/LGD approach. Chinese Walls, which are mandatory to prevent insider trading, prevent financial undertakings being able to share PD data from the lending department, where all relevant information on the credit quality of a counterparty is held, with the department that manages the equity exposures. This means that financial undertakings must determine separate PDs for all counterparties in their equity portfolio. If as a result of this or the lack of a credit relationship, a compliant definition of default cannot be properly applied, the financial undertaking must, as a compensating measure, multiply the final risk weights by 1.5. As is the case with the simplified risk weight approach and the internal models approach, any unfunded credit protection, being guarantees and credit derivatives, may be recognised under the PD/LGD approach. The same provisions apply to PD as to the determination of the risk mitigating effect of credit exposures on the basis of Article 4:93(3) and (5). This leads to the substitution of the PD of the equity exposure by that of the protection provider. Through the application of Article 3:52, the fixed values of 0.9 or 0.65 apply to LGDs, depending on the nature of the exposure, and a value of 5 applies to M. Articles 3:30 to 3:32 Within the class of equity exposures, a special treatment applies to positions in collective investment undertakings (CIUs). This treatment will, of course, only apply if and when the positions in CIUs do not form part of portfolios which pursuant to Article 76 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) are excluded from the IRB approach. The reason for the special treatment is that CIUs are, in fact, nothing else than a package of underlying exposures. Treatment as equities can be very disadvantageous, particularly for investments in fixed-income securities. The criteria set out in Article 3:30(1) mean that, if the position in a CIU meets the requirements set out in the standardised approach with respect to the supervision of the fund manager and the disclosure of investments, and the financial undertaking is aware of all the investments, the financial undertaking looks through the CIU and calculates the risk-weighted exposure amounts in accordance with the application of the IRB approach on the underlying exposures. This will, in fact, only be the case for in-house funds and index trackers. If the positions in CIUs meet these requirements but the financial undertaking does not apply the IRB approach to the underlying exposures, under Article 3:30(2) it must treat the underlying equity exposures using the simplified risk weight approach and other exposures using the standardised approach, where the risk weight is one step higher than normal. If the positions in CIUs do not meet the conditions or the financial undertaking is not aware of all the underlying investments, the financial undertaking may not calculate the risk- 180

181 weighted exposure amounts by applying the IRB approach to the underlying exposures. This will, in fact, often be the case. Financial undertakings will then apply the simplified risk weight approach in accordance with Article 3:31, allocating the positions to the various classes in accordance with the mandate. The same applies to non-equity exposures, which are also allocated to one of the classes, taking account of their risk profiles. This treatment aims, among other things, to encourage financial undertakings to obtain sufficient information from the CIUs they invest in, so that the IRB method can be applied. An alternative treatment is possible under Article 3:32 in which a third party, for example a custodian, is engaged, on the initiative of the CIU or otherwise, to calculate the risk-weighted exposure amounts for the participants in the CIU. The underlying equity exposures must then be treated using the simplified risk weight approach and other exposures using the standardised approach, where the risk weight is one step higher than normal. The financial undertaking itself may also calculate the risk-weighted exposure amounts. To this end, sufficient information on the underlying exposures must be available. Financial undertakings must have procedures in place to adequately ensure that the calculations (and any third-party reports) are accurate. Article 3:33 No specific IRB method has been developed for determining the risk-weighted exposure amounts for other non-credit obligation assets. The risk weight to be applied is 100%. For the residual value of leased real estate, this risk weight may, under specific conditions, be divided by the remaining maturity of the lease contract. Article 3:34 A slightly different treatment applies to determining the risk-weighted exposure amounts for the dilution risk of purchased receivables. As stated in the explanatory notes to Article 3:16, the credit risk of purchased receivables is treated in the corporate exposure classes or in the retail exposure class, depending on the ultimate obligors of the receivables. This distinction is not relevant when calculating the risk-weighted exposure amounts for dilution risk. The riskweighted exposure amounts for dilution risk are determined in accordance with the risk weight function for corporates. The calculation of the risk-weighted exposure amounts for dilution risk may be dispensed with if the bank can demonstrate from empirical loss data that this risk is negligible in the specific pool. Articles 3:35 to 3:38 Expected loss amounts must be compared with provisions formed for the credit risk when determining the solvency ratio under the IRB method. The provisions of Articles 3:35 to 3:38 set out how the expected loss amounts must be determined under the IRB approach. The expected loss amount for exposures to central governments and central banks, banks and investment firms, and corporate and retail exposures is the product of the PD, LGD and the exposure value. Each exposure is assumed to have the same input parameters for PD, LGD and the exposure value as used for the calculation of risk-weighted exposure amounts. The above-mentioned product cannot be calculated for exposures for which financial undertakings use the supervisory slotting method, as there are no PD and LGD estimates for these exposures. In that case, the financial undertaking must use the percentages included in table II to estimate the expected loss (PD*LGD) and then multiply them by the exposure value. Specific provisions also apply to the calculation of expected loss amounts for equity exposures, for which three different methods are used. For EL, the percentages set out in 181

182 formula 13 are applied to equities under the simplified risk weight approach, ranging from 0.8% for positions in non-exchange traded equities in sufficiently diversified portfolios and for positions in exchange traded equities to 2.4% for other equity exposures. These percentages are then multiplied by the exposure value. The financial undertaking need not calculate an expected loss amount for equity exposures that are treated in accordance with an internal models approach. The same method as for exposures to corporates is available for equities under the PD/LGD approach. Also, the same method as for exposures to corporates may be used for the expected loss amounts for the dilution risk of purchased receivables. As already indicated in the explanatory notes to Article 3:19, a financial undertaking must, pursuant to Articles 92(2)(d) and 94(2)(g) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), add up all expected loss amounts and subtract them from the appropriate value adjustments and provisions. A possible shortfall must be deducted from regulatory capital, and an excess may, up to a certain extent, be added to regulatory capital. Article 3:39 The risk weight functions referred to in Section 3.3 use a number of input parameters. Section 3.4 sets out the provisions on determining the input parameters PD, LGD and M. The provisions on determining the input parameter exposure value are set out in Section 3.5. The provisions in that Section relate mainly to a number of conditions which the input parameters must comply with in a number of specific cases. Substantive requirements for rating systems and estimation methods that are the basis for the financial undertaking s own estimates are set out in Section 3.6. Within the risk weight functions, the input parameters PD and LGD are expressed in decimals and the input parameter M in years. This means, for example, that a PD of 1.28% is expressed as and an LGD of 45% as An M of 2 years and 3 months is equal to 2.25 years. The present Regulation does not prescribe the exact number of decimals in which the input parameters must be expressed but financial undertakings are expected, in their interim computations, to round off as little as possible. Article 3:40 According to the definition of default, a financial undertaking will be faced with default if it is deemed unlikely that the obligor will comply in full with its obligations to the financial undertaking, the parent undertaking or any of its subsidiaries. Pursuant to Article 3:40, financial undertakings must assess at least six indicators which could help them determine the possible unlikelihood of compliance. It is, in principle, up to the financial undertaking to develop and apply consistent policies in this respect. Financial undertakings have a certain freedom in deciding on the substance and use of the six indicators. Financial undertakings must devote appropriate attention to the six indicators in order to prevent that default would solely be triggered by the mechanical application of the 90 days overdue criterion. In the opinion of De Nederlandsche Bank, such a purely mechanically-driven definition of default is not appropriate for the mandatory application of proper risk management. The use of a number of specific indicators is addressed below. For government portfolios, a financial undertaking could seek to apply the definition of default as used by eligible rating agencies whilst for bank portfolios it would seem logical to include the implementation of emergency measures by the supervisory authority as a trigger for default. For retail portfolios, it does not seem feasible to regularly monitor the indicators for all borrowers, and some flexibility in applying the indicators in the retail portfolio would 182

183 therefore be desirable. Financial undertakings must apply especially those indicators that are in fact indicators of default. If financial undertakings can demonstrate that the indicators predict defaults poorly (for instance, less than 1% of actual defaults), they may be dispensed with. It is also possible in the retail portfolio only to look at indicators if payment by a borrower is overdue by a specific number of days, for instance 15. Indicator (c) (sale at a material credit-related economic loss) is aimed mainly at preventing that financial undertakings avoid default by selling an exposure at a loss. As a rule of thumb, De Nederlandsche Bank as yet defines material in this context as a 5% loss. A different situation arises when an entire portfolio of loans is sold as there may be reasons underlying the sale other than to avoid recording a default. It is also necessary to ascertain how a credit-related loss can be distinguished from other profits or losses that arise, for example, from a change in interest rates or market conditions. The supervisory authority will, in the first instance, assess the consistency of the policy pursued and the use test for selling loans at an economic loss. However, it is possible that the definition of default differs between portfolios, for example, because different indicators hold sway in different portfolios. Articles 3:41 to 3:46 The probability of default (PD), loss given default (LGD) and maturity (M) are the input parameters required for computing the risk weights for exposures to central governments and central banks, financial undertakings and corporates. Articles 3:41 to 3:43 address the PD for exposures to central governments and central banks, financial undertakings and corporates. Articles 3:44 and 3:45 address the LGD and Article 3:46 sets out provisions on determining M. Article 3:41(2) specifies that the value of the PD for exposures to financial undertakings and corporates cannot be below This minimum does not apply to exposures to central governments and central banks. The PD for obligors where there has been default in accordance with the financial undertaking s definition, is equal to 1. Article 3:42 addresses the determination of the PD for the credit risk of corporate receivables. As stated in the explanatory notes to Article 3:22, there are two methods of determining the PD for corporate receivables. In principle, the risk parameters are set at the individual obligor level (bottom up) in accordance with the requirements set out in Section 3.6 for risk quantification of exposures to corporates. If, however, the bottom up approach proves too burdensome for the financial undertaking because, for example, the pool of purchased receivables has been purchased temporarily in preparation for securitisation and the conditions set out in Article 3:22(2) are met, the financial undertaking may use the top down approach, in which the risk parameters are determined for the pool of purchased receivables as a whole. The application of this top down method does not depend on whether the financial undertaking applies the foundation IRB approach or the advanced IRB approach. However, financial undertakings using the advanced IRB approach must be able to demonstrate that they can decompose the estimated pool EL in a reliable manner into a PD component and a LGD component. Financial undertakings using the foundation IRB approach must use the values listed in Articles 3:42 and 3:44. In that case, the PD of a senior purchased receivable is equal to the EL divided by the LGD value (0.45) referred to in Article 3:44. The PD of a subordinated purchased receivable is equal to the EL because of the fact that, in accordance with the provisions of Article 3:44, the LGD for a subordinated purchased receivable is equal to 1. With respect to the effect of unfunded credit protection (guarantees and credit derivatives) on the PD estimate, a distinction is made in Article 3:43 between financial 183

184 undertakings that apply the foundation IRB approach and financial undertakings that apply the advanced IRB approach. For financial undertakings using the foundation IRB approach, the rules set out in Chapter 4 apply to guarantees and credit derivatives. Financial undertakings that apply the advanced IRB approach have freedom of choice as to how to treat the effect of guarantees or credit derivatives. These financial undertakings may themselves determine, with due regard for the requirements on LGD and subject to the provisions of Section 3.6, whether they wish to express the effect of the guarantee or the credit derivatives in the PD and/or the LGD. However, this is subject to the condition that the final risk weight may not be lower than that of a comparable direct exposure to the guarantor. With respect to the LGD, a distinction has also been made between financial undertakings that apply the foundation IRB approach and financial undertakings that apply the advanced IRB approach. Financial undertakings applying the foundation IRB approach must use the values for LGD as set out in Article 3:44 while financial undertakings applying the advanced IRB approach must prepare their own estimates of LGD in accordance with Article 3:45. In the context of adjusting the risk-weighted exposure amounts for the effect of double default, financial undertakings must, in their application of formula 4a in Annex 3 for the LGD, use the LGD that is associated with either an unhedged facility to the guarantor or the unhedged facility of the obligor. This depends on the structure of the guarantee and the available evidence. If these indicate that, in the case of double default, the amount recovered would depend on the financial condition of the guarantor, the LGD for the guarantor s facility will be used, whereas the LGD for the obligor s facility will be used if the amount recovered would depend on the financial condition of the obligor. Article 3:46 provides that financial undertakings applying the foundation IRB approach and financial undertakings applying the advanced IRB approach use the same methodology for determining the input parameter M. This methodology is based on the cashflow weighted average maturity of the exposure, with a minimum of one year and a maximum of five years. The one-year minimum does not apply to a number of specified exposures, nor does it apply to exposures which are not part of the ongoing financing of the obligor. De Nederlandsche Bank will not prepare a list of the types of eligible exposures. Financial undertakings must demonstrate that the exception is only applied to exposures which are not part of ongoing financing. The minimum M is ten days for exposures arising from repurchase agreements or securities or commodities lending or borrowing transactions subject to a master netting agreement, whilst there is a minimum M of 90 days for purchased corporate receivables. Article 3:46 sets out supplementary provisions on determining M in a number of specific cases. For instance, master netting agreements and pools of purchased receivables must be weighted using the amount of each element of the master netting agreement or the pool of purchased receivables as a weight. If an exposure is hedged in the context of credit risk mitigation, the provisions of Chapter 4 apply to the treatment of maturity mismatches. If a financial undertaking uses the internal model method set out in Section 5.6 to calculate the exposure value, M will not be calculated in accordance with formula 18, but in accordance with formula 18a. This modified formula takes account of the specific aspects of the internal model method for counterparty credit risk. For the purposes of recognising the double default effect, M will be equal to 1 or the effective maturity of the credit protection if that is more than one year. Articles 3:47 and 3:48 184

185 The probability of default (PD) and the loss given default (LGD) are the input parameters required for computing the risk weights for retail exposures. For this class of exposures, there is no distinction between financial undertakings applying the foundation IRB approach and financial undertakings applying the advanced IRB approach. In either case, a financial undertaking must prepare its own estimates for PD and LGD. The difference with exposures to central governments, financial undertakings and corporates is that the rating system for retail exposures may be based on pools of similar exposures, whereas exposures to central governments, financial undertakings and corporates are based on the risk categories of the individual obligor and exposure. This difference is addressed in Section 3.6. The input value of PD cannot be below The PD for obligors where there has been default in accordance with the financial undertaking s definition, is equal to 1. In line with the provisions for the advanced IRB approach, the effect of guarantees and credit derivatives may be recognised in the estimates for the PD or the LGD. The adjusted risk weight for retail exposures cannot, however, be lower than that for a direct exposure to the guarantor. If a financial undertaking wishes to recognise the effect of double default in determining the risk-weighted exposure amounts for retail exposures, the financial undertaking must, in its application of formula 4a in Annex 3 for the LGD, use the LGD that is associated with either an unhedged facility to the guarantor or the unhedged facility of the obligor. As is the case for exposures to corporates, this depends on the structure of the guarantee and the available evidence. Articles 3:49 to 3:52 Three methods are available for computing the risk weights for equity exposures. One of these, the PD/LGD approach, uses PD, LGD and M as input parameters. Articles 3:49 to 3:52 set out specific provisions on determining the PDs and LGDs under the PD/LGD approach. There is a minimum PD ranging from to , depending on the type of equity exposure. As well as the types of exposure listed in the explanatory notes to Article 3:25, a distinction is also made as regards positions in exchange traded equities, where the investment is part of a long-term customer relationship. This aspect is subject to opinion. In the opinion of De Nederlandsche Bank, a customer relationship exists if the financial undertaking has a business relationship with the customer in addition to the equity position held in the customer s undertaking, such as a credit relationship, an investment management or advisory relationship or a collaborative relationship with respect to a product. The assessment as to whether the investment is part of a long-term relationship is made on the basis of return expectations and planned investment horizons. It must be clear that the equities are not held with the intention of realising short-term gains, whilst above-average capital gains are not expected in the long term, either. An investment horizon of five years or more is to be considered. The LGD under this approach is 0.65 for positions in diversified private equity portfolios and 0.9 for all other exposures. M is five years for all exposures. These values also apply to the provider of the hedging instrument. Article 3:53 As is the case with the treatment of the credit risk of purchased receivables, the approach to the dilution risk of purchased receivables is slightly different. The PD and LGD are determined from the EL estimate for the dilution risk. As is the case with the estimates for the credit risk of purchased receivables, this estimate may be at the individual level of the purchased receivable or the aggregated level of the pool. The choice must, of course, be consistent with the choice of determining the EL of the credit risk under Article 3:42. For 185

186 financial undertakings applying the foundation IRB approach, the PD is equal to the estimated EL, and LGD is equal to 1. Financial undertakings applying the advanced IRB approach prepare their own estimates of PD and LGD based on the EL for dilution risk. If, however, a financial undertaking applying the advanced IRB approach cannot decompose the EL in a reliable manner into a PD and an LGD, it may, as a conservative solution, opt to use an LGD of 1 and set the PD equal to the EL in the case of dilution risk. Articles 3:54 to 3:62 The risk weights determined in accordance with the risk weight functions and the input parameters arising from Sections 3.3 and 3.4 must be multiplied by the input parameter exposure value to arrive at risk-weighted exposure amounts. To a significant extent, the provisions of Articles relating to this input parameter are not new, but are existing provisions with the odd minor change. Exceptions are the application of the amended provision in Article 3:57 for exposures from repurchase transactions, securities or commodities lending or borrowing transactions, long settlement transactions and margin lending transactions arising from the changed treatment of counterparty credit risk, and the determination of the conversion factors as referred to in Article 3:58. This Article specifies that financial undertakings applying the advanced IRB approach must use their own estimates of the conversion factors to determine the input parameter exposure value. The input parameter exposure value is based on the gross balance sheet value of the exposure, i.e. prior to the effect of any value adjustments. If an asset is reported at fair value on the balance sheet, the balance sheet value equals the fair value. In this context, value adjustments only consist of pure amortisations, if any, and specific provisions. However, the IRB framework is based on the value-at-risk concept. Within this concept, a link is established between the required level of the risk buffer (i.e. regulatory capital) and the level of risk (a possible decline in the value of the assets). Theoretically, the value-at-risk arising from the IRB computations is the closest approximation to regulatory capital if unexpected losses and the corresponding capital are consistent and both derive from valuation at fair value. Consequently, if in specific instances fair value effects are eliminated from regulatory capital, such elimination may also be taken into account when determining the input parameter exposure value, thereby leaving the valuation principle for the risk buffer and the risk unchanged. Financial undertakings must apply a consistent approach in these matters. For exposures that are purchased at a price different from the amount owed, the difference will be denoted discount if the amount owed is larger than the value recorded on the balance sheet, and premium if the amount owed is smaller than the value recorded on the balance sheet. The balance sheet value also serves as the basis for determining the value of the input parameter exposure value for equity exposures and other non-credit obligation assets. Reference is made to the corresponding provisions of Chapter 4 for exposures included in master netting agreements, exposures under a repurchase agreement, loan amounts and exposures where netting of assets and liabilities is possible. These provisions specify the netting process of the various elements of such exposures. The exposure value for purchased receivables is calculated by taking the outstanding amount and reducing it by the capital requirement for dilution risk. The effect of any credit risk mitigation is to be ignored. Various methods may be used to calculate the exposure value for positions in derivatives. These methods and the conditions for their use are described in Chapter 5. Article 3:58 addresses the determination of conversion factors. These conversion factors are applied to the committed but undrawn portion of a facility and are an estimate of the amount of the undrawn portion that could still be expected to be drawn by the obligor up to a possible default. Along with the drawn portion (determined in accordance with Article 186

187 46), this leads to an estimate of the outstanding amount in the event of default. This is the basis for computing the risk-weighted exposure amounts. Article 3:58(1) prescribes the conversion factors for financial undertakings applying the foundation IRB approach. Article 3:58(2) stipulates that financial undertakings applying the advanced IRB approach must prepare their own estimates of conversion factors. Section 3.6 Sections 3.3 to 3.5 address the various risk weight functions and a number of specific provisions on the required input parameters. Section 3.6 sets out the minimum requirements for the rating systems which a financial undertaking uses to assess the credit risk, to assign obligors and exposures to grades or pools (rating) and to quantify its own estimates of input parameters. The overall principle of the minimum requirements set out in Section 3.6 is that the systems and procedures that banks use to determine their internal ratings and own estimates of the input parameters lead to a meaningful differentiation between various credit risks and a sufficiently accurate and consistent estimate of the level of risk. The systems and procedures must also be in line with the internal use of the estimates. The emphasis of the minimum requirements is on the financial undertaking s ability to recognise, classify and quantify credit risks robustly and accurately. The minimum requirements are by their nature principle based. In other words, they are standards that in many instances allow scope for subjective opinion. This has advantages and disadvantages. A disadvantage is that financial undertakings cannot always fall back on detailed, objective requirements. An advantage is that this principle based approach gives every financial undertaking the scope to develop and use its own rating system in a wellreasoned manner, within applicable standards. It is not desirable to restrict this scope by relying on detailed requirements in all instances where subjective standards are used, as that would hinder banks in their implementation of the IRB approach. Article 3:63 In accordance with the recast Banking Directive, the financial undertaking s rating system must meet certain minimum requirements which are set out in general terms in Article 3:63. These requirements aim to ensure a robust and accurate application of rating systems, allowing a financial undertaking to differentiate and quantify risks in a meaningful way. The rating systems used for the capital requirement must play an essential role in the financial undertaking s operations. The financial undertaking must have processes in place to ensure proper internal control, data collection and documentation on the operation of the rating system. These minimum requirements are set out in detail in the rest of Section 3.6. Article 3:64 The documentation of the rating system is an important factor in ensuring a proper and consistent use of the rating system throughout the financial undertaking. Documentation is also important for the internal and external testing of the rating system, inter alia by the supervisory authority. Areas to be tested are, for instance, model development and validation. Article 3:64 sets out the minimum requirements for documentation. Documentation of a more generally descriptive nature is meant here, in contrast to the provisions on documentation referred to in Subsections 3.6.2, and The documentation must include the definitions of default and loss, the underpinning of the rating criteria and the underpinning and validation of the statistical models and the organisational embedding of the rating system. An explicit requirement is that the existence of vendor models constitutes no reason for a financial undertaking to have less documentation 187

188 on the rating system. The financial undertaking has primary responsibility for meeting all the minimum requirements, including where vendor models are concerned. It is important that financial undertakings demonstrate, partly through their internal documentation, that certainly where vendor models are concerned, they understand the model s operation. No requirements are imposed on the form of the rating documentation, but the documentation must show that all the requirements set out in this Regulation are met and that the IRB approach is applied properly and consistently. An easy to use system is, therefore, important for orderly documentation and access to this information. Article 3:65 A financial undertaking s rating system will in all probability consist of several relatively independent elements, all focusing on a different part of its credit portfolio. A financial undertaking will, for example, have one rating method for its loans and advances to large enterprises, another one for the middle segment and yet another for lending to small businesses. Different rating methods can also be used for different geographical areas: these may be completely different methods for the same market segment or the same methods but with specific geographical factors. Financial undertakings must assign each obligor or transaction that is or will be included in a portfolio treated under the IRB approach to a single specific rating system. In other words: a financial undertaking must record in advance which rating system is to be used in which segment of the portfolio. It is important that both the fit between rating system and market segment as well as the individual allocations are tested regularly. Article 3:66 Input parameters can be estimated in two manners. Firstly, there is the indirect manner, where obligors are first assigned to grades with a relatively similar degree of risk on the basis of their risk characteristics. The second step is to estimate the corresponding values of the input parameters for those grades. An alternative method is the direct classification into grades based on an estimate of the input parameter. This is mainly used for estimating LGDs and conversion factors, but direct estimates may also be used in systems to estimate PDs, although the empirical validation of such direct PD estimates can be problematic. Articles 3:67 and 3:68 Articles 3:67 and 3:68 set out the minimum requirements for the structure of the rating system. Article 3:67 addresses the structure of the rating system for exposures to central governments and central banks, financial undertakings and corporates. Article 3:68 addresses the structure of the rating system for retail exposures. A distinction is made between obligor risk characteristics and transaction risk characteristics for exposures to central governments and central banks, financial undertakings and corporates. Own estimates of PDs for exposures to central governments and central banks, financial undertakings and corporates only include obligor risk characteristics. Financial undertakings applying the advanced IRB approach have a supplementary rating scale for transactions which exclusively reflect transaction risk characteristics and from which own estimates of LGDs and conversion factors are made. The rating system for retail exposures is based on pools of exposures which, on the basis of their loss characteristics, may be regarded as homogeneous. The definition of default for these exposures may be used at the individual exposure level. This means that if, for instance, an obligor is in default on a revolving exposure, the obligor need not also be in default on a possible mortgage exposure. However, the fact that the obligor is in default on one type of exposure has information value for the probability of default on other exposures. 188

189 An internal ratings-based system must be able to differentiate between risks. The structure of the rating system must therefore be chosen in such a way that a sufficient degree of diversification is obtained across the various grades or pools. If, however, obligors or exposures are concentrated in a few grades of the rating system, this must be underpinned empirically. Articles 3:69 and 3:70 Articles 3:69 and 3:70 address the general requirements for the rating criteria and the use of models for classifying obligors or exposures. A thorough description of the rating criteria is needed to ensure that obligors posing similar risks are assigned to the same rating grades or pools. The description of the rating criteria must also be sufficiently detailed to allow third parties to reproduce and check the rating assignment for accuracy. The overrides process must also be well documented and the rating must be in line with internal procedures and incorporate all relevant and available information. In the absence of information, financial undertakings must make conservative estimates. The rating must be up to date and have a predictive nature; after all, the rating system focuses on managing credit risks that may arise under unknown future circumstances. Therefore, a rating system that only works retrospectively, using only weighted average values of PD and LGD from the dataset, would not be adequate. A link must be made between past experience and future expectations. A rating system that is based primarily on an external rating, without the financial undertaking having added supplementary information, is not adequate, either. After all, because of its credit relationship with the obligor, a financial undertaking should be able to gather more and better information on the obligor s risk characteristics than the party issuing the external ratings. There are a number of specific requirements for the use of statistical models to assign obligors or exposures to rating grades or pools which focus on ensuring the suitability of the model, both objectively and specifically for the obligors and exposures it is used for. Attention should thereby be given to the model s predictive power, the reliability and representative value of the underlying data and the creation of a regular validation and improvement cycle. It is not permitted to use a statistical model for classifying obligors or exposures without supplementary manual plausibility checks on the output. Articles 3:71 and 3:72 Articles 3:71 and 3:72 address supplementary requirements for rating criteria, firstly for central governments and central banks, financial undertakings and corporates and subsequently for individuals and small or medium-sized entities. As regards central governments and central banks, financial undertakings and corporates, financial undertakings must assign each individual legal counterparty to which they have an exposure to a given rating grade. If different legal counterparties are part of a larger group, the financial undertaking must take this into account in its rating assignment process. The effect on the individual ratings depends on the relationship between these counterparties. Circumstances are conceivable where a default by one party has consequences for the rating of another party. For example, if two counterparties are jointly and severally liable for a loan, both parties are in default if the obligations are not met. If a group as a whole has been assigned a single rating, the whole group is in default if one member of that group does not meet its obligations. If the different members of the group are assessed separately and there is a payment problem, only the counterparty concerned and not the whole group will be in default. If a counterparty is a member of a group where the other members have no legal 189

190 obligation to step in financially, circumstances will determine whether, in the event of default by the counterparty, the other members will also be in default. This depends on the intragroup relationships. If other members of the group are connected with the counterparty in default to the extent that it is unlikely that they can meet their obligations, the connected party should also be in default. Financial undertakings must therefore identify the mutual dependencies between the various elements of a group of counterparties. Furthermore, an obligor can have only one PD, which must be used by all units of the financial undertaking. Thus, an obligor with international operations may be present in various local rating systems, but all rating assignments must result in similar PDs. To this end, financial undertakings may work with a master scale which links together all the different parts of the rating system. The only exceptions to this rule are the effect of transfer risk, the effect of guarantees or impediments to the exchange of data arising from other legislation such as consumer protection or bank secrecy laws. Financial undertakings applying the advanced IRB approach must also assign each exposure to a facilities grade. As regards retail exposures, each individual exposure must be assigned to a pool. In the retail portfolio, a financial undertaking may decide that only the facility, and not the counterparty, is in default if different facility-dependent ratings are used for each counterparty. It is conceivable that a counterparty, while meeting its mortgage obligations, defaults only on its credit card payments (and not on other loans). It would, however, be more risk sensitive if the financial undertaking takes account of cross defaults and uses all available information for each rating. For example, a default on a mortgage would likely lead to a default on all retail products of that counterparty. Although preferring such a risk sensitive approach, De Nederlandsche Bank is not prescribing it as such an approach is not always in line with the manner in which financial undertakings manage their retail risks. Furthermore, not all banks have set up their records in such a manner that all retail products are recorded centrally by counterparty. Notwithstanding the fact that, under Article 3:69(5), a rating must include all available current information, the financial undertaking must update the ratings of obligors and exposures at least once a year. Non-performing obligors and problem exposures are assessed more frequently. This applies to exposures to central governments and central banks, financial undertakings and corporates as well as to retail exposures. As regards the latter exposures, sample testing may be used to review rating assignments. Articles 3:73 to 3:75 Articles 3:73 to 3:75 set out which detailed information a financial undertaking must at least maintain if it applies the IRB approach. Firstly, this is the data required to meet the disclosure requirements under pillar 3. Furthermore, different types of production data are required such as the ratings history, the principal basic data underlying the ratings, and detailed data on defaults and losses. As regards the data to be kept, a distinction is made between the various classes and between financial undertakings applying the foundation IRB approach and those applying the advanced IRB approach. Articles 3:76 to 3:78 Articles 3:76 to 3:78 address the general requirements for quantifying own estimates of PD, LGD and conversion factors. These estimates must be based on empirical evidence and material determinants of the input parameters. The financial undertaking must also take account of possible changes in circumstances in the area of lending practices, the financial undertaking s market segment and the quantification of credit risks. The estimates are revised at least once a year. It is important that the financial undertaking builds in a margin of conservatism proportionate to the expected range of estimation errors. In cases where the 190

191 methods and data are less satisfactory and the expected margin for error is greater, the margin of conservatism will also be greater. Article 3:76(6) does not rule out the use of other estimates for internal purposes, but this needs to be well documented and its reasonableness must be demonstrated. Examples of possible differences are divergences between the PDs for pricing (looking at the full maturity) and for credit risk management (looking at the coming year and expected to be in line with the IRB parameters). Financial undertakings may use data which in itself does not meet requirements, for example, those on the definition of default. This may also apply to the use of data sets based on external ratings. Under Article 3:77, this data may be used, but the financial undertaking must adjust the data to bring it into line with the requirements. For example, a definition of default based merely on the event of bankruptcy underestimates the actual probability of default. Financial undertakings must adjust for this. If pooled data sets are used, it is important that the co-operating financial undertakings use similar rating systems and criteria and that the data set is representative of the financial undertaking s population. The use of pooled data does not relieve the financial undertaking of its obligation to meet the other requirements. Article 3:78 provides that an obligor or exposure may be upgraded to a better rating from a position of default. Financial undertakings must develop specific procedures to ensure that such upgrades are carried out consistently and accurately. The question as to whether a consistent policy has been pursued and the use test for these procedures will play an important role in the supervisory authority s assessment. If, in due course, the obligor is again in a situation of default, a new default will be recorded. Article 3:79 Article 3:79 addresses the minimum requirements for preparing own estimates of PDs for central governments and central banks, financial undertakings and corporates. The estimates of PDs must be derived from the average annual default percentages over a period of at least five years. If a longer observation period is available in which relevant data has been collected, that longer period must be used. A more flexible requirement on the PD data period applies to financial undertakings applying the foundation IRB approach. Upon implementing the IRB approach, financial undertakings must have relevant PD data at their disposal that cover a period of at least two years. The period to be covered increases by one year each year until the relevant PD data cover a period of at least five years. The fact that average annual actual figures must be used, does not, however, mean that it is sufficient to calculate the averages of annual default percentages in the observed period. The estimates must have predictive value, thus establishing a relationship between the average annual default percentages observed and their determinants. This applies accordingly to estimates of PDs for retail exposures and estimates of LGDs and conversion factors. A financial undertaking may, in general, use three different techniques for the estimates: estimates using internal data, estimates based on mapping to external data and estimates using a specific PD estimation model. Article 3:79 sets out specific requirements for each situation. In many cases, a combination of methods will be used. In all cases, financial undertakings must pay attention to the significance of human judgment and the effects of combining methods and, in particular, recognise the limitations of the techniques used. Paragraph 4 stipulates that if a financial undertaking uses default data from an external credit assessment institution, it must compare its internal ratings criteria and the criteria used by the external organisation. The external organisation s criteria may relate to default risk only and may not reflect transaction characteristics. The definition of default must also be 191

192 compared with the provisions of Article 1 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) and the provisions of Articles 3:1, 3:45 and 3:82 of this Regulation. If the external data does not in itself meet the said provisions, under Article 3:77 the financial undertaking must make appropriate adjustments to the external data to adjust for the differences. Distortions or inconsistencies in mapping or in the underlying data must be avoided. Article 3:80 The estimate for retail exposures may be based directly on the average default percentages observed or derived from the observed losses and an estimate of LGD. The observation period must be at least five years. Here, too, if a longer observation period is available in which relevant data has been collected, that longer period must be used. A more flexible requirement on the data period also applies to PD data for retail exposures. Upon implementing the IRB approach, financial undertakings must have relevant PD data for retail exposures at their disposal that cover a period of at least two years. The period to be covered increases by one year each year until the relevant PD data cover a period of at least five years. In view of the institution-specific nature of the classification of exposures into homogeneous groups, internal data must be the principal source of the estimates. Other sources may serve as reference material. Only under strict conditions may financial undertakings use external or pooled data for these exposures. According to paragraph 6, a financial undertaking need not give equal importance to historical data, if it can demonstrate that more recent data is a better predictor of future loss rates. This is expected to occur only in exceptional cases, however. The financial undertaking must demonstrate the relevance and significance of its departure from the rule. Article 3:81 Financial undertakings must prepare their own estimates of LGD for exposures treated under the advanced IRB approach. These estimates are based on an observation period of at least seven years for exposures to central governments and central banks, financial undertakings and corporates and on a period of at least five years for retail exposures. Here, too, a longer observation period must be used if and when relevant whilst, for retail exposures, it is not necessary to apply the same weight to all historical data. More flexible requirements on the observation period also apply to the LGD. For retail exposures, financial undertakings may start out with two years of relevant LGD data. The period to be covered increases by one year each year until the relevant LGD data cover a period of five years. For exposures to corporates, financial undertakings and governments, financial undertakings may start out with five years of relevant LGD data. This will increase every year until there is an observation period of at least seven years. LGD estimates are based on the default weighted average losses observed for each facility grade. This means that financial undertakings must weight in accordance with the total default amount and not the number of defaults in a given year. Consequently, all defaults in the observation period have an equal weight in determining the LGD. This may be illustrated as follows: suppose that the following defaults have been observed for a facility in the dataset in a given year: 85 defaults of size 20 with 10% loss 250 defaults of size 95 with 85% loss 25 defaults of size 15 with 100% loss 192

193 The realised LGD for that year in the dataset is obtained by dividing the sum of the losses by the total outstanding exposures in default in the dataset in that year, and not by dividing the weighted sum of the loss percentages by the number of defaults. Thus, the realised LGD for this facility (grade) in the dataset in that year is 80%. ((85*20*10%+250*95*85%+25*15*100%)/(85*20+250*95+25*15) instead of 68% ((85*10%+250*85%+25*100%)/( ). The possible effects of an economic downturn on the LGD (the downturn LGD) must also be taken into account. The assumption is thereby made that LGDs could turn out higher in difficult economic times than the observed averages. Examples of sectors where downturn effects could affect LGDs are marine, aircraft and residential financing As a mirror image for determining PDs, the LGD for retail exposures may also be calculated from an estimate of the expected loss and an estimate of PD. In this case, too, however, downturn conditions must be recognised. If the financial undertaking takes account of collateral obtained in its estimate of LGDs, it has a certain degree of freedom in recognising the effects of such collateral on the LGD. However, the financial undertaking must take account of correlations between the collateral obtained and the obligor, any currency mismatches and possible problems in recovering the collateral. No restrictions are imposed on the type of collateral, but the financial undertaking must draw up internal policies that are generally consistent with the minimum requirements for credit risk mitigation as included in a number of specific Articles in Chapter 4. These Articles correspond with the relevant provisions of Annex VIII, Part 2 of the recast Banking Directive. Depending on the specific economic situation and, for instance, on the state of the execution process, the estimate of LGD for exposures in default will probably not be equal to the LGD that was assigned to the exposure before it went into default. This adjusted estimate is termed best estimate of LGD (ELBE). The financial undertaking increases this estimate by any additional unexpected losses that may be incurred during the execution period. The purpose hereof is to take account in regulatory capital of any additional unexpected losses on top of the best estimate of LGD. After all, the capital requirement is the maximum of 0 and 12.5*(LGD-ELBE). The obligation to prepare a best estimate of LGD including additional unexpected losses does not mean that this must always be done at the individual level based on an additional estimate on top of the pre-default LGD. Financial undertakings may also prepare direct estimates of the post-default LGD for different facilities. Article 3:82 The estimate of the conversion factor is based on the observed, default weighted average conversion factors for each facility grade, allowing for a possible downturn effect. The minimum observation period is seven years and the same provisions for longer or shorter periods apply as to LGD and PD. As regards more flexible requirements on the data observation period, the same applies to conversion factors as to the LGD above. For retail exposures, financial undertakings may start out with two years of relevant data. The period to be covered increases by one year each year until the relevant data cover a period of five years. For exposures to corporates, financial undertakings and governments, financial undertakings may start out with five years of relevant data. This will increase every year until there is an observation period of at least seven years. The estimates of conversion factors focus on estimating the additional amount that will be drawn up to the time of expected default. Consequently, financial undertakings also must take into account their specific policies and strategies for account management and payment processing, and their ability to prevent actual additional drawings ahead of default. To this 193

194 end, financial undertakings must also have procedures in place allowing them to monitor changes in outstanding amounts for each obligor and rating grade on a daily basis. Article 3:83 Financial undertakings applying the advanced IRB approach may incorporate the effect of guarantees or purchased credit derivatives by adapting the PD and/or the LGD. To this end, a number of preconditions have been set out in Articles 3:69, 3:71 and 3:72. Financial undertakings must have clearly specified criteria which determine the types of guarantors they recognise and the effect of the guarantees on the PD and/or LGD. The same requirements for assigning ratings apply to these guarantors as to normal obligors. Article 3:83 also lists a number of specific criteria to be applied when assigning revised ratings. These criteria stipulate, among other things, that the guarantee must be evidenced in writing and must be legally enforceable against the guarantor in a jurisdiction where the guarantor has assets. Also, claims for payments under the guarantee must remain valid while there are still exposures to the guarantor under the guarantee received, even if the maturity of the original exposure or the original guarantee has expired. For conditional guarantees, the financial undertaking must demonstrate that it has recognised every potential reduction in the risk mitigation effect. The provisions apply accordingly to single-name credit derivatives. Articles 3:84 and 3:85 Articles 3:84 and 3:85 address the specific requirements for assigning ratings and quantifying risks of purchased receivables. As noted earlier, the treatment of purchased receivables differs in part from that of other exposures. This is because, in the case of purchased receivables, there is an indirect relationship between the financial undertaking and the ultimate obligor, where the credit relationship is not in fact entered into directly by the financial undertaking itself, but by the seller of the receivables. The financial undertaking is, as it were, one stage removed. The credit risk is, however, determined by the underlying obligor. Article 3:84 includes a series of conditions that the pool of purchased receivables, or the financial undertaking itself, must meet to allow proper treatment of the purchased receivables. These conditions relate to the contractually agreed terms between the financial undertaking and the seller, to monitoring the financial condition of both the receivables pool and the seller, and to the policies which financial undertakings must pursue when entering into such exposures. Article 3:89 contains all specific provisions which apply in addition to those set out in Articles 3:76 to 3:82 for quantifying the input parameters for purchased receivables. Article 3:86 In accordance with Article 3:28, financial undertakings may use an internally developed model to calculate the capital requirements for equity exposures. This model must meet a number of preconditions as set out in Article 3:86. The model must be based on the value-at-risk method and be appropriate for the complexity of the equity portfolio it is used for. The model should take account of both the general risks in the equity market and the specific risks of the individual equities in the portfolio. The models must lead to results that are in line with the risks arising from adverse market developments and allow for the long-term horizon that is appropriate for equity exposures. For the development of VaR models for equities for which there are no frequent market prices, financial undertakings themselves must ensure adequate quarterly valuations of such exposures. 194

195 Article 3:87 A minimum requirement for applying the IRB approach is that financial undertakings regularly perform a stress test and assess its impact on the internal ratings and the capital requirements for credit risk (including equity exposures). The aim of the stress tests under pillar 1 is to identify possible events or future changes in economic conditions that could adversely affect the financial undertaking s credit risk exposures and to assess the financial undertaking s ability to withstand such changes. Financial undertakings are free to choose the type of stress test they wish to apply. Financial undertakings must themselves determine meaningful and reasonably conservative scenarios for the credit risk stress tests. The stress tests must be applied to a significant proportion of the portfolio. This Article does not require that credit risk stress tests assume extreme worst-case scenarios; the scenarios must be based on harsh but credible conditions. The stress tests must provide insight into the effects of possible adverse economic developments. Possible scenarios are contractions in the economy as a whole or in a specific sector, or specific adverse events on the financial markets, such as a specific market risk event or liquidity crisis. At least two consecutive quarters of no growth must be assumed. Financial undertakings must determine meaningful and reasonably conservative scenarios for stress testing the risk in their equity portfolios. With respect to exposures that are treated in accordance with the internal model method, stress tests are particularly meaningful if they provide insight into the impact in the tail of the distribution (beyond the confidence interval used in the modelling process) and if financial undertakings use hypothetical or historical worst-case scenarios in their models, including volatility analyses. Such insight is also meaningful for stress testing the exposures that are treated in accordance with the PD/LGD approach as referred to in Article 3:29. Article 3:88 Article 3:88 sets out minimum provisions on validating the IRB systems and internal models for equity exposures and the associated internal estimates. Such validation is an important but difficult task. The supervisory regulation is principle based in this specific area, since the rating systems for credit risk in particular are not validated against hard knock-out criteria, as is the case with internal models for market risk, for example. Validation will be much more of a process in which the financial undertaking assures itself of the robustness, reliability and accuracy of the rating systems and modelling techniques it uses. The comparisons of results against expectations as referred to in the Article are only a small part of the activities that financial undertakings must undertake to validate their models internally. 1. The validation process must focus on establishing the predictive power of the IRB system. The rating system must be based on empirical evidence and the results must have predictive value. Rating systems must be able to differentiate risks effectively and be sufficiently accurate in estimating the value of the risks. To be able to assess the predictive and discriminating power, financial undertakings must also look to the general applicability of the method chosen for the specific portfolio and the degree of objectivity and conservatism used in the rating systems. Also, the specific ratings philosophy (ranging from pure Through-the- Cycle to pure Point-in-Time and everything in between) must be incorporated into the design and operation of the validation process. Within a financial undertaking, this rating philosophy may change from model to model, requiring extra attention in the validation process. Where there is no historical data for a proper statistical validation, it is important to look to the development process and the chosen methods underlying the rating system. 195

196 2. Financial undertakings must draw up their own acceptable standards for the confidence and significance intervals to be used for deviations. The regulations do not prescribe these standards. Financial undertakings must have sound arguments to support their choices. Articles 3:89 and 3:90 Articles 3:89 and 3:90 list minimum requirements for internal controls on the application of the IRB approach. Article 3:89 states that financial undertakings must draw up policies, procedures and controls to ensure the integrity of the rating system and modelling process. It also sets out the minimum requirements that these policies must meet, such as the integration of the systems in the financial undertaking s day-to-day process and adequate embedding of the controls with respect to systems operation. The more general aspects of internal control listed in this Article supplement the specific provisions on procedures or controls to be set up, such as those on assigning individual ratings. The conditions set out in Article 3:89 only apply to internal models for equity exposures in the recast Banking Directive. They are, however, also appropriate for ensuring that rating systems for credit risk are used accurately and consistently and will, therefore, apply accordingly to such rating systems. These conditions arise from the provisions of Article 84(2)(b), (c) and (e) of the recast Banking Directive, and do not in fact constitute a tightening but a detailing of requirements for financial undertakings, aimed at creating robust systems that are applied accurately. Article 3:90 addresses the division of tasks between the financial undertaking s different organisational units that play an important role in the internal control of the IRB system. These are the board of directors, the level of management immediately below it (the management), the supervisory board, the credit risk control unit and the internal audit unit. Given the responsibilities of the board of directors, it is important that this body or at least a designated committee thereof, in addition to senior management, have a good general understanding of the rating system used by the financial undertaking and a profound knowledge of the respective management reports. These management reports provide internal ratings-based analyses of the financial undertaking s risk profile. The knowledge and involvement of the management goes further than that of the board. The management must not only be aware of the design and operation of the rating system, but is also directly responsible for its proper functioning in the financial undertaking s day-to-day operations. The inherent supervisory role of the supervisory board means that it assesses in outline the organisational structure and control mechanism and is notified of material changes in or exceptions from established policies that will materially impact the operation of the financial undertaking s rating systems. The credit risk control unit plays a particularly significant role in monitoring a consistent, adequate and accurate application of the IRB approach throughout the financial undertaking and reports to higher levels of management. The credit risk control unit is also actively involved in the design, implementation and validation of the models and rating systems used. This task represents an inherent conflict of interests, which financial undertakings must manage by means of a proper segregation of duties. The internal audit unit also has a significant role. It must assess, at least once a year, the rating systems used by the financial undertaking and the activities performed in this context, including the activities of the credit risk control unit, and the estimates of PDs, LGDs, ELs and conversion factors. This is not necessarily a direct task of the internal audit unit: a similar independent specialist unit can also perform that task, that is, apart from the credit risk control unit. After all, an independent opinion on the rating system is to be given, for which the credit risk control unit is not suited because of its monitoring role. 196

197 This Article does not, however, require that the internal audit unit itself validates the estimates of PDs, LGDs and conversion factors. Its task is especially to test them against the minimum requirements and the operation of the credit risk control unit, addressing questions such as: how is the IT environment, what is the data quality, how does the credit risk control unit operate, how is accurate and consistent application ensured, has adequate validation taken place, is there a process of periodic re-validation and what has been done with the results thereof. This requires an understanding of the statistical methods and systems used. The internal audit unit must be able to assess the implications of the choices and assumptions that have been made in the development and validation process, since it must be in a position to assess whether the conclusions made by the credit risk control unit are well founded. The internal audit unit may not have a role in the validation process itself. If the financial undertaking does not have a structural segregation of duties between model development and model validation up to the highest level in the organisation, it may be required to have at least one of its Basel II models (or model change) validated externally each year as an additional compensating measure. Although not explicitly required by this Regulation, for completeness sake it is noted that the external auditor will probably have to perform his own assessment of the reliability of Basel II systems. In view of the materiality of these systems for the BIS ratio and their significance for the continuity of the financial undertaking, the external auditor will have to form an opinion on the design, existence and operation of the financial undertaking s Basel II systems. This means that the external auditor will also be expected to perform his own audit of the model cycle. The choice and depth of the audit operations will follow from a risk analysis and will depend in part on the segregation of duties that the bank applies to the model cycle and on the robustness of the internal audit unit s assessment in this area. 197

198 Annex to the Explanatory Notes to the Supervisory Regulation on Solvency Requirements for Credit Risk Chapter 3, IRB Detailed Overview of the supervisory slotting criteria referred to in Article 3:21(3) for the assignment of risk weights for specialised lending Table 1 Supervisory Rating Grades for Project Finance Exposures Strong Good Satisfactory Weak Financial strength Market conditions Few competing suppliers or substantial and durable advantage in location, cost, or technology. Demand is Financial ratios (e.g. debt service coverage ratio (DSCR., loan life coverage ratio (LLCR., project life coverage ratio (PLCR., and debt-to-equity ratio. strong and growing Strong financial ratios considering the level of project risk; very robust economic assumptions Stress analysis The project can meet its financial obligations under sustained, severely stressed economic or sectoral conditions Financial structure Duration of the credit compared to the duration of the project Useful life of the project significantly exceeds tenor of the loan Few competing suppliers or better than average location, cost, or technology but this situation may not last. Demand is strong and stable Strong to acceptable financial ratios considering the level of project risk; robust project economic assumptions The project can meet its financial obligations under normal stressed economic or sectoral conditions. The project is only likely to default under severe economic conditions Useful life of the project exceeds tenor of the loan Project has no advantage in location, cost, or technology. Demand is adequate and stable Standard financial ratios considering the level of project risk The project is vulnerable to stresses that are not uncommon through an economic cycle, and may default in a normal downturn Useful life of the project exceeds tenor of the loan Amortisation schedule Amortising debt Amortising debt Amortising debt repayments with limited bullet payment Political and legal environment Political risk, including transfer risk, considering project type and Very low exposure; strong mitigation instruments, if needed Low exposure; satisfactory mitigation instruments, if needed Moderate exposure; fair mitigation instruments Project has worse than average location, cost, or technology. Demand is weak and declining Aggressive financial ratios considering the level of project risk The project is likely to default unless conditions improve soon Useful life of the project may not exceed tenor of the loan Bullet repayment or amortising debt repayments with high bullet repayment High exposure; no or weak mitigation instruments mitigants Force majeure risk (war, civil unrest, Low exposure Acceptable exposure Standard protection Significant risks, not fully

199 etc. Mitigated Government support and project s importance for the country over the long term Stability of legal and regulatory environment (risk of change in law. Acquisition of all necessary supports and approvals for such relief from local content laws Project of strategic importance for the country (preferably export-oriented.. Strong support from Government Project considered important for the country. Good level of support from Government Project may not be strategic but brings unquestionable benefits for the country. Support from Government may not be explicit Favourable and stable Favourable and stable Regulatory changes can regulatory environment regulatory environment be predicted with a fair over the long term over the medium term level of certainty Strong Satisfactory Fair Weak Project not key to the country. No or weak support from Government Current or future regulatory issues may affect the project Enforceability of contracts, collateral and security Contracts, collateral and security are enforceable Transaction characteristics Design and technology risk Fully proven technology and design Construction risk Permitting and siting All permits have been Obtained Type of construction contract Fixed-price date-certain turnkey construction EPC (engineering and procurement contract. Completion guarantees Substantial liquidated damages supported by financial substance Contracts, collateral and security are enforceable Fully proven technology and design Some permits are still outstanding but their receipt is considered very likely Fixed-price date-certain turnkey construction EPC Significant liquidated damages supported by financial substance and/or Contracts, collateral and security are considered enforceable even if certain non-key issues may exist Proven technology and design - start-up issues are mitigated by a strong completion package Some permits are still outstanding but the permitting process is well defined and they are considered routine Fixed-price date-certain turnkey construction contract with one or several contractors Adequate liquidated damages supported by financial substance and/or There are unresolved key issues in respect if actual enforcement of contracts, collateral and security Unproven technology and design; technology issues exist and/or complex design Key permits still need to be obtained and are not considered routine. Significant conditions may be attached No or partial fixed-price turnkey contract and/or interfacing issues with multiple contractors Inadequate liquidated damages or not supported by financial substance or weak 199

200 Track record and financial strength of contractor in constructing similar projects. Operating risk Scope and nature of operations and maintenance (O & M. contracts Operator's expertise, track record, and financial strength Off-take risk (a. If there is a take-or-pay or fixed-price off-take contract: (b. If there is no take-or-pay or fixed-price off-take contract: Supply risk Price, volume and transportation risk of feed-stocks; supplier's track record and financial strength Reserve risks (e.g. natural resource development. and/or strong completion guarantee from sponsors with excellent financial standing completion guarantee from sponsors with good financial standing completion guarantee from sponsors with good financial standing Strong Good Satisfactory Weak completion guarantees Strong long-tem O&M contract, preferably with contractual performance incentives, and/or O&M reserve accounts Very strong, or committed technical assistance of the Sponsors Long-term O&M contract, and/or O&M reserve accounts Limited O&M contract or O&M reserve account No O&M contract: risk of high operational cost overruns beyond mitigants Strong Acceptable Limited/weak, or local operator dependent on local authorities Excellent creditworthiness of off-taker; strong termination clauses; tenor of contract comfortably exceeds the maturity of the debt Project produces essential services or a commodity sold widely on a world market; output can readily be absorbed at projected prices even at lower than historic market growth rates Good creditworthiness of off-taker; strong termination clauses; tenor of contract exceeds the maturity of the debt Project produces essential services or a commodity sold widely on a regional market that will absorb it at projected prices at historical growth rates Acceptable financial standing of off-taker; normal termination clauses; tenor of contract generally matches the maturity of the debt Commodity is sold on a limited market that may absorb it only at lower than projected prices Weak off-taker; weak termination clauses; tenor of contract does not exceed the maturity of the debt Project output is demanded by only one or a few buyers or is not generally sold on an organised market Long-term supply contract with supplier of excellent financial standing Long-term supply contract with supplier of good financial standing Long-term supply contract with supplier of good Financial standing - a degree of price risk may remain Short-term supply contract or long-term supply contract with financially weak supplier a degree of price risk 200

201 Reserve risks (e.g. natural resource development. Strength of Sponsor Sponsor's track record, financial strength, and country/sector experience Sponsor support, as evidenced by equity, ownership clause and incentive to inject additional cash if necessary Security Package Assignment of contracts and Accounts Pledge of assets, taking into account quality, value and liquidity of assets Lender's control over cash flow (e.g. cash sweeps, independent escrow accounts. Strength of the covenant package (mandatory prepayments, payment deferrals, payment cascade, dividend restrictions.... Reserve funds (debt service, O&M, renewal and replacement, unforeseen events, etc. Independently audited, proven and developed reserves well in excess of requirements over lifetime of the project Independently audited, proven and developed reserves in excess of requirements over lifetime of the project Proven reserves can supply the project adequately through the maturity of the debt definitely remains Project relies to some extent on potential and undeveloped reserves Strong sponsor with excellent track record and high financial standing Strong. Project is highly strategic for the sponsor (core business - longterm strategy. Good sponsor with satisfactory track record and good financial standing Good. Project is strategic for the sponsor (core business - longterm strategy. Adequate sponsor with adequate track record and good financial standing Acceptable. Project is considered important for the sponsor (core business. Weak sponsor with no or questionable track record and/or financial weaknesses Limited. Project is not key to sponsor's longterm strategy or core business Fully comprehensive Comprehensive Acceptable Weak First perfected security interest in all project assets, contracts, permits and accounts necessary to run the Perfected security interest in all project assets, contracts, permits and accounts necessary to run the project Acceptable security interest in all project assets, contracts, permits and accounts necessary to run the project project Strong Satisfactory Fair Weak Little security or collateral for lenders; weak negative pledge clause Covenant package is strong for this type of project Covenant package is satisfactory for this type of project Covenant package is fair for this type of project Covenant package is Insufficient for this type of project Project may issue no additional debt Longer than average coverage period, all reserve funds fully Project may issue extremely limited additional debt Average coverage Average coverage period, period, all reserve funds all Project may issue limited additional debt Average coverage Average coverage period, period, all reserve funds all Project may issue unlimited additional debt Shorter than average coverage period, reserve funds funded 201

202 funded in cash or letters of credit from highly rated bank reserve funds fully fully funded reserve funds fully fully funded from operating cash flows Table 2 Supervisory Rating Grades for Object Finance Exposures Strong Good Satisfactory Weak Financial strength Market conditions Demand is strong and growing, strong entry barriers, low sensitivity to changes in technology and economic outlook Financial ratios (debt service Strong financial ratios coverage ratio and loan-to-value considering the type of asset. ratio) Very robust economic assumptions Stress analysis Stable long-term revenues, capable of withstanding severely stressed conditions through an economic cycle Market liquidity Market is structured on a worldwide basis; assets are highly liquid Political and legal environment Political risk, including transfer risk Very low; strong mitigation instruments, if needed Legal and regulatory risks Jurisdiction is favourable to repossession and enforcement of contracts Demand is strong and stable. Some entry barriers, some sensitivity to changes in technology and economic outlook Strong/acceptable financial ratios considering the type of asset. Robust project economic assumptions Satisfactory short-tem revenues. Loan can withstand some financial adversity. Default is only likely under severe economic conditions Market is worldwide or regional; assets are relatively liquid Low; satisfactory mitigation instruments, if needed Jurisdiction is favourable to repossession and enforcement of contracts Demand is adequate and stable, limited entry barriers, significant sensitivity to changes in technology and economic outlook Standard financial ratios for the asset type Uncertain short-term revenues. Cash flows are vulnerable to stresses that are not uncommon through an economic cycle. The loan may default in a normal downturn Market is regional with limited prospects in the short term, implying lower liquidity Moderate; fair mitigation instruments Jurisdiction is generally favourable to repossession and enforcement of contracts, even if repossession might be long and/or difficult Demand is weak and declining, vulnerable to changes in technology and economic outlook, highly uncertain environment Aggressive financial ratios considering the type of asset Revenues subject to strong uncertainties; even in normal economic conditions the asset may default, unless conditions improve Local market and/or poor visibility. Low or no liquidity, particularly on niche markets High; no or weak mitigation instruments Poor or unstable legal and regulatory environment. Jurisdiction may make repossession and enforcement of contracts lengthy or impossible 202

203 Transaction characteristics Financing term compared to the economic life of the asset Full pay-out profile/minimum balloon. No grace period Operating risk Permits/licensing All permits have been obtained; asset meets current and foreseeable safety regulations Scope and nature of O&M contracts Strong long-term O&M contract, preferably with contractual performance incentives, and/or O&M Operator s financial strength, track record in managing the asset type and capability to re-market asset when it comes off-lease Asset characteristics Configuration, site, design and maintenance (e.g. age, size for a plane) compared to other assets on the same market reserve accounts (if needed) Excellent track record and strong re-marketing capability Strong advantage in design and maintenance. Configuration is standard such that the object meets a liquid market Resale value Current resale value is well above debt value Sensitivity of asset value and Asset value and liquidity are liquidity to economic cycles relatively insensitive to economic cycles Strength of sponsor Operator s financial strength, track record in managing the asset type and capability to re-market asset when it comes off-lease Excellent track record and strong re-marketing capability Balloon more significant, but still at satisfactory levels All permits obtained or in process of being obtained; asset meets current and foreseeable safety regulations Long-term O&M contract, and/or O&M reserve accounts (if needed) Satisfactory track record and re-marketing capability Above-average design and maintenance. Standard configuration, maybe with very limited exceptions such that the object meets a liquid market Resale value is moderately above debt value Asset value and liquidity are sensitive to economic cycles Satisfactory track record and re-marketing capability Important balloon with potential grace periods Most permits obtained or in process of being obtained, outstanding ones considered routine, asset meets current safety regulations Limited O&M contract or O&M reserve account (if needed) Weak or short track record and uncertain re-marketing capability Average design and maintenance. Configuration is somewhat specific, and thus might cause a narrower market for the object Resale value is slightly above debt value Asset value and liquidity are quite sensitive to economic cycles Weak or short track record and uncertain re-marketing capability Repayment in fine or high balloon Problems in obtaining all required permits, part of the planned configuration and/or planned operations might need to be revised No O&M contract: risk of high operational cost overruns beyond mitigants No or unknown track record and inability to re-market the asset Below-average design and maintenance. Asset is near the end of its economic life. Configuration is very specific; the market for the object is very narrow Resale value is below debt value Asset value and liquidity are highly sensitive to economic cycles No or unknown track record and inability to re- market the asset 203

204 Sponsors track record and financial strength Sponsors with excellent track record and high financial standing Security package Asset control Legal documentation provides the lender with effective control (e.g. a first perfected security interest, or a leasing structure including such security) over the asset, or over the company owning it Rights and means at the lender s The lender is able to monitor disposal to monitor the location and the location and condition of condition of the asset the asset, at any time and place (regular reports, possibility for inspections) Insurance against damage Strong insurance coverage including collateral damage with top-quality insurance companies Sponsors with good track record and good financial standing Legal documentation provides the lender with effective control (e.g. a perfected security interest, or a leasing structure including such security) over the asset, or over the company owning it The lender is able to monitor the location and condition of the asset, almost at any time and place Satisfactory insurance coverage (not including collateral damage) with good-quality insurance companies Sponsors with adequate track record and good financial standing Legal documentation provides the lender with effective control (e.g. a perfected security interest, or a leasing structure including such security) over the asset, or over the company owning it The lender is able to monitor the location and condition of the asset, almost at any time and place Fair insurance coverage (not including collateral damage) with acceptable-quality insurance companies Sponsors with no or questionable track record and/or financial weaknesses The contract provides little security to the lender and leaves room to some risk of losing control over the asset The lender is able to monitor the location and condition of the asset to a limited extent only Weak insurance coverage (not including collateral damage) or with weakquality insurance companies Table 3 Supervisory Rating Grades for Commodities Finance Exposures Strong Good Satisfactory Weak Financial strength Degree of over-collateralisation of Strong Good Satisfactory Weak trade Political and legal environment Country risk No country risk Limited exposure to country risk (in particular, offshore location of reserves in an Mitigation of country risks Very strong mitigation: Strong offshore mechanisms Strategic commodity emerging country) Strong mitigation: Offshore mechanisms Strategic commodity Exposure to country risk (in particular, offshore location of reserves in an emerging country) Acceptable mitigation: Offshore mechanisms Less strategic commodity Strong exposure to country risk (in particular, inland reserves in an emerging country) Only partial mitigation: No offshore mechanisms Non-strategic commodity 204

205 Asset characteristics Liquidity and susceptibility to damage First class buyer Strong buyer Acceptable buyer Weak buyer Commodity is quoted and can be hedged through futures or OTC instruments. Commodity is not susceptible to damage Strength of sponsor Financial strength of trader Very strong, relative to Commodity is quoted and can be hedged through OTC instruments. Commodity is not susceptible to damage Commodity is not quoted but is liquid. There is uncertainty about the possibility of hedging. Commodity is not susceptible to damage Commodity is not quoted. Liquidity is limited given the size and depth of the market. No appropriate hedging instruments. Commodity is susceptible to damage Strong Adequate Weak trading philosophy and risks Track record, including ability to manage the logistic process Extensive experience with the type of transaction in question. Strong record of Sufficient experience with the type of transaction in question. Above-average Limited experience with the type of transaction in question. Average record of Limited or uncertain track record in general. Volatile costs and profits operating success and cost efficiency record of operating success and cost efficiency operating success and cost efficiency Trading controls and hedging policies Strong standards for counterparty selection, hedging and monitoring Adequate standards for counterparty selection, hedging and monitoring Past deals have experienced no or minor problems Trader has experienced significant losses on past deals Quality of financial disclosure Excellent Good Satisfactory Financial disclosure contains Security package Asset control First perfected security interest provides the lender with legal control over the assets at any time, if needed Insurance against damage Strong insurance coverage including collateral damage with top-quality insurance companies First perfected security interest provides the lender with legal control over the assets at any time, if needed Satisfactory insurance coverage (not including collateral damage) with good-quality insurance companies At some point in the process, there is a rupture in the control over the assets by the lender. The rupture is mitigated by knowledge of the trade process or a thirdparty undertaking, as the case may be Fair insurance coverage (not including collateral damage) with acceptable-quality insurance companies some uncertainties or is insufficient Contract leaves room for some risk of losing control over the assets. Recovery could be jeopardised Weak insurance coverage (not including collateral damage) or with weakquality insurance companies 205

206 Table 4 Supervisory Rating Grades for Income-Producing Real Estate Finance Exposures Strong Good Satisfactory Weak Financial strength Market conditions The supply and demand for the project s type and location are currently in equilibrium. The number of competitive properties coming to market is equal or lower than forecasted demand Financial ratios and advance rate The property s debt service coverage ratio (DSCR) is considered strong (DSCR is not relevant for the construction phase) and its loan-to-value ratio (LTV) is considered low given the property type. Where a secondary market exists, the transaction is underwritten to market standards Stress analysis The property s resources, Cash-flow predictability (a) For complete and stabilised property contingencies and liability structure allow it to meet its financial obligations during a period of severe financial stress (e.g. interest rates, economic growth) The property s leases are long-term with creditworthy tenants and their maturity dates are scattered. The property has a track record of The supply and demand for the project s type and location are currently in equilibrium. The number of competitive properties coming to market is roughly equal to forecasted demand The DSCR (not relevant for development real estate) and LTV are satisfactory. Where a secondary market exists, the transaction is underwritten to market standards The property can meet its financial obligations during a sustained period of financial stress (e.g. interest rates, economic growth). The property is likely to default only under severe economic conditions Most of the property s leases are long-term, with tenants that range in creditworthiness. The property experiences a Market conditions are roughly in equilibrium. Competitive properties are coming on the market and others are in the planning stages. The project s design and capabilities may not be state of the art compared to new projects The property s DSCR has deteriorated and its value has fallen, increasing its LTV During an economic downturn, the property would suffer a decline in revenue that would limit its ability to fund capital expenditures and significantly increase the risk of default Most of the property s leases are medium rather than longterm with tenants that range in creditworthiness. The property experiences a Market conditions are weak. It is uncertain when conditions will improve and return to equilibrium. The project is losing tenants at lease expiration. New lease terms are less favourable compared to those expiring. The property s DSCR has deteriorated significantly and its LTV is well above underwriting standards for new loans The property s financial condition is strained and is likely to default unless conditions improve in the near term The property s leases are of various terms with tenants that range in creditworthiness. The property experiences a very 206

207 (b) For complete but not stabilised property tenant retention upon lease expiration. Its vacancy rate is low. Expenses (maintenance, insurance, security and property taxes) are predictable Leasing activity meets or exceeds projections. The project should achieve stabilisation in the near future (c) For construction phase The property is entirely preleased through the tenor of the loan or pre-sold to an investment-grade tenant or buyer, or the bank has a binding commitment for take-out financing from an investment-grade lender Asset characteristics Location Property is located in highly desirable location that is convenient to services that tenants desire Design and condition Property is favoured due to its design, configuration, and maintenance, and is highly competitive with new properties Property is under construction Construction budget is conservative and technical hazards are limited. Contractors are highly normal level of tenant turnover upon lease expiration. Its vacancy rate is low. Expenses are predictable Leasing activity meets or exceeds projections. The project should achieve stabilisation in the near future The property is entirely preleased or pre-sold to a creditworthy tenant or buyer, or the bank has a binding commitment for permanent financing from a creditworthy lender Property is located in desirable location that is convenient to services that tenants desire Property is appropriate in terms of its design, configuration and maintenance. The property s design and capabilities are competitive with new properties Construction budget is conservative and technical hazards are limited. Contractors are highly moderate level of tenant turnover upon lease expiration. Its vacancy rate is moderate. Expenses are relatively predictable but vary in relation to revenue Most leasing activity is within projections; however, stabilisation will not occur for some time Leasing activity is within projections but the building may not be pre-leased and there may not exist a takeout financing. The bank may be the permanent lender The property location lacks a competitive advantage Property is adequate in terms of its configuration, design and maintenance Construction budget is adequate and contractors are ordinarily qualified high level of tenant turnover upon lease expiration. Its vacancy rate is high. Significant expenses are incurred in preparing space for new tenants Market rents do not meet expectations. Despite achieving target occupancy rate, cash flow coverage is tight due to disappointing revenue The property is deteriorating due to cost overruns, market deterioration, tenant cancellations or other factors. There may be a dispute with the party providing the permanent financing The property s location, configuration, design and maintenance have contributed to the property s difficulties Weaknesses exist in the property s configuration, design or maintenance Project is over budget or unrealistic given its technical hazards. Contractors may be underqualified 207

208 Strength of sponsor/developer Financial capacity and willingness to support the property Reputation and track record with similar properties Relationships with relevant real estate actors qualified qualified The sponsor/developer made a substantial cash contribution to the construction or purchase of the property. The sponsor/developer has substantial resources and limited direct and contingent liabilities. The sponsor/developer s properties are diversified geographically and by property type Experienced management and high sponsor quality. Strong reputation and lengthy and successful record with similar properties Strong relationships with leading actors such as leasing agents Strong relationships with leading actors such as leasing agents The sponsor/developer made a material cash contribution to the construction or purchase of the property. The sponsor/developer s financial condition allows it to support the property in the event of a cash flow shortfall. The sponsor/developer s properties are located in several geographic regions Appropriate management and sponsor quality. The sponsor or management has a successful record with similar properties Proven relationships with leading actors such as leasing agents The sponsor/developer s contribution may be immaterial or non-cash. The sponsor/developer is average to below-average in financial resources Moderate management and sponsors quality. Management or sponsor track record does not raise serious concerns Adequate relationships with leasing agents and other parties providing important real estate services The sponsor/developer lacks capacity or willingness to support the property Ineffective management and substandard sponsor quality. Management and sponsor difficulties have contributed to difficulties in managing properties in the past Poor relationships with leasing agents and/or other parties providing important real estate services Security package Nature of lien Perfected first lien 1 Perfected first lien 1 Perfected first lien 1 Ability of lender to foreclose Assignment of rents (for projects leased to long-term tenants) The lender has obtained an assignment. It maintains current tenant information that would facilitate providing notice to remit rents directly to the lender, such as a current rent roll and The lender has obtained an assignment. It maintains current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as current The lender has obtained an assignment. It maintains current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as current is constrained The lender has not obtained an assignment of the leases or has not maintained the information necessary to readily provide notice to the building's tenants 208

209 copies of the project's leases rent roll and copies of the project's leases rent roll and copies of the project's leases Quality of the insurance coverage Appropriate Appropriate Appropriate Substandard 1 Lenders in some markets extensively use loan structures that include junior liens. Junior liens may be indicative of this level of risk if the total LTV inclusive of all senior positions does not exceed a typical first-loan LTV. 209

210 Chapter 4 General Credit risk mitigation is a technique used by a financial undertaking to reduce the credit risk associated with an exposure or exposures held by a financial undertaking. This can be done by using different types of on-balance sheet netting and collateralisation (i.e. funded protection) or by using different types of guarantees (i.e. unfunded protection). The Credit Risk Mitigation Chapter contains all provisions that specifically govern the use of credit risk mitigation. Sections 4.1, 4.9 and 4.10 cover both funded and unfunded protection. Sections 4.2 to 4.6 cover the various forms of eligible funded protection and their treatment. Sections 4.7 and 4.8 cover the various forms of eligible unfunded protection and their treatment. In the case of funded protection, financial undertakings may choose between more complicated and less complicated methods and approaches, subject to their using the standardised approach or the foundation IRB approach. For unfunded protection, no such choice exists. Financial undertakings using the standardised approach and financial undertakings using the foundation IRB approach apply the same treatment for unfunded protection. This is illustrated in the following diagram: Standardised Approach (SA) Foundation IRB Approach (FIRB) simple method comprehensive method simple method comprehensive method use of volatility adjustments use of volatility adjustments On-balance substitution - supervisory adjustments not allowed - supervisory adjustments sheet netting - own estimates - own estimates Master netting not allowed use of volatility adjustments - supervisory adjustments not allowed use of volatility adjustments - supervisory adjustments agreements - own estimates - own estimates - internal models - internal models Financial substitution use of volatility adjustments - supervisory adjustments not allowed use of volatility adjustments - supervisory adjustments collateral under - own estimates - own estimates SA and FIRB Financial not applicable not allowed use of standard LGDs collateral under FIRB Other funded protection Guarantees & credit derivatives to be treated as guarantees use of substitution to be treated as guarantees use of substitution In some respects, the structure of this Chapter deviates from that of Annex VIII of the recast Banking Directive. The structure of Chapter 4 is based on a subdivision by product type whereby all provisions regarding eligibility, minimum requirements and treatment are combined. 210

211 Explanatory notes to individual Articles Article 4:1(c) (capital market-driven transaction) In Chapter 4, a distinction is made between three types of transactions: repo-style transactions, capital market-driven transactions and secured lending transactions. This distinction is necessary as these transactions have different liquidation periods. Article 4:2(1)(a) Although credit risk mitigation techniques serve to reduce credit risk, their use may at the same time create or increase other risks, thereby rendering the overall risk reduction less effective. These other risks are, for instance, the risk that the collateral provided as security cannot be realised or the risk that a protection provider refuses (timely) payment. A financial undertaking must also be able to control these risks. Article 4:2(1)(b) and (2) Also if credit risk mitigation is applied to an exposure, a financial undertaking must continue to monitor the gross exposure (i.e. not taking any credit risk mitigation into account). Only in the case of repo-style transactions may the net exposure be monitored, because monitoring net exposures corresponds with the manner in which such exposures are controlled as part of a financial undertaking s risk management process and because controlling such risks on a gross basis would signify a disproportionally high administrative burden. Article 4:3 This Article refers to an Article in the Standardised Approach Chapter, specifying which procedure is applicable if several credit assessments are available for a specific type of credit risk mitigation. Article 4:4 to 4:9 The types of netting set out in Articles 4:7 and 4:8 have not been included in the recast Banking Directive. They constitute a further interpretation of this Directive and are a continuation of current Dutch regulations on on-balance sheet netting. The lending financial undertaking considers the loan extended as an exposure and the deposit received as collateral. Under the standardised approach and the foundation IRB approach, these two variables are used as input for the calculation of the fully adjusted value of the exposure. Reference is thereby made to the calculations according to the financial collateral comprehensive method as set out in Section 4.4. The outcome of the calculation of the risk-weighted exposure amount or expected loss amount will therefore be the same irrespective of whether the provisions of Section 4.2 or Section 4.4 are used. What distinguishes these two Sections are the minimum requirements. Netting is a somewhat easier tool to arrive at a lower weighting; the minimum requirements are slightly less stringent. If, however, all conditions for financial collateral set out in Section 4.4 are complied with, a financial undertaking may also choose to treat the collateral according to the rules for financial collateral instead of the rules for netting. The treatment of netting is explained only briefly in the recast Banking Directive, viz. that the items subject to on-balance sheet netting are to be treated as cash collateral. In order to follow as closely as possible the internationally accepted interpretation of the rules, use has been made here of the Basel text, which provides explanation about the manner in which such treatment is to take place. 211

212 Calculation example Suppose: Secured lending transaction Use of supervisory approach Loan 100 Deposit 90 HE 0 HC 0 Hfx 0 E* = max {0, [(E x (1 + H E )) (C x (1 H C H FX ))] E* = max {0, [(100 x (1 + 0)) (90 x (1 0 0))] E* = max {0, [100 90] E* = max {0, 10} = 10 Article 4:10 The possibility to recognise the effect of bilateral netting agreements is only open to a financial undertaking using the financial collateral comprehensive method for its collateral. A separate treatment applies to such transactions if the financial collateral simple method is used (see Subsection 4.4.5). Paragraph 2 specifies that without prejudice to the provisions of Annex II to the recast Capital Adequacy Directive, the eligibility requirements for financial collateral must also be complied with. The possibilities for eligible collateral listed in Annex II namely exceed those for eligible collateral set out in Section 4.4. Hence, this paragraph serves to restrict the possibilities provided in Annex II. Annex II to the recast Capital Adequacy Directive has been implemented by De Nederlandsche Bank in Articles 3:28 to 3:33 of the Supervisory Regulation on Solvency Requirements for Market Risk ((Regeling solvabiliteitseisen voor het marktrisico), and a part thereof has been implemented in Annex 5A to this Regulation. Article 4:11 The conditions set out in this Article (including the conditions to which subparagraph (c) of this Article refers) all aim to safeguard that the credit risk mitigation is effective. Such a safeguard can be achieved, among other things, by imposing requirements on contractual provisions, by requiring that financial undertakings follow specific procedures and processes and by precluding any potential risks (e.g. correlated positions). Article 4:12 For the calculation of the volatility adjustments for master netting agreements covering repostyle transactions and capital market-driven transactions, three methods can be used: - the supervisory volatility adjustments method - the own estimates volatility adjustments method - the VaR method The supervisory volatility adjustments approach and the own estimates volatility adjustments approach are also used to calculate volatility adjustments for financial collateral (Section 4.4). As these methods are explained in detail in Section 4.4, only some references need to be made in this Article to a number of Articles in Section 4.4. It must be noted, however, that a different formula is used for the calculation of the fully adjusted exposure value (E*), for which Article 4:12 contains a modified formula (see Annex 4A). 212

213 The third method is available specifically and exclusively for master netting agreements: the VaR method. This method is explained in detail in Subsection Article 4:13 A financial undertaking opting for the VaR method must apply this method to all its counterparties and securities. Only in the case of an immaterial portfolio may the supervisory volatility adjustments method or the own estimates volatility adjustments method be applied to that specific portfolio. A portfolio s immateriality will not only be measured by the size of the portfolio but also by the risks inherent in such a portfolio. Immaterial size alone is not enough reason to refrain from using the VaR method. Only if a portfolio is qualified as immaterial in terms of both size and risks is it possible to use a method other than the VaR method. Derivative transactions may not be treated according to the VaR method. They must be treated as capital market-driven transactions under the supervisory volatility adjustments method or the own estimates volatility adjustments method. Article 4:14 To be allowed to use the VaR method, a financial undertaking must have a recognised internal VaR model, specifically for the purposes of this Article. A financial undertaking which had earlier received approval from De Nederlandsche Bank to use a specific internal VaR model for market risk, may also use this model for the purposes of this Article. In the past, a number of financial undertakings received specific approval to use their internal models for the measurement of market risk. To extend the scope of this approval to the use of the internal model for this subcategory of credit risk, it has been stipulated in paragraph 3 of this Article that financial undertakings which had already received approval, must be regarded as having been given the recognition as referred to in paragraph 2 of this Article. If a financial undertaking has not yet received approval to use an internal VaR model as referred to above, the financial undertaking may submit a request for recognition of its model to De Nederlandsche Bank. To that end, the financial undertaking must demonstrate that it meets the conditions set out in Articles 4:15 to 4:20. Article 4:16 This Article specifies that the internal VaR model must be integrated into the daily risk management process. Hence, a financial undertaking may not possess different internal models that serve internal and external purposes. Also, a financial undertaking must assess a sufficient number of risk factors in its internal VaR model in order to capture a material proportion of the price risks. Price risks are hereby understood to mean the risks that may have a potential impact on the price volatility of transactions. It is therefore not necessary to include all risk factors in the VaR model, but those that highly contribute to the price risks must at any rate be included. Article 4:17 This Article specifies that the financial undertaking must have a risk control unit which can operate with a sufficient degree of independence and is not subject to any influence that would jeopardise its operational independence. For a smaller financial undertaking this may imply that instead of setting up a separate unit, it assigns the risk control function to a person meeting the requirement of sufficient operational independence. Paragraph 2 stipulates that the financial undertaking must have sufficient numbers of staff with the necessary skills to use complex models, not only at the business trading unit but 213

214 also at the units engaged in risk management, internal control, internal and external accounting and reporting, including the back office. Article 4:19 The financial undertaking s models must have sufficient predictive value. This must be demonstrated through a system of annual back-testing. The data to be used in back-testing must cover at least one year, and if more relevant data are available, a longer period. Also, a rigorous programme of stress testing must be implemented. These tests, which serve to identify events and influences that could seriously impair a financial undertaking s financial position, are an extremely important element in the assessment of capital adequacy. The methodology of stress testing is subject to De Nederlandsche Bank s assessment after it has received a financial undertaking s request to use internal models. Changes in an accepted methodology would require renewed recognition from De Nederlandsche Bank. The scenarios for these stress tests must capture factors that could lead to extraordinary gains or losses on the transactions subject to the master netting agreement or could seriously impair control of the risks associated with these transactions. These factors include events which could arise, albeit with a low degree of probability, but which would subsequently have a material impact on several if not all risk areas. The stress scenarios must provide insight into the impact of such events on the value of the transactions. The stress tests to be conducted by financial undertakings must comprise both quantitative and qualitative criteria. Quantitative criteria are to identify plausible stress scenarios to which financial undertakings may be exposed. Qualitative criteria are to reflect two important objectives of the tests, viz.: an assessment of the financial undertaking s capacity to absorb major potential losses; and the adoption of mechanisms for risk mitigation and the preservation of capital adequacy. The output of the tests must be included in the standard reports submitted to senior management and in the periodic reports submitted to the board of directors. Article 4:20 The financial undertaking must periodically review its risk measurement system to ensure compliance with a documented set of internal policies and procedures. The risk measurement system must be well-documented, for instance by means of a risk management manual describing the basic principles of the risk management system and providing an explanation of the empirical techniques used for the measurement of market risk. As part of its internal auditing process, the financial undertaking must regularly subject its risk measurement system to an independent review. This review must cover both the activities of the various business trading units and of the independent risk control unit. The overall risk management process must be periodically reviewed and, if necessary, adjusted (preferably not less than once a year). This review must specifically address, at a minimum: the documentation of the risk management system and process; the organisation of the risk control unit; the integration of measured risk into daily risk management ; the approval process for risk-pricing models and valuation systems that are used by frontoffice and back-office personnel; the validation of any significant changes in the risk measurement process; the scope of risks captured by the risk measurement system; the integrity of the management information system; the accuracy and completeness of position data; 214

215 the verification of the consistency, timeliness and reliability of data sources used to run the internal model, including the independence of such data sources; the accuracy and appropriateness of volatility and correlation assumptions; the accuracy of the valuation and calculations. Article 4:21 This Article sets out the points of departure for estimates of potential changes in value. As regards the historical observation period, it must be noted that the exceptive clause in subparagraph 2(d) of this Article does not detract from the provision that, in all cases, at least one year of data must be available, even though a significant upsurge in price volatility would justify a shorter observation period. The internal model must really be an internal model. Potential changes in value must be estimated on the basis of the financial undertaking s own historical data and risk measurement method. The risk measurement system must therefore include not just generally available third party information (e.g. Bloomberg). Third party data may be used, but only as part of a greater whole. As regards the liquidation period, it must be noted that the liquidity of the relevant collateral is to be taken into account. If there is uncertainty about the liquidity of the collateral, the minimum liquidation period must be adjusted (the equivalent). Articles 4:22 to 4:28 These Articles specify the collateral which (if the conditions set out in Articles 4:29 to 4:32 are met) is recognised as eligible collateral. In many cases, this is done on the basis of the credit assessment given to the relevant collateral under the standardised approach. If reference is made to a credit assessment to which De Nederlandsche Bank has assigned credit quality step 3 or above, the word above is understood to mean credit quality steps that result in lower risk weightings. In the present example that would be credit quality steps 2 and 1. In Articles 4:26(2) and 4:27(2) it is stipulated that a collective investment undertaking using derivatives to hedge investments shall not prevent units in that undertaking from being recognised as eligible collateral. These paragraphs are included with a view to Article 82(3) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), which provides that, where a form of credit protection already applies to the collateral, this collateral may not be recognised another time. In the above situation, derivatives are used to hedge against the risk on investments. As units in the collective investment undertaking, these investments serve indirectly as collateral. The conclusion might then be drawn that the collateral already has some form of credit risk mitigation (the credit derivatives), which would prevent the collateral, and thus the units in the collective investment undertaking, from being recognised as eligible. The exceptive clause in Articles 4:26(2) and 4:27(2) prevents this undesirable effect by stipulating that units in a collective investment undertaking are recognised as collateral even if credit risk mitigation has been taken into account on the underlying securities. Articles 4:29 to 4:32 These Articles set out the conditions which financial collateral must meet to be recognised as eligible collateral. Article 4:29 contains requirements as regards correlation. No material correlation may exist between the obligor s credit quality and the value of the collateral. Such correlation 215

216 could take several forms. The most distinct form, set out in subparagraph 1(b), is the use of securities issued by the obligor itself or an affiliated party. A material positive correlation may also exist if the obligor and the issuer of the collateral are in the same industry which may give rise to a domino effect (e.g. the dot-com bubble). As regards the exceptive clause in paragraph 2, viz. that the obligor s own issues of covered bonds may be recognised, it must be noted that the collateral covering the bonds may not have a material correlation with the obligor s credit quality. This would, for instance, occur when the obligor operates in a particular industry and would therefore be sensitive to the economic developments in that industry, whilst the collateral would also be sensitive to the economic developments in the same industry. Article 4:30 sets out the requirements as regards legal certainty. A financial undertaking must have conducted and must continue to conduct sufficient legal review to ensure continuing enforceability of the collateral arrangements. After all, the collateral has no credit risk mitigating effect if it is not certain whether the lending financial undertaking will be able to realise or liquidate the collateral in the event of the obligor s default. Article 4:31 sets out the operational requirements with respect to the recognition of financial collateral as eligible collateral. Risks arising from the use of collateral as referred to in subparagraph 1(b) include: - risks associated with deficient or diminished credit protection; - valuation risks; - risks arising from termination of the credit protection; - concentration risks associated with the use of collateral; and - interaction with the financial undertaking s overall risk profile. Subparagraph (e) of Article 4:31 contains a performance obligation, which does, however, not imply that this condition is more lenient than the other conditions set out in Articles 4:29 to 4:31. The financial undertaking must make an effort to ensure with a high degree of certainty that, in the event of bankruptcy of the third party, the assets shall not form part of the bankrupt estate. Article 4:32 For the calculation of risk-weighted exposure amounts, two financial collateral methods are available: the financial collateral simple method and the financial collateral comprehensive method. The financial collateral simple method uses the substitution technique. The financial collateral comprehensive approach uses volatility adjustments. A financial undertaking applying the standardised approach may choose whether to use the financial collateral simple method or the financial collateral comprehensive method. The financial undertaking must apply the chosen method consistently to the whole portfolio. Thus, it is not allowed to use both methods at the same time, or to change methods repeatedly. A financial undertaking applying the foundation IRB approach has no such choice and must use the financial collateral comprehensive method. Article 4:34 If the maturity of the collateral is shorter than the residual maturity of the exposure, the collateral cannot be recognised as financial collateral under the financial collateral simple method. For, as soon as a loss is incurred, it would then be uncertain whether the collateral could actually be used to absorb such a loss. And there is no advance knowledge as to whether a loss will be incurred within or after the collateral s period of maturity. Therefore, explicit synchronisation must exist between the maturity of the collateral and the maturity of the exposure. 216

217 Article 4:35 Under the simple financial collateral method, no fully adjusted exposure value is calculated. Instead, the substitution mechanism is used (the method already used under Basel I). This means that the risk weight of the collateral applies to the collateralised portion of the exposure, whereas the risk weight of the underlying asset continues to be applicable to the uncollateralised portion. A 20% floor applies to the risk weight for the collateralised portion of the exposure. A number of exceptions to this general rule are set out in Articles 4:36 to 4:38. These concern specific situations with such stringent requirements that the risk is really significantly lower. Article 4:36 This Article deals with the treatment of repo-style transactions. Under the financial collateral comprehensive method it is possible, instead of calculating a volatility adjustment, to use a 0% volatility adjustment. A number of specific conditions must then be met, i.e. the collateral must be in the form of cash or cash-assimilated instruments or debt securities issued by the central government or a public sector entity as referred to in Article 2:11(2) of this present Regulation that qualifies for a 0% risk weight, the counterparty must be a core market participant and there must not be any currency mismatch. If the criteria set out in Subsection are met, this exception may also be used under the financial collateral simple method, and instead of a 0% volatility adjustment a 0% risk weight would then apply (paragraph 1). If the counterparty is not a core market participant, but all further criteria are fulfilled, a 10% risk weight may be applied (paragraph 2). Article 4:37 This Article deals with the treatment of OTC derivatives that are subject to daily marking-tomarket. If such transactions are collateralised by cash or cash-assimilated instruments and there is no currency mismatch, a 0% risk weight may be applied to the collateralised portion. If the transaction is not collateralised by cash or cash-assimilated instruments, but is collateralised by debt securities issued by central governments or central banks (which have a 0% risk weight under the standardised approach), a risk weight of 10% may be applied. The derivatives that can be used for the purposes of this Article are listed in Annex IV of the recast Banking Directive, as implemented in Annex B of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). The value of the derivative is determined in accordance with Annex III of the recast Banking Directive, which has been implemented in Chapter 5 of this present Regulation. Depending on the type of derivative, a financial undertaking may choose by which method to determine the value of the derivative. Article 4:38 In respect of other transactions, a financial undertaking may also qualify for a lower risk weight if there is no currency mismatch and if the collateral is in the form of cash or cashassimilated instruments or debt securities issued by central governments and central banks that qualify for a 0% risk weight under the standardised approach. In that case, the value of the debt securities must be discounted by 20% Article 4:39 Paragraph 1 specifies that financial undertakings must calculate the fully adjusted exposure value by applying volatility adjustments to the exposure and the collateral. See also the calculation example in the explanatory notes to Article 4:9. If the collateral consists of several 217

218 recognised items (for instance, a block of securities), paragraph 2 specifies that the volatility adjustment for the collateral must be calculated by multiplying the volatility adjustments for the different collateral items by their proportion to the collateral as a whole. Calculation example Suppose: use of supervisory volatility adjustments method, 10-day liquidation period Collateral A 50 suppose: applicable H = 2% Collateral B 20 suppose: applicable H = 15% Collateral C 30 suppose: applicable H = 6% Total collateral 100 H = a H i i i H = [(50/100 x 2%) + (20/100 x 15%) + (30/100 x 6%)] = 1% + 3% + 1.% = 5.8% Paragraphs 3 and 4 stipulate that in this Chapter a different treatment than that under the standardised approach and the foundation IRB approach is to apply to specific categories of off-balance sheet items. In concrete terms, this means that a conversion factor or percentage of 100% is taken into account, even if it is possible under the standardised approach and the foundation IRB approach to apply lower conversion factors or percentages. In the formula for the calculation of the volatility-adjusted exposure amount (formula 1b) this is reflected in the value of E. The original exposure is therefore taken into account for 100% in calculating the volatility-adjusted exposure amount. The principle here is that first the adjustments in respect of credit risk mitigation are applied and then the credit conversion factors. Article 4:42 The volatility adjustments to be applied under the supervisory volatility adjustments method are included in tables 1 to 4 in Annex 4B, in which a standard volatility adjustment is applied to the different types of collateral, based on a liquidation period of five days, ten days and twenty days. These tables are based on the assumption of daily revaluation. If revaluation takes place less frequently, the volatility adjustment must be scaled up. The manner in which this must be done is set out in Subsection Article 4:44 In calculating volatility adjustments, correlation may not be taken into account and is, in fact, set at 1. Diversification effects are therefore disregarded. The volatility adjustments calculated under the own estimates volatility adjustments method must, in principle, be calculated for each individual debt security. If debt securities have been given a credit assessment from an eligible external credit assessment institution equivalent to investment grade, a financial undertaking may make a combined volatility estimate for all debt securities belonging to that category. This implies that all debt securities with comparable residual maturities, comparable issuers, comparable ratings and comparable modified durations are combined and that a volatility estimate is made for the whole category. If debt securities are given a rating below investment grade, the volatility estimate must be made for each individual item. An investment grade rating is equivalent to a credit assessment to which De Nederlandsche Bank, under the standardised approach, has assigned credit quality step 3 or above to exposures to governments. Credit assessments for other categories (corporates, 218

219 financial undertakings, etc) equivalent to or above credit quality step 3 are also considered to be investment grade. It follows, mutatis mutandis, that credit assessments below the rating mentioned above are non-investment grade. Article 4:45 The calculation of volatility adjustments must be subject to daily revaluation. If the frequency of revaluation is less than daily, volatility adjustments must be scaled up. The manner in which this must be done in set out in Subsection A financial undertaking must update its data sets no less frequently than once every three months and must also reassess them whenever market prices are subject to material changes. New volatility adjustments must be calculated every time the data sets are changed. This implies that volatility adjustments must be calculated at least every three months and more frequently if market conditions so require. Article 4:46 If a financial undertaking uses a shorter or longer liquidation period, the volatility adjustment (which must be based on the applicable liquidation period as referred to in Article 4:46(1)) must be adjusted. Also, the liquidation period must be adjusted in cases where there is doubt about the liquidity of the collateral. A financial undertaking must identify where historical data may understate potential volatility. An example is the anchor currency, which plays a role in determining the volatility adjustment for the currency mismatch between exposure and collateral. If a currency is pegged to another currency (whether formally or informally), volatility is historically low because the exchange rate between the two currencies is kept within a currency band. Exchange rate volatility would be higher, if the exchange rate were left to float. Should the situation eventually prove unsustainable for either of the two currencies, this could lead to a revaluation or a devaluation of one of them. Financial undertakings must incorporate these and similar situations in their stress scenarios. If such a stress scenario would point to a particular vulnerability, the financial undertaking must take steps towards an adequate management of the ensuing risks. Volatility adjustments must, at any rate, be scaled up. Eventually, this would result in a higher risk-weighted asset and thereby to a higher solvency level to cover potential risks. Article 4:48(3) A financial undertaking must have a documented set of policies that should cover the use and operation of its system of volatility estimates, the integration of these estimates into its risk management process, the control steps to be taken and other procedures that are of significance. Procedures should also be in place to monitor and assess compliance. Article 4:49 A portfolio s immateriality is not only measured by the size of the portfolio but also by the risks associated with such a portfolio. Immaterial size alone is not enough reason to refrain from using the own estimates volatility adjustments approach. This would require that a portfolio be qualified as immaterial in terms of both size and risks. Article 4:50 This Article specifies that volatility adjustments must be scaled up if a financial undertaking s frequency of revaluation is less than daily. Within the framework of credit risk 219

220 mitigation it is assumed that daily revaluation takes place for the calculation of volatility adjustments. A financial undertaking may, of course, apply a lower frequency of revaluation. In that case, the financial undertaking must scale up the volatility adjustment based on daily revaluation to the volatility adjustment that applies to that lower frequency of revaluation. Subsection Under the financial collateral comprehensive method it is possible, instead of calculating a volatility adjustment, to use a 0% volatility adjustment. A number of specific conditions must then be met, i.e. the collateral must be in the form of cash or cash-assimilated instruments or debt securities issued by the central government or a public sector entity as referred to in Article 2:11(2) that qualifies for a 0% risk weight, the counterparty must be a core market participant and there must not be any currency mismatch. Also, conditions are imposed on revaluation and transaction documentation. Also included is the possibility for a financial undertaking to follow another Member State in applying a 0% volatility adjustment to a repo-style transaction in securities issued by the national government of that Member State. This possibility is especially important if in the other Member State other counterparties are included in the definition of core market participant than those referred to in Article 4:1(b). The possibility to apply a 0% volatility adjustment is not available to financial undertakings using the VaR method for transactions subject to master netting agreements. Section 4.5 Only for financial undertakings using the foundation IRB approach will it be possible, in addition to financial collateral, to recognise physical collateral. Article 4:56(1)(a) A situation where the value of the real estate does not materially depend on the credit quality of the obligor may be the following: a shopkeeper who owns his shop on which he has taken out a mortgage. If the shopkeeper goes bankrupt, the shop premises can be sold at the normal value. The premises retain their value. A situation where the value of the property materially depends on the obligor s credit quality is that of premises from which especially the obligor draws benefit. A possible bankruptcy of the obligor could impede others from using the obligor s premises unless these premises are thoroughly renovated or even torn down. Such restrictions on the premises clearly detract from their value. In general, it may be stated that if a property could only be of use to a very limited number of other people, this would usually detract from the property s value. In such cases, the property cannot be recognised as collateral. The requirement that the value of the property may not materially depend on the credit quality of the obligor is not intended to preclude situations where purely macroeconomic factors would adversely affect both the value of the property and the performance of the borrower. For instance, during an economic downturn, a shopkeeper (e.g. of a luxury goods shop) would see his income decline. At the same time, the value of the collateral may decline because of a change in the demand and supply of shop premises. As more shopkeepers go bankrupt, more shop premises come on the market, so supply increases. As demand goes down at the same time, downward pressure is generated on the prices of shop premises. Yet, this constitutes no reason not to recognise the shop premises as collateral. Article 4:56(1)(b) 220

221 The tenor of this paragraph is that the correlation between the borrower s credit quality and the collateral value may not be too high. If the income which the collateral should generate is not enough to meet the loan obligations, the collateral itself probably also has a lower-thanexpected value and offers less protection than anticipated. This situation must be avoided. Shop premises are an example of real estate where the credit risk on the borrower does not materially depend on the performance of the property. The shop premises are needed to carry out the shopkeeper s business but, as such, they do not generate the cash flow from which the borrower (the shopkeeper who owns the shop) repays the debt. That particular cash flow is generated by the proceeds, for instance, of goods sold or services rendered. A typical example where the credit risk on the borrower materially depends on the performance of the property is the housing market. A borrower buying a block of flats and renting out the individual units usually must repay the loan from the rental proceeds: the property itself generates the cash flow from which to repay the loan. In this case, the block of flats is not recognised as collateral. Article 4:56(3) Under the recast Banking Directive, the supervisory authorities of the various Member States may waive the requirement for the financial undertakings under their supervision to comply with the provisions of subparagraph 1(b) for property situated within the territory of that Member State. De Nederlandsche Bank has chosen not to use this waiver for the Netherlands because, in its view, the risks associated with such collateral do not justify any preferential treatment. Under the recast Banking Directive, Member States may also extend this waiver to property situated within the territory of another Member State, provided that the other Member State has implemented the said waiver. Also, Member States which do not use the waiver for property situated within their own territories, may use the waiver for property situated within the territory of another Member State. Suppose that country X implements the waiver and country Y does not. A financial undertaking in country Y may then submit a written request to recognise property situated in country X as eligible collateral. The competent authorities in country Y may grant their approval if all conditions which country X imposes on eligible collateral are met. To provide a level playing field, it had already been decided earlier, in respect of Dutch financial undertakings doing business in Germany, to adopt the German supervisory authority s preferential treatment. In the interests of a level playing field, De Nederlandsche Bank will make limited use of the possibility to adopt the preferential treatment of foreign supervisory authorities. De Nederlandsche Bank will publish a list of Member States where real estate not meeting the requirements of subparagraph 1(b) may be recognised as eligible collateral. Member States may be added to this list if financial undertakings submit a request to that effect to De Nederlandsche Bank. Thus, De Nederlandsche Bank will not, on its own initiative, add Member States to the list. An exception is Germany, as a decision to adopt the German supervisory authority s preferential treatment had already been taken. Article 4:57 The lender must be granted a limited right to collateral in the form of real estate, such as a lien or a mortgage. Under this limited right and the procedures for exercising that right, it must be possible to realise the collateral (the real estate) within a reasonable timeframe. Foreclosure of the real estate should, for instance, be possible in the short term. Article 4:58 221

222 For provisions with respect to the appraisal of real estate, reference is made to Section 1:27 of this Regulation. For the purposes of weighting the credit risk, an indexation method may be used, instead of object-specific appraisals, to calculate the foreclosure value of the individual properties in an existing residential mortgage portfolio. The basic principle in using an indexation method is that it must lead to a reliable and prudent estimation of the foreclosure value of a mortgage portfolio and the corresponding credit risk. In addition, the method must be applied in an unequivocal, consistent and verifiable manner in accordance with the Policy rule for indexation method for determining the forced-sale value of the mortgage portfolio (Beleidsregel indexatiemethode ter bepaling van executiewaarde hypotheekportefeuille). Article 4:59 The value referred to in paragraph 1 is the value for private freehold sale. Article 4:61 The legal mechanism must be demonstrably robust and effective. It does not suffice that the mechanism is clearly specified; there must also be a reasonable degree of certainty that the mechanism will actually work as described. A financial undertaking may establish a first priority claim, such as a lien, over the collateral, which will give the financial undertaking priority upon liquidation of the collateral, for instance in the event of bankruptcy of the borrower. By law, prior rights may have been assigned to preferential creditors whose rights will supersede the financial undertaking s right of execution. The existence of such prior rights does not detract from the legal admissibility of the financial undertaking s first priority claim. Prior rights of preferential creditors may, for instance, be wages due to employees but also outstanding tax claims. In its legal review as referred to in subparagraph (b), a financial undertaking not only examines whether the collateral arrangements are enforceable but also whether there are any indications that the proceeds from the collateral would benefit the preferential creditors instead of the financial undertaking. This could, for instance, be the case if the tax authorities already have such a high outstanding claim on the obligor in question that the financial undertaking would be unlikely to realise the collateral under the collateral arrangement. Article 4:62 Where there is a specific correlation between the value of the underlying exposures and the borrower s credit quality because both variables depend materially and equally on the same economic factors, this must be taken into account in the setting of margins for the receivables pool as a whole. The receivables would then offer much less protection should the borrower s credit quality deteriorate, since the receivables would themselves also deteriorate in quality. Subparagraph 1(f) specifies that the borrower is, in the first instance, the contracting party which collects payment on the underlying receivables. This shall continue as long as the borrower fulfils its payment obligations. In the event of the borrower s payment default, the contract of pledge may provide, for instance, for a notification clause. This implies that, after giving notification to the borrower s obligors, the financial undertaking may collect payment (on the receivables) from these obligors. Article 4:64 A financial undertaking may recognise physical collateral (i.e. other than real estate, receivables and collateral in the form of leasing) if there is a liquid market with wellestablished and publicly available market prices. 222

223 A principle-based approach is used in this Article. This implies that De Nederlandsche Bank will not publish a list of eligible types of physical collateral. The financial undertaking itself must ensure that the relevant conditions are met, thereby take the following into account: - the collateral value in relation to the market: is the value of the collateral such that putting it on the market will have a material effect on the market price; - its daily traded volume: is it a frequently traded commodity or are such commodities traded only now and again; - the spread between the bid and ask prices. Article 4:69 The value of the collateral must at any rate be equal to or higher than the amount of the outstanding lease payments. Only the amortisation component of the lease payment must be used here. Components such as interest and insurance are disregarded. If these components were to be included in the calculation, the amount of the lease payments would nearly always be much higher than the value of the collateral. This means, in fact, that the rate of depreciation of the collateral must not exceed the rate of amortisation of the lease payments. If the rate of depreciation of the asset were much higher than the rate of amortisation of the lease payments, a growing differential would, in time, emerge between the (high) amount of the lease obligations and the (low) residual value of the assets. The rates of depreciation are mostly based on the expected economic life of the asset. The period of the lease contract should also be based on that economic life. In its risk management, the financial undertaking must take into account the possibility that in the case of deviating percentages, credit risk mitigation will be overstated. Depending on the extent of the potential overstatement of credit risk mitigation, the physical asset may be recognised only partially, or not at all, as collateral. Article 4:70 Different LGDs may apply to eligible physical collateral. This is, among other things, subject to the extent to which the exposure is secured by collateral (i.e. the level of collateralisation). Three possible situations are distinguished: low collateralisation, average collateralisation, high collateralisation. Different LGDs apply to the product groups described in the previous Articles (real estate, receivables and other physical collateral). These LGDs are shown in table 5. The level of collateralisation is low if the ratio of the value of the collateral to the exposure value is below the percentage stated in the column under C* (the required minimum level of collateralisation). In that case, the exposure is deemed not to be secured by collateral. Therefore, the collateral provided is not included and does not bring about a lower LGD. The LGD* applicable to the exposure in question is the LGD which under the foundation IRB approach applies to uncollateralised exposures to the counterparty. The level of collateralisation is high if the ratio of the value of the collateral to the exposure value exceeds the percentage stated in the column under C**. In that case, the exposure is fully collateralised. Depending on whether non-subordinated or subordinated exposures are concerned, the LGD* to be applied is that of the first or the second column of table 5. The level of collateralisation is average if the ratio of the value of the collateral to the exposure value is between C* and C**. In that case, the exposure is split into two portions, viz. a secured portion and an unsecured portion. The secured portion is calculated by dividing the collateral amount by the percentage stated under C**. The unsecured portion is the value 223

224 of the total exposure minus the secured portion of the exposure. For clarification see the calculation example below. The LGD* as described for a situation of high collateralisation will then apply to the secured portion of the exposure, whereas the LGD* as described for a situation of low collateralisation shall apply to the unsecured portion. Calculation example where the level of collateralisation is average Suppose: The exposure is 100 Eligible collateral in the form of real estate to the amount of 20 Eligible other collateral to the amount of 30 For both types of collateral, C* is 30% and C** is 140% The ratio of the total collateral value to the exposure is 50% (( ) / 100). As this value is between C* and C**, the level of collateralisation is average. The exposure must now be split into a secured portion and an unsecured portion, whereby the two different types of collateral are taken into account. The portion of the exposure that is secured by real estate is 20/140% = The LGD* for this portion is 35% (in conformity with table 5). The portion of the exposure that is secured by other collateral is 30/140% = The LGD* for this portion is 40% (in conformity with table 5). The unsecured portion of the exposure is = The LGD* for this portion is the LGD which under the foundation IRB approach applies to unsecured loans. It is evident from the above that the more significant the collateral, the lower the LGD*. The loss that is eventually incurred on the exposure is inversely proportional to the value of the collateral. Also evident is that the use of relatively limited collateral does not lead to a lower LGD. It is further evident that even if the exposure is amply secured by physical collateral, LGD shall still be applicable. After all, even if significant collateral has been provided, a risk still remains. Article 4:72 Deposits held with third party financial undertakings may be recognised as eligible credit protection. These deposits may not be considered equivalent to cash as they are not held by the lending financial undertaking itself, and are not readily available if the third party financial undertaking where the deposits are held is in financial problems. Consequently, the deposits receive the risk weight of the third party financial undertaking. If the conditions set out in this Article are met, such deposits shall be recognised as a guarantee by the third party financial undertaking and treated in accordance with the provisions of Article 4:93. This implies that the secured portion of the exposure receives the risk weight of the deposits held with a third party financial undertaking, and the unsecured portion receives the risk weight of the exposure itself. Deposits held under a custody agreement with a third party financial undertaking remain the property of the original owner and not the third party financial undertaking. If a borrower holds deposits under a custody agreement with a third party financial undertaking and pledges these deposits to the lending financial undertaking, this collateral is treated as normal collateral in accordance with Section 4.4. Article 4:73 Life insurance policies pledged to the lending financial undertaking may be recognised as eligible credit protection. If the relevant conditions are met, these life insurance policies are also recognised as a guarantee by the undertaking providing the life insurance and treated in 224

225 accordance with the provisions of Article 4:93. The collateralised portion of the exposure then receives the risk weight of the life insurance policies that have been pledged, and the unsecured portion receives the risk weight of the exposure itself. Subparagraph 1(d) implies that upon signing the pledge contract, a minimum surrender value must have been determined, at least for the maturity of the protection. Contractual provisions may be included stipulating how the minimum surrender value is to be reduced over the period of the contract, which provisions shall be incontrovertible for the maturity of the protection. It is therefore not possible to determine, for instance, annually the minimum surrender value for the next year. This would contravene with the principle that the obligation must be explicitly documented ex ante. It would also contravene with the spirit of the regulations on guarantees, under which the amount of the protection must be clearly documented ex ante and must be indisputable. The right referred to in subparagraph 1(e) implies that it must, for instance, be possible to cancel the policy if the borrower still pays the insurance premiums and is, in that respect, not in default. Subparagraph 1(g) specifies that a maturity mismatch between the credit protection and the loan is not allowed. This means, among other things, that the life insurance contract may not include any provisions allowing a party other than the lending financial undertaking to surrender the life insurance policy. Nor may the contract include any provisions that would provide a positive incentive for the lending financial undertaking to surrender the life insurance policy prematurely. Article 4:74 This Article specifies that instruments issued by a third party financial undertaking and repurchased by that financial undertaking on the request of the holder of these instruments, may be recognised as eligible credit protection. It mostly concerns debt instruments issued by smaller-sized foreign financial undertakings. It is not feasible for such smaller-sized financial undertakings to issue paper that meets the conditions for financial collateral set out in Section 4.4 and, more specifically, Article 4:25. The paper issued by these financial undertakings has no credit rating nor is it listed on a recognised exchange. A financial undertaking may recognise as eligible credit protection debt instruments issued by another financial undertaking and received from a third party which does not meet all conditions for financial collateral as specified under Section 4.4, provided that the other financial undertaking will repurchase the paper on request. The said collateral will then be recognised as a guarantee by the issuing financial undertaking and treated in accordance with the provisions of Article 4:93. This implies that the secured portion of the exposure receives the risk weight of the issuing financial undertaking. The unsecured portion of the exposure receives the risk weight of the exposure itself. Article 4:76 The double default framework has been designed in such a way that it only applies if the creditworthiness of the obligor and the creditworthiness of the protection provider are not strongly correlated. Hence, the framework is not applicable to financial undertakings using the standardised approach, since under that approach it is not possible to determine the creditworthiness of the obligor and the correlation with the creditworthiness of the protection provider. Furthermore, the protection provider must be a financial undertaking with sufficient knowledge of and expertise in the area of protection provision. Such a financial undertaking may, after all, incorporate the guarantee concerned in a diversified portfolio, which would minimise the correlation between the creditworthiness of the obligor and the protection provider. 225

226 Article 4:77 It is possible to account for the deterioration in the value of the protected asset as referred to in paragraph 2, among other things, by reducing the real value of the protected asset or by making additions to the reserves. It is also possible that neither the protected asset nor the swap are revalued. In that case, too, the credit protection may be recognised. Either way, the treatment must be consistent. Article 4:78 When a financial undertaking conducts an internal hedge using a credit derivative, it hedges the credit risk associated with an exposure in the non-trading book by a credit derivative included in the trading book. An internal hedge is not recognised as credit risk mitigating because this transaction does not change the risk profile of a financial undertaking as a whole. In a solo assessment, credit derivatives issued by parent or affiliated corporate entities may be recognised as credit risk mitigating. After all, in a solo assessment there is no internal hedge. This is consistent with the provisions of Article 4:75(1)(g) which explicitly recognise parent and affiliated corporate entities of the financial undertaking as eligible providers of unfunded credit protection. On the other hand, credit derivatives issued to parent or affiliated corporate entities must be charged to the account of the issuer. Article 4:80 Guarantees and credit derivatives must comply with the requirement of providing for timely settlement. Timely settlement means that, in the event of default by the obligor, the financial undertaking providing the protection is compensated for its losses at short notice. A bankruptcy procedure, for instance, may take years to complete, and it is not considered prudent that a financial undertaking has to wait so long before receiving compensation for the loss incurred. In the case of guarantees, this Article provides that, in the event of default by the original obligor, the protection provider is obliged to pay out forthwith. In the case of credit derivatives with cash settlement, this Articles provides that there must be a predefined period in which to estimate the loss amount. The length of this period must be in line with customary procedure in the market for such credit derivatives. This period may, among other things, depend on the length of time which market parties expect they will need for obtaining the relevant market prices at the time of occurrence of the credit event (post credit event quotes). These market prices are needed to make a reliable estimate of the pay-out amount. In the case of (bilateral) loans, for which no reliable market price can be obtained, a longer period may be needed to determine the amount of the pay-out. The settlement amount must represent a reasonable and sufficiently conservative estimate of the loss amount, based on the financial undertaking s experience, and may require an independent third party view. This does not preclude the financial undertaking from performing a full work-out of the underlying exposure. Timely settlement only refers to the pay-out to the lending financial undertaking by the protection seller, and is independent of the relationship between the lending financial undertaking and the borrower, which may continue after pay-out. Article 4:81 This Article provides that, if specific conditions are met, it is not necessary to comply with the condition that the guarantee must be direct and explicit. The provision of a counterguarantee is allowed. A case in point is export credit insurance. In many countries, export credit policies are guaranteed by the sovereign. As long as both the original guarantee and the counterguarantee fulfil all other requirements for guarantees, the exposure for which export 226

227 credit insurance has been taken out and which is guaranteed by the sovereign may be treated as covered by a sovereign guarantee. Article 4:82 If an obligor does not meet its payment obligations or is very unlikely to meet its payment obligations in the short term, a lending financial undertaking may pursue the guarantor for payment. A guarantee contract may contain a list of qualifying default instances, which, once they occur, would also give occasion to pursuing the guarantor for payment. The condition that the obligation under the guarantee must be clearly defined, is fulfilled if incontrovertible documentation exists as to whether and, if so, to which extent an individual obligation is guaranteed. The guarantee covers, in principle, all amounts that the obligor is due under the claim, including payments of principal, interest and fees. If the guarantee covers a lower amount than the amount of the claim (e.g. in the case of a principal-only guarantee), the application of the lower risk weight of the guarantor will only be permitted up to the guaranteed amount. The remainder that is not covered by the guarantee (i.e. the total claim minus the guaranteed amount) must be weighted according to the usual requirements for such exposures. The requirements which this Article imposes on guarantees shall apply likewise to blanket guarantees, where a guarantee is issued for all potential outstandings under a credit limit or even for all future outstandings against an obligor. Article 4:83 Subparagraph 1(a) refers to the guarantee contract providing for a provisional payment. Because, in some instances, the exact measurement of a loss may take some time, the contract may provide for a robust estimate of the loss and for subsequent pay-out of the loss amount. A robust estimate means that the expected loss amount must be estimated as closely as possible. Payment of a symbolic amount therefore does not suffice. Once the loss amount has been definitely established, final pay-out will be made while deducting the provisional amount that has already been paid. Subparagraph 2(b) refers to exceptional situations where, due to various circumstances, no immediate payment under the guarantee will be forthcoming but where the guarantee is nonetheless deemed to provide such protection that recognition is justified. One such exceptional case is where the financial undertaking must first pursue the obligor for payment before being able, after a waiting period of a few months, to call upon the guarantor. Article 4:85 The grace period, based on which the credit event is defined, must be about as long as the grace period in the underlying exposure. If the obligor has not fulfilled its obligation before the end of the grace period, payment must be effected on the basis of the credit derivative. Past due interest must, in principle, also be covered by the guarantee. Where past due interest is not guaranteed, it is important that a direct claim can be made under the protection as soon as a single interest payment has been missed, thus preventing any further accrual of past due interest. If such is not the case, the guarantee may be recognised only for the present value of the principal, discounted by the contractual interest rate. The interest due shall not be taken as guaranteed and shall therefore receive the risk weight of the obligor. The objective of specifying credit events is to make sure that credit events are sufficiently linked to the factors that may cause loss or depreciation of the underlying asset. In restructuring, a distinction can be made between distressed restructuring and, for instance, voluntary restructuring for reasons other than a deterioration of the obligor s credit quality. Important is that distressed restructuring gives rise to a credit event. Any change in the 227

228 contract terms or contract performance due to which the financial undertaking must record a value adjustment in its financial records or a debit to its profit and loss account, is regarded as a case of distressed restructuring. Non-payment of interest must also qualify as a credit event. Interest liabilities need not be guaranteed, however. If interest liabilities are not guaranteed, they shall receive the risk weight of the obligor. Article 4:86 Paragraph 1 of this Article specifies that the protection provider may not determine unilaterally whether a credit event has occurred. It is important to identify credit events or else, if the slightest loss occurs (e.g. when a payment is a few days overdue because of a systems failure or error), the protection provider may settle the contract without incurring any significant loss. The protection provider comes off well, receiving a premium and not having to make any material pay-out. The protection buyer, however, no longer has any protection for the underlying exposure. Especially if the credit quality of the exposure in question is deteriorating, it will cost the protection buyer more money to find new protection. In other words, the protection buyer comes off much worse. Also, the protection buyer should not have to wait until the protection seller finally determines that a credit event has occurred before the protection seller pays out under the contract. The provision has therefore been made that the protection buyer must have the right and the ability to inform the protection seller of the occurrence of a credit event. By ability is understood that the protection buyer must be able to actually use its right. The protection provider must, for instance, be easy to reach. According to paragraph 3, the contract of the underlying obligation must stipulate that the counterparty to the underlying obligation must give its consent to the transfer of the obligation, unless there are reasonable grounds to refuse such consent. This is to prevent that settlement is impeded due to the fact that the underlying obligation cannot or may not be transferred. This should be verified and contractually arranged ex ante. Article 4:87, preamble This Article is about asset mismatch. Two types of asset mismatch are distinguished. In the first type of asset mismatch, the obligation used under the credit derivative to determine the cash settlement value or the deliverable obligation (the reference obligation ) is not the same as the obligation whose credit risk is covered by the credit derivative (the underlying obligation ). In the second type of asset mismatch, the obligation used for the purposes of determining whether a credit event has occurred does not correspond with the underlying obligation. In the first type of asset mismatch, there is no perfect correlation between the loss that may be incurred on the underlying obligation and the amount of the pay-out under the credit derivative. In the second type of asset mismatch, it is possible that default occurs on the underlying obligation, but not on the obligation used to determine the credit events. In both types of asset mismatch, the loss incurred may not be (fully) paid out. To avoid such situations, requirements (a) and (b) are imposed on the credit derivative in the case of an asset mismatch. Article 4:88 As stated in the explanatory notes to Article 4:76, the double default framework has been designed in such a way that it only applies if the creditworthiness of the obligor and the creditworthiness of the protection provider are not strongly correlated. Exposures to financial undertakings, central governments and members of the same group as the protection provider are therefore excluded from the application of double default treatment. 228

229 Article 4:91 If an exposure is divided into two or more tranches each with a different risk profile, the exposure shall come under the definition of securitisation as referred to in Chapter 6 of this Regulation, and is subject to treatment under the securitisation rules as set forth in that Chapter. Paragraph 2 stipulates that the existence of a materiality threshold leads to a tranched risk and must therefore be treated in accordance with the securitisation rules as set forth in Chapter 6 of this Regulation. A materiality threshold may take the form of either a payment requirement or a default requirement. This implies that for the purposes of the contract a credit event occurs only if the amount to be paid or the loss incurred exceeds a specific threshold. A materiality threshold explicitly does not mean a deduction from or discount on a contractual payment when a credit event has taken place. Article 4:91(2) The calculation method referred to in Article 4:92(2) is closely aligned to that described in Article 4:85(2), i.e. where the list of credit events specified in a credit derivative does not include restructuring of the underlying obligation. Restructurings are meant here which involve forgiveness or postponement of principal, interest or fees and which result in a value adjustment or, otherwise, a debit to the profit and loss account. If restructuring is not included as a credit event, the value of the credit protection will be reduced by at least 40%. If the amount of the protection exceeds the exposure value, the protection may be recognised for at most 60% of the exposure value. The purpose hereof is to prevent that protection is provided for a higher amount, as this would make it theoretically possible to have the whole exposure covered by protection (e.g. when the protection is 166 and the exposure 100). Article 4:94 Article 2:5 of the standardised approach provides for preferential treatment of exposures to the central government or the central bank of a country that is not a Member State of the European Union, denominated and funded in the domestic currency of that country. Given the long-standing policy of equating exposures guaranteed by sovereigns or central banks with exposures to those sovereigns or central banks, the preferential treatment allowed under the standardised approach will also be allowed for credit risk mitigation purposes. Articles 4:95 and 4:96 The generic term basket products refers to credit derivatives which transfer the credit risk of more than one reference entity (multiple name) instead of that of a single reference entity (single name ). These Articles distinguish between two types of basket products: (1) first-to-default credit derivatives. The first default among any of the reference entities shall trigger payment under and settlement of the contract. Suppose that ten reference entities have been included in the basket. As soon as any one of these ten reference entities has defaulted, payment under and settlement of the contract will follow. (2) nth-to-default credit derivatives. The nth default will trigger payment under and settlement of the contract. Suppose that ten reference entities have been included in the basket and a credit derivative for the fourth default is concerned here. As soon as any four of these reference entities have 229

230 defaulted, payment under and settlement of the contract will follow, and will exclusively concern the fourth default. In the case of (1), the risk-weighted exposure amount is calculated by taking the underlying exposure which in the absence of protection would have the lowest risk weight. Credit protection may be recognised in respect of this exposure, provided that the value of the credit protection is at least equal to the exposure value. In the case of (2), the protection may only be recognised if n-1 defaults have already occurred or if protection has also been obtained for defaults 1 to n-1. If n-1 defaults have already occurred, the nth-to-default credit derivative applies to the next following default. The risk-weighted exposure amount is then calculated by taking, from the underlying exposures that have not yet defaulted, the exposure which in the absence of credit protection would have the lowest risk weight. For this exposure, credit protection may be recognised, provided that the value of the credit protection is at least equal to the exposure value. If protection has also been obtained for defaults 1 to n-1, the risk-weighted exposure amount is calculated by first ranking the underlying exposures from high to low according to the risk weight they would have in the absence of credit protection. The protection that is provided by the nth-to-default credit derivative is then applied to the nth exposure in the ranking, provided that the protection is at least equal to the value of this exposure. Article 4:98 The positive incentive mentioned in subparagraph 2(b) refers, for instance, to the situation where, from a predefined date, a step-up in premium must be paid for the protection and where the protection buyer has the option to terminate the protection contract from that date. If there is no such positive incentive, it may be assumed that such an option does not affect the maturity of the protection. Article 4:100 Financial undertakings may distribute the various forms of credit risk mitigation to create the most beneficial effect on risk-weighted assets. For instance, a financial undertaking may have both collateral and a guarantee partially covering an exposure. In that case, the financial undertaking must subdivide the exposure into portions covered by each type of credit risk mitigation tool, e.g. a portion covered by the collateral and a portion covered by the guarantee. Article 4:101 For financial undertakings using the foundation IRB approach, the effects of a guarantee will reflect in the PD and the effects of collateral in the LGD. This Article only refers to the use of a combination of different types of collateral covering a single exposure. Hence, only the impact on the calculation of the LGD is addressed, there being no impact on the calculation of the PD. 230

231 Chapter 5 General In Chapter 5, four methods are described which for the purposes of this present Regulation may be used in the standardised approach or the IRB approach to determine the size of the credit risk exposure (CCR exposure value, or EAD under the IRB approach) of OTC derivatives and long settlement transactions 9. One of these methods, the internal model method, may also be applied to securities financing transactions (SFTs). In all cases, instruments are concerned that are included in both the trading book and the banking book and whose counterparty credit risk is treated under the standardised approach (Chapter 2) or the IRB approach (Chapter 3) for credit risk. SFTs are taken to include repo-style transactions and capital market-driven margin lending transactions including those that are carried out as prime brokerage activities 10 as distinguished in Chapter 4. Repo-style transactions are understood to be repurchase transactions (including the reverse variety, i.e. repos and reverse repos) and commodities or securities lending or borrowing transactions. Financial undertakings are supposed to choose a method that is appropriate for the nature and size of their exposures. The four methods used for the determination of CCR exposures in this Chapter are: -the (current) mark-to-market method (current exposure method, CEM), -the original exposure method, -a standardised method, -the internal model method (IMM). The choice of the internal models approach for SFTs is in addition to the four alternative methods that may be used for SFTs according to Subsections 4.3.4, and of Chapter 4 (financial collateral simple method, financial collateral comprehensive method with supervisory volatility adjustments approach, financial collateral comprehensive method with own estimates volatility adjustments approach and VaR method). These methods are optional, i.e. they are alternative methods for a financial undertaking to choose from irrespective of the method used by that undertaking to weigh the overall credit risk, the standardised approach or the IRB approach. Also, the newly added methods may, in principle, be used any time from 1 January 2007 at the financial undertaking s discretion, although for the use of the internal model method, approval from De Nederlandsche Bank must first be obtained and for the use of the original exposure method, the relevant conditions must be met and it must be appropriate for the nature and volume of the business concerned. If a financial undertaking seeks De Nederlandsche Bank approval for the use of the internal model method, a roll-out plan must be included in its application. The instruments or transactions dealt with in this Chapter have the following general characteristics in common: - They generate current exposure or market value; 9 Definition included in Article 5:1: transactions with a deferred settlement date or a settlement date of more than five business days after the transaction date, which up to the settlement date are treated as forward contracts. Non-settled transactions or failed trades are dealt with in the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). 10 In a general sense, prime brokerage may be understood to be a business activity incorporating a number of investment management and clearing services which may comprise the execution of transactions with a single counterparty in different products under a prime brokerage or margin lending agreement. These (proprietary) agreements may comprise a crossproduct netting or cross-product collateral arrangement bridging the individual transactions and their underlying contracts. 231

232 - They have a future market value that can only be approximated stochastically on the basis of market variables; - They generate an exchange of payments or an exchange of financial instruments (including gold, precious metals and other commodities) against payment; - They are entered into with an identified counterparty for which a PD can be established. Other common characteristics may be the following: - Collateral may be used to mitigate the risks inherent in some of these transactions ; - Short-term financing is usually a primary goal in the sense that the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, for the purposes of financing. The two sides of the transaction are not the result of individual decisions but constitute an inseparable whole with a clearly identified purpose; - Netting may be used to mitigate risks; - Exposures are marked-to-market at frequent intervals, mostly on a daily basis, by using market variables; - Daily re-margining may be used. Exceptive clause An exposure value of zero may be attributed to derivative contracts and SFTs that are outstanding with a recognised central counterparty (such as a central clearing institution). However, this does not apply to SFTs where settlement has failed. Collateral posted with a central counterparty due to variation margin may be deducted from the CCR capital requirements, but a risk weight will be assigned to the initial margin according to the capital requirements for credit risk based on the standardised approach or the IRB approach. The exception with respect to the calculation of CCR exposure may be used only if the CCR exposures are fully collateralised on a daily basis. As regards the methods of determining the size of CCR exposure (= EAD) that are dealt with in this Chapter, the following applies: where a financial undertaking, using a derivative, buys credit protection for a banking book exposure, the capital requirement for the hedged exposure must be set in conformity with the conditions and general rules for the recognition of credit derivatives (i.e. using such rules as substitution or double default). The explanatory memorandum below does not contain explanatory notes to all individual Articles. This is because in some instances no further explanation is needed whilst in others, De Nederlandsche Bank and fellow supervisory authorities still have to build up experience with the use of relatively new instruments to calculate CCR. Explanatory notes to individual Articles Article 5:1 (d) (credit valuation adjustment) This adjustment reflects the market value of the credit risk due to any failure to perform on contractual agreements with a counterparty. The adjustment may reflect the market value of the credit risk of the counterparty or the market value of the credit risk of both the financial undertaking and the counterparty. (f) (current exposure) The current exposure is equal to zero. If larger than zero, the current exposure is equal to the market value of a transaction or a portfolio of transactions within a netting set with a 232

233 counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy. (g) (current market value) Both positive and negative market values are used in computing current market value. (j) (effective EE (effective expected exposure) at a specific date) This means the maximum expected exposure that occurs at that date or any prior date. Alternatively, such exposure may be defined for a specific date as the greater of the expected exposure at that date, or the effective exposure at the previous date. (l) (effective maturity under the internal model method, for a netting set with maturity greater than one year) See Annex 5:3. This means the ratio of the sum of expected exposure over the life of the transactions in a netting set discounted at the risk-free rate of return divided by the sum of expected exposure over one year in a netting set discounted at the risk-free rate of return. This effective maturity may be adjusted to reflect roll-over risk by replacing expected exposure with effective expected exposure for forecasting horizons under one year. (q) (long settlement transaction) It does not matter whether a transaction based on delivery-versus-payment is concerned here or not. (s) (margin lending transactions) These are collateralised loans used in securities financing, whereby the lending financial undertaking has the right to call for additional collateral if the collateral value falls below a certain threshold value, as well as the right to liquidate existing collateral upon the debtor s default to deliver the additional collateral. Margin lending transactions do not include loans other than those defined in paragraph (r) of Article 5:1, which are secured by securities collateral. (v) (netting set) Each transaction for which netting as referred to in Section 127 of Volume 6 of the Dutch Civil Code (Burgerlijk Wetboek) is not possible must be interpreted as its own netting set in the context of the standardised method (Section 5.5). (bb) (roll-over risk) This means the amount by which expected positive exposure (EPE) is understated when no or insufficient account is taken of future transactions with a counterparty being conducted on an ongoing basis. The additional exposure generated by these future transactions is not included in the calculation of EPE. (cc) (specific wrong-way risk) A financial undertaking is considered to be exposed to a specific wrong-way risk if the future credit exposure to a specific counterparty is expected to be high when the counterparty s PD is also high. Articles 5:2 and 5:3 To determine eligible CCR exposure (for the purposes of this Regulation also known as exposure value or, in the terminology of the IRB approach to credit risk, EAD), financial 233

234 undertakings may, under the conditions set out in this Regulation, use the earlier-mentioned four alternative methods subject to the conditions with respect to the scope and use of several methods within a single financial undertaking. All four methods may, in principle, be used for OTC derivatives. For the purposes of Chapter 5, only the internal model method may be used for repo-style transactions or securities financing transactions (SFTs) in addition to the methods described in Chapter 4. When using the internal model method, financial undertakings must draw up a roll-out plan and coordinate this plan with De Nederlandsche Bank. The combined use of methods is, in principle, not permitted on a permanent basis to a single legal financial entity within a group. Hence, during the roll-out stage such combined use may be permitted for different types of portfolios and transactions. After the primary roll-out stage, combined use may still be permitted for relatively small exposures, for instance during an introductory stage for new types of instruments or transactions with which experience must be gained. Pursuant to Article 5:2(4), combined use is permitted within an economic group as referred to in Section 24B of Volume 2 of the Dutch Civil Code (Burgerlijk Wetboek), which is under consolidated supervision. The use of the term on a permanent basis may be seen as a requirement of consistent behaviour. The cases described in Article 5:2(5) concern transactions with a non-linear risk profile as referred to in Article 5:18 for which the financial undertaking cannot determine the delta or modified duration and for which an alternative approach must be chosen in consultation with De Nederlandsche Bank. Instruments referred to in Annex B to the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft): Types of derivatives 1. Interest rate contracts: (a) Single currency interest rate swaps (b) Basis swaps (c) Forward rate agreements (FRAs) (d) Interest rate futures (e) Interest rate options purchased (f) Other contracts of a similar nature 2. Foreign exchange contracts and contracts concerning gold : (a) Cross-currency interest rate swaps (b) Forward exchange contracts (c) Currency futures (d) Currency options purchased (e) Other contracts of a similar nature (f) Contracts concerning gold of a nature similar to (a) to (e). 3. Contracts of a nature similar to those in points 1(a) to (e) and 2(a) to (d) concerning other reference items or indices. This includes as a minimum all instruments specified in points 4 to 10 of Section C of Annex I to Directive 2004/39/EC not otherwise included as interest rate contracts or foreign exchange contracts and contracts concerning gold (as referred to in points 1 and 2). The financial instruments listed in Section C to Annex I to Directive 2004/39/EC are: (1) Transferable securities (2) Money market instruments 234

235 (3) Units in collective investment undertakings (4) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash. (5) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event ). (6) Options, futures, swaps and any other derivative contracts relating to commodities that can only be physically settled provided that they are traded on a regulated market and/or an MTF (Multilateral Trading Facility according to the definition in Directive 2004/39/EC. (7) Other options, futures, swaps, forwards and any other derivative contracts relating to commodities (not otherwise mentioned in Section C, point 6 of Annex I to Directive 2004/39/EC), that can be physically settled, are not for commercial purposes and have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses and are subject to regular margin calls. (8) Derivative instruments for the transfer of credit risk. (9) Financial contracts for differences. (10) Options, futures, swaps, forwards and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in Section C of Annex I to Directive 2004/39/EC. Articles 5:4 and 5:5(1) The CCR exposure value (EAD) is zero for sold credit default swaps in the banking book, and for credit risk purposes they are therefore treated as a guarantee by the bank (with a capital requirement for the notional transaction amount). The purpose of this provision is to avoid double counting. Article 5:5(2) Under all four methods dealt with in this Chapter, the CCR exposure value (EAD) for a given counterparty is equal to the sum of the exposure values calculated for each netting set with that counterparty, in conformity with the definition of netting set in Article 5:1. Article 5:5(3) For an explanation of this paragraph, reference is first made to the general explanatory notes (see Exceptive clause). Furthermore, with respect to subparagraph 3(d), De Nederlandsche Bank may, on the initial recommendation of financial undertakings, designate other - similar exposures to central counterparties, to which the same provision will apply. Article 5:5(6) If, for instance, the contract stipulates a multiplication of cash flows (leverage), the notional value must be adjusted to take account of the effects of this multiplication for the risk structure of the relevant contract. 235

236 Section 5.3, general The method described in this Section is the existing mark-to-market method (or in Basel terminology: current exposure method, CEM). For the determination of the exposure value (EAD), this method, which can only be applied to OTC derivatives, is used to determine the positive market value of the contract, supplemented by an add-on for the potential credit risk as defined according to table 1 in Annex 5A. Depending on the type of contract and maturity, the percentages given in this table are applied to the notional principal amount or underlying value of the contract, both in case the market value of the contract is positive and in case the market value of the contract is negative. The sum of the current replacement cost (mark-to-market) and the add-on percentage constitutes the credit risk equivalent that is taken into account as exposure value in the calculation of credit risk under the standardised approach (Chapter 2) or IRB approach (Chapter 3). Article 5:6(4) For the purposes of this paragraph, the collective term commodities may be understood to include: -precious metals other than gold, -base metals, -agricultural products (softs), and -other products including energy products. The approval from De Nederlandsche Bank as referred to in this paragraph may be obtained if, at a minimum, the following conditions are met. Financial undertakings must: -trade to a considerable extent in commodities, -have a diversified commodities portfolio, -be unable as yet to use internal models for the calculation of the capital requirement for commodity risk, in conformity with Chapter 4 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). Furthermore, De Nederlandsche Bank may impose operational requirements, including those with respect to organisation, risk management and experience. Article 5:7 The original exposure method is the least risk-sensitive method and may only be applied if the financial undertaking falls under the de minimis regulation as referred to in Section 1.2 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). Section 5.5, general In terms of risk sensitivity, the standardised method lies between the mark-to-market method and the internal model method (IMM) and, as a result of a number of simplifications in the underlying assumptions, its use is easier than the calculation of the exposure value under the IMM. Under the standardised method, the exposure value (EAD) is determined on the basis of the higher of the net market value or expected positive exposure (EPE) 11 for each netting set using a number of parameters set by the supervisory authority (a supervisory EPE ) and 11 In the case of netting sets which are deep-in-the-money, EPE is mainly determined by market value. In the case of out-of-the money netting sets, CCR is mainly determined by the potential change in the value of the transactions. 236

237 multiplied by a beta factor, in a manner comparable to and underlain by the same reasons as the alpha scaling factor under the IMM. This scaling factor is used for the following reasons: - to allow for the risk of poor economic conditions; - because of the stochastic dependency of the distribution of market values of exposures across counterparties, and - because of estimation and model risks. Moreover, the beta factor may constitute an incentive for the use, where possible, of the IMM. The standardised method may be used for derivatives and long settlement transactions. The latter transactions are treated as forward transactions until the settlement date (in the same way as derivatives). The method is suitable for financial undertakings which hold that the mark-to-market method is insufficiently risk-sensitive but which are not yet equipped to use the internal model method. The method may also be used in the event of specific transactions in respect of which it is not yet possible to meet the conditions attaching to the use of the internal model method. One major advantage which the standardised method shares with the IMM is that (contrary to the current exposure method, CEM) hedging is recognised within netting sets. A drawback relative to the IMM is that risk diversification effects are recognised to a very limited extent only. Annex 5B describes the exact method for determining the exposure value (EAD) under the standardised method. To illustrate the operation of the method, an example of a calculation is given below, with an explanation: Example Table 1 below shows an example of the use of the CCR standardised method. A euro-based financial undertaking has entered into five transactions with a single counterparty which may, under the applicable rules, be netted. The undertaking does the following: (1) it divides each transaction into separate long and short positions; (2) it calculates the effective notional value of the transactions; (3) it calculates the modified duration of each position in the transaction, and (4) it calculates the current market value of the transactions. The five transactions consist of two euro interest rate swaps, a foreign exchange swap, a cross-currency swap and a total return swap on the AEX. In the table, each position is listed separately, so that a total of ten rows is used in this example. For each interest rate related position, the effective notional value is multiplied by the modified duration to determine the risk position for each hedging set. For the first transaction (an IRS), the receiver part has a modified duration of eight years and the effective notional value is 80 million. This results in an amount of 640 (8x80), which is included as the risk position in the hedging set for euro interest rate risk with a maturity in excess of five years (based on the modified duration of eight years). The payer part of the same transaction has the same effective notional value of 80 million and a modified duration of This part results in the inclusion of an amount of 20 ( x 80) in the hedging set for euro interest rate risk with a maturity of less than one year (based on the modified duration of -0.25). Subsequently, the risk positions in each hedging set are added up. In the next row, the absolute value is calculated for each hedging set. Each hedging set has its own credit conversion factor (CCF), which serves as a multiplier for the absolute values of the sum of all risk positions. The sum total of the resulting amounts constitutes the equivalent of an at-themoney expected positive exposure value, being

238 The higher of the current market value (1.000) or the at-the-money amount of the expected positive exposure ( ), multiplied by a beta of 1.4, is the exposure value (EAD) for this netting set. Thus, the EAD is

239 i Transaction type Effective notional value Table 1, Example of CCR standardised method Euro-based financial undertaking, single counterparty, single netting set Risk positions RPij per hedging set j Modified duration million Years CMV million Interest rate risk on hedging sets FX risk on hedging sets Equity risk EUR non-gov M<1 Effective notional value x modified duration EUR non-gov M>5 Effective notional value x modified duration 1 EUR Interest rate swap Receiver part EUR Interest rate swap Payer part EUR Interest rate swap Receiver part EUR Interest rate swap Payer part USD nongov M<1 Effective notional value x modified duration USD nongov M>5 Effective notional value x modified duration JPY non-gov M>5 Effective notional value x modified duration USD/EUR JPY/EUR AEX Effective notional value (+ = long, - = short) 3 USD FX swap Receiver part EUR FX swap Payer part USD 4 JPY cross-currency swap cross-currency swap Receiver part Effective notional value (+ = long, - = short) Payer part Effective notional value (+ = long, - = short) Total return swap 5 S&P500 Receiver part in EUR Total return swap 5 S&P500 Payer part 150 N/A -150 in EUR Sum of risk positions RPTij per hedging set j Absolute amount sum of RPTij of the risk positions per hedging set j Credit conversion factors CCFj per hedging set j 0.20% 0.20% 0.20% 0.20% 0.20% 2.50% 2.50% 7% CCFj x sum of RPTij : CCF-weighted absolute amounts of risk positions per hedging set Sum of (CCFj x sum of RPTij ) CMV: sum of current market values of transactions CMVi Max(CMV, sum of (CCFj x sum of RPTij)) Beta: Exposure value (EAD) De Nederlandsche Bank

240 Standardised method, supplementary notes Risk positions of the same category (e.g. the same currency) arising from transactions within the same netting set, constitute a hedging set. Hence, within each hedging set, offsetting is fully recognised. One of the simplifications inherent in the method is that risk positions are included as delta equivalent positions. Another simplification is that no differentiation is applied in respect of categories per issuer of any underlying debt instrument and that the hedging sets notably address the general market risk. There is, however, a differentiation with regard to the reference rates used, namely those based on government paper versus those not based on government paper. Where equities are concerned, the differences in price changes between issuers are too large for netting at the national equity index level to be recognised. Hence, in this case, netting is only recognised at the level of the individual issuers. Interest rate derivatives, foreign exchange derivatives and the payment leg of equity and commodity derivatives are subject to interest rate risk for the remaining maturity. For floating rate notes (FRNs) and the variable payment leg of interest rate swaps, the remaining maturity is the period until the next interest reset date. Risk positions representing a long position have a positive sign and risk positions representing a short position have a negative sign. Owing to the method used to calculate the total exposure value per netting set as a portfolio, sold options are also included in the calculation on the basis of their delta equivalent. This differs from the mark-to-market method (CEM), which is applied on an individual transaction basis and where only purchased options are relevant to the determination of a (positive) exposure value. By applying modified duration and delta, the standardised method covers only the simple directional risk and not the basic risk. Considering the fact that, under this method, netting is only recognised on a counterparty-versus-counterparty basis and by netting set and hedging set, there is no need for the same degree of detail as under the standardised methods for the determination of capital requirements for market risk in the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) (with more maturity bands and disallowance factors). The CCR multipliers (CCRMs, known in Basel terminology as credit conversion factors) have been calibrated on the basis of the assumption of an at-the-money forward contract or swap and a forecasting horizon of one year (in conformity with the IRB approach regarding the PD horizon). Article 5:8 For the definition of securities and commodities financing transactions, reference is made to the general explanatory notes on securities financing transactions (SFTs). Article 5:10(1) to (4) When an OTC derivative transaction with a linear risk profile provides for delivery of a financial instrument against payment, the payment part is referred to as the payment leg. Article 5:10(1)(b) The procedure for payment legs mentioned in this subparagraph applies within a single transaction and may not be used for different transactions with the same counterparty. Article 5:18 240

241 Reference to this Article is made in Article 5:2(6). Transactions with a non- linear risk profile are included in the calculation on the basis of a delta equivalent, usually split into several parts. If these delta equivalent positions are difficult to calculate, the financial undertaking may, with the consent of De Nederlandsche Bank, include in the calculation an alternative and conservatively determined representation of the risk positions concerned, with an appropriate conversion factor. In the event that alternative methods for generating a delta equivalent amount might fail to decompose a transaction into several parts, it must be noted that it is fairly frequent for a single transaction to involve several risk positions. A foreign exchange swap, for instance, leads to a foreign exchange risk position as well as an interest rate risk position. Article 5:19 The provisions in Section 5.7 about contractual netting concern the conditions under which netting of opposite positions in a bilateral contractual arrangement may be recognised in the context in question. Section 5.6, general The internal model method is the most risk-sensitive of the four methods discussed in Chapter 5 for the determination of the exposure value (EAD). Of the four methods, this is the only one that can be applied to both derivatives and securities financing transactions (SFTs). In principle, the internal model method may be applied irrespective of the method used to determine credit risk in general: the standardised approach or the IRB approach. The use of the internal model method for the purposes in question requires the prior approval of De Nederlandsche Bank. An application for permission to use the internal model method (IMM) must be accompanied by adequate, detailed documentation about the operational as well as the quantitative and modelling aspects, and by a roll-out plan. Once approval has been obtained for the use of the IMM, the financial undertaking must, within a reasonable period of time, apply this method to all CCR activities within a single product category. An exception on a permanent basis is possible for activities where the risk magnitude is immaterial. Furthermore, during the roll-out stage, the financial undertaking is permitted to make temporary use of several methods side by side for different activities within a single product category. A financial undertaking which has been allowed to use the IMM may be given permission by De Nederlandsche Bank to apply to certain elements of its business operations a more conservative less risk-sensitive method for determining the CCR exposure value than that under the model, if this can be justified on the basis of, for instance, cost-benefit considerations. In such cases, the financial undertaking must still meet the use test for these more conservative measures and it must also be able to justify the differences in the degree of conservatism within its overall CCR risk management process. In these cases, De Nederlandsche Bank may require a higher scaling factor in view of the complexity of the activities and the nature of the risks. In this respect, there is no requirement to use one specific model. A model must be used which is capable in a reasonably conservative manner of estimating, for the instrument concerned, an average expected positive exposure value of a netting set in respect of a single counterparty over a horizon of one year. In some cases, a financial undertaking may, with the consent of De Nederlandsche Bank, also opt for a (more conservative) measure on the basis of expected potential peak exposure values, estimated at a high confidence interval. In this context, a VaR-based approach, the internal models approach in Chapter 4 concerning SFTs, may be viewed as a model variant. 241

242 In line with the time horizon chosen under the IRB approach for the calculation of PD, EPE is determined for a maturity of one year. In this context, in a comparable way as under the IRB approach for other types of exposures, a maturity adjustment must be applied (with a cap of five years). For transactions with an original maturity in excess of one year (the longest maturity within a netting set), this maturity adjustment is effected on the basis of a modified formula (compared to the standard formula under the IRB approach). For transactions with an original maturity of less than one year, the formula is the same as under the IRB approach, except for short-term transactions recognised under the IRB approach. As EPE may understate the risk inherent in SFTs or OTC derivatives with a short maturity due, among other things, to roll-over risk, a more conservative effective EPE must be calculated. In both cases, a scaling factor known in this method as alpha must be applied to allow for a number of uncertain factors. EE and EPE Internal models used for determining the exposure value usually estimate a time profile of expected exposures (EE) at each future point in time each such expected exposure corresponding to the probability-weighted average exposure value at that point in time for the possible future values or relevant market risk factors, such as interest rates, exchange rates, et cetera. Expected positive exposure (EPE) is the weighted average over time of the EEs for the time interval concerned (see Article 5:1(n); in this context, EPE is thus defined as Average EE (AEE)). In figure 1 below, the bent curve represents the EE time profile while the dotted line represents its average, that is, EPE over a time horizon of, in this case, one year. Figure 1 CCR Expected Exposure Profile Exposure EPE EE Time (years) Because SFTs, in particular, usually have a short maturity, they may cause problems in properly estimating EPE. In such cases, expected exposure (EE) may increase very rapidly during the first few days, followed by a sharp decrease towards the maturity date. However, in many cases the counterparty will wish to conclude a new SFT or roll over the existing transaction. Such transactions will then create new exposures that are not reflected in the EE time profile. Measurement entails additional problems if short-term transactions are combined with long-term ones, causing the EE initially to be high, subsequently to decrease for a while and then to increase again on account of the long-term transactions. If the short-term transactions are rolled over, the decreased EE could understate the magnitude of the 242

243 counterparty credit risk. Similar problems might arise for netting sets of OTC derivatives, especially if they include a considerable number of short-term OTC derivatives. Effective EPE In order to allow for the shortcomings of the use of normal EPE, as outlined above, it has been provided that the exposure value (EAD) calculated under the IMM is equal to effective EPE, multiplied by the scaling factor alpha. Effective EPE is calculated on the basis of the time profile of estimated effective EE for a netting set. Effective EE at a specific date is the maximum EE that occurs at that date or any prior date. As a result, a ratchet time profile is obtained. In figure 2 below, the dashed line with squares represents effective EE. Effective EPE is the average of effective EE and is represented by the solid dotted line. Figure 2 CCR Effective EE Profile & Effective EPE Exposure Effective EPE EPE Effective EE EE Time (years) Under the IMM, with the consent of De Nederlandsche Bank, a more conservative measure 12 than effective EPE may be used, such as one based on potential peak exposure values (estimated at a high confidence interval), for instance for repo-style transactions under a master agreement on the basis of a VaR model. Effective EPE can be derived simply from an EE profile serving as the basis for a standard EPE calculation. Effective EPE will always be somewhere between EPE and peak EE. For rising EE profiles, effective EPE will be equal to EPE. For descending profiles, effective EPE will be equal to peak EE. The general rule is that the sooner EE peaks, the closer effective EPE will be to peak EE, and the later EE peaks, the closer effective EPE will be to EPE. It is recognised that in the future financial undertakings may also be able to allow for the roll-over effect in their EPE models; still, given the early stage of development of such models in general and the limited supervisory experience in this area, it is not as yet permitted to use such in-house estimates of the roll-over risk in the determination of supervisory capital requirements. Article 5:21 12 Subject to periodic validation. 243

244 Financial undertakings must use a method which is appropriate to the nature and volume of their business operations. Without prejudice to the provisions of the remainder of Section 5.6, there is no requirement to use one specific model when applying the IMM. Articles 5:22 and 5:23 Immaterial exposures are understood to be exposures that are comparatively minor, that is, minor relative to overall credit risk and relative to own funds. In principle, the IMM may be used for all instruments subject to CCR as distinguished in this Chapter. Application to the various product categories requires the prior approval of De Nederlandsche Bank. In principle, under a roll-out plan, implementation may be effected sequentially across different product categories. De Nederlandsche Bank s approval is subject to the condition that the financial undertaking must, within a reasonable period of time, start full-scale application of the IMM to one or more product categories for which the approval was granted, except for immaterial exposures. Where these immaterial exposures are concerned, it will be agreed beforehand which specific elements may be kept on a permanent basis beyond the scope of the IMM treatment on account of immateriality and which elements may be kept beyond the scope of the IMM treatment for a specified initial period only. To the extent that elements are kept beyond the scope of the IMM treatment, they must be subject to one of the other methods discussed in this Chapter. In such cases, it is permitted to use the mark-to-market method and the standardised method side by side within a group but not within a single legal entity within a group. Within a single legal entity, the relevant exposures not covered by the IMM must be subjected to one of the alternative methods listed in this Chapter. Article 5:24 The principle set out in this Article, viz. that a financial undertaking which has obtained permission to use the IMM may not, on arbitrary grounds, revert to the use of one of the alternative methods, may be viewed as a generally applicable principle in the context of the use of internal models for the calculation of capital requirements, and hence also applies to the use of the IMM. Article 5:25 The manner in which the exposure value is calculated is described in Annex 5C. With regard to margin requirements, distributions, historical data, et cetera, reference is made, among other things, to Article 5:28 for the treatment of margin agreements and Article 5:44 for the integrity of the modelling process. With regard to the stochastic distributions to be used, it must be noted that, in theory, the expectations regarding the actual distribution of future exposure must be taken rather than the risk-neutral distribution. However, it is recognised that, for practical reasons, using the risk-neutral distribution may be more feasible. Hence, no obligation to opt for one or the other is prescribed here. Where the treatment of collateral is concerned, it must be noted that if a financial undertaking has taken account of collateral in its current exposure, it is not permitted to benefit again from such collateral in the estimation of LGD. Articles 5:26 and 5:27 The alpha scaling factor mentioned in Annex 5C is 1.4. In principle, this factor applies if the 244

245 financial undertaking has not obtained permission to estimate alpha itself (in other words, if it does not meet the conditions for in-house estimation of alpha). Permission to estimate alpha is conditional upon whether the exposures to which alpha applies justify such a factor. However, this does not fully rule out that due, for instance, to a changed risk profile as a result of more or less structurally changed exposures, a higher alpha may be required. Structurally changed exposures may arise owing to the addition of exposures resulting from new transaction types with a potentially higher specific wrong-way risk or owing to reduced granularity of counterparties, which increases the general wrong-way risk. In this context, a higher alpha may also be applied solely to elements with, for instance, relatively new instrument types within the product category concerned. Generally, a higher alpha is not intended to compensate for non-compliance with the requirements regarding the use of the IMM. The material sources of stochastic dependency set out in Article 5:26(c) must be taken to refer notably to the correlation of defaults across counterparties and the correlation between market risk and default. The granularity of portfolios referred to in Article 5:26(d) concerns the distribution of exposures across counterparties and categories of counterparties, or, in short, the number and the diversity of counterparties as a factor determining the concentration risk and influencing the magnitude of the general wrong-way risk. With regard to the frequency of re-estimating alpha as referred to in Article 5:27(2), it must be noted that the financial undertaking need not in all cases undertake a full-scale recalculation if it can make out a reasonable case that the new estimate would not be substantially different and would, for instance, remain well above the floor of 1.2. However, a recalculation must be made at the time when a structural change takes place in the portfolio which will probably have an effect on the value of alpha. Within a financial undertaking, procedures must be in place permitting such structural changes to be timely identified. Article 5:28 Three options are provided to take account of margin agreements. The option referred to in Article 5:28(3) provides that, in its internal model, the financial undertaking takes full account of the effects of margining when estimating EE. Such models are considerably more complex than models that disregard margining. For that reason, the former models must be examined more closely before approval for their use is granted. Financial undertakings which can model EPE without margining but have not yet reached the required higher level where they can model EPE with margining, may avail themselves of the options listed in Article 5:28(1)(a) and (b). The choice between (a) and (b) in effect means that effective EPE may be the lower of the results produced by the two methods. Hence, in such cases, the positive threshold plus the applicable add-on may be calculated using the effective EPE without margining as the floor. If the effects of margining are taken into account by the model itself, De Nederlandsche Bank will not prescribe a minimum margin period of risk, but will closely monitor financial undertakings that would wish to use periods shorter than five day for repos and reverse repos or ten days for derivatives. Articles 5:30 to 5:36 A sound CCR management system comprises determination, measurement, management, approval and internal reporting of CCR. The operational requirements set out in the Subsection CCR control correspond to a significant extent with similar requirements regarding the use of internal models for market 245

246 risk, which is understandable given the fact that, in the final analysis, the magnitude of the CCR exposure value is determined in large measure by (changes in) mark-to-market values and is measured using similar models. Because CCR is a form of credit risk, all conditions for sound credit risk management also apply. One important aspect of CCR is that a financial undertaking may, at the same time, be exposed to counterparty credit risk from transactions or positions in the trading book, the banking book and the settlement of foreign exchange, securities and commodities transactions, and that this risk may come on top of the credit risk vis-à-vis the same counterparty from other transactions in the banking book, such as loan agreements and unused (irrevocable ) credit facilities. Hence, this risk must be managed for each counterparty on an aggregated basis. Article 5:33(3) The financial undertaking must take account of large and concentrated positions, including at any rate positions that can be categorised by group. These may include positions in respect of groups of affiliated counterparties, by sector, by market, et cetera. Article 5:36 The requirement of an independent review of the CCR management system is without prejudice to the fact that integration with the treatment of credit risk and, to the extent possible, that of market risk is generally expected. Articles 5:37 to 5:39 The phrase where appropriate in Article 5:38(1) refers to a situation where a financial undertaking takes account of collateral when calculating the exposure value. The provision on daily estimation set out in Article 5:38(3) refers to the requirement that the financial undertaking must, in principle, be capable of estimating EE on a daily basis; This does not imply, however, that systematic daily estimation would actually be required. If a financial undertaking can make a reasonable case that, for the calculation of its CCR exposure, a less frequent estimation would suffice, there are no objections to such less frequent estimation. Articles 5:40 and 5:41 The stress tests concerned form part of the supervisory review under pillar 2 of the supervisory framework. This means that, as part of the determination of internal capital, explicit account must be taken of an estimate of the potential effects referred to in the Articles concerned. Article 5:42 General and specific wrong-way risks are defined in Article 5:1(o) and (cc), respectively. If, owing to portfolio changes, there are indications that the risks referred to in this Article might increase considerably, this must be reported to De Nederlandsche Bank in the context of the agreed alpha to be applied (for further details, reference is made to the explanatory notes to Articles 5:26 and 5:27). Articles 5:43 to 5:48 The comparisons referred to in Article 5:46(1)(b) and (c) serve to check whether the model operates properly. Where subparagraph (b) is concerned, the comparison focuses on the 246

247 maturity adjustment. For more details, reference is made to the explanatory notes on effective EPE in the general explanatory notes to the IMM. If EPE over the life of the exposure is significantly in excess of estimated EPE over one year, this should be taken into account in the determination of internal capital. Section 5.7 A provision as referred to in Article 5:57 is often referred to as a walkaway clause. Under the arrangement with regard to (exclusively bilateral) contractual netting, crossproduct netting is recognised for the product categories listed in Article 5:53, provided that specific conditions are satisfied. A first condition is that the financial undertaking uses the internal model method for calculating counterparty credit risk. Since cross-product netting is comparatively new to the financial markets and only limited experience with this phenomenon has so far been gained, De Nederlandsche Bank will monitor closely whether the conditions regarding recognition of this type of netting for the purposes in hand are actually met. De Nederlandsche Bank will, if necessary after consultation with other competent authorities involved, have to be convinced that contractual netting is valid under the law of all jurisdictions concerned. If one of these competent authorities is not entirely convinced of such validity, contractual netting will not be recognised as risk-mitigating for either counterparty concerned. De Nederlandsche Bank may accept reasoned legal opinions prepared for individual types of contractual netting. Chapter 6 General The securitisation framework as laid down in this Chapter is underlain by Recital 44 of the recast Banking Directive: In order to ensure that the risks and risk reductions arising from credit institutions' securitisation activities and investments are appropriately reflected in the minimum capital requirements of credit institutions it is necessary to include rules providing for a risk-sensitive and prudentially sound treatment of such activities and investments. Securitisation serves to ensure a high degree of marketability for financial assets and debts in the form of securities. The securitisation of mortgages, credits and other assets involves the realisation of assets by issuing new securities that entitle holders to (part of) the cash flows from those assets. The best-known forms of securitisation are securitised mortgage portfolios (mortgage-backed securities MBS). The general term for securities backed by securitised assets is asset-backed securities (ABS), which also covers securitisations of, for instance, receivables arising from credit card payments and consumer credit. CDOs (collateralised debt obligations) are securities backed by a pool of bonds or loans. Within the securitisation framework, a distinction is made between a traditional and a synthetic securitisation. In a traditional securitisation the underlying exposures are transferred to a Securitisation Special Purpose Entity (SSPE) and the ensuing cash flows are used to service the asset-backed securities. The payments to the investors depend on the performance of the pool of underlying assets and do not derive from a general obligation on the part of the originator financial undertaking. In a synthetic securitisation the transfer of the credit risk in respect of the underlying exposures is effected in full or in part by the use of credit derivatives. The risk for the investor is that he must make payments in the event of poor performance of the asset pool. 247

248 The securitisation framework covers securitisations where two or more risk positions or tranches reflecting different degrees of credit risk are created at the inception of the transaction. This is what distinguishes a securitisation as referred to in the regulations from other capital market transactions. Hence, a so-termed single-tranche transaction, where just one risk position is created, is beyond the scope of the securitisation framework. In this context, a first loss position is considered a tranche, irrespective of whether that position is shown on the SSPE s balance sheet as a liability. A transaction involving credit derivatives is considered a synthetic securitisation if the transaction gives rise to two or more separate tranches. Where credit derivatives are concerned, a materiality threshold for payments, below which no payments are made in the event of a loss, is considered a first loss position and thus leads to a risk transfer in tranches (see Article 4:91). A second characteristic feature of a traditional securitisation is that the payments to investors depend solely on the performance of the underlying exposures; the investors have no claim on the party which initiated the exposures. This distinguishes a securitisation from a covered bond, where a pool of exposures serves as collateral for a debt security issued by the initiating party. The tranched structure that is typical of a securitisation differs from most other forms of subordination of debt instruments in that junior securitisation tranches can absorb losses without interrupting contractual payments to more senior (non-subordinated) tranches. Subordination in a normal subordination structure usually is a matter of priority of rights to the proceeds from liquidation, and therefore involves a suspension of contractual payments to all creditors. It is not always simple to draw a clear-cut distinction between project finance (as a subcategory of Specialised Lending) and securitisation. The principal difference is that, in the case of a securitisation, the cash flow receipts are divided among the securities. First, debt service obligations are satisfied in respect of the senior securities, and only then in respect of the junior (subordinated) securities. If insufficient funds are received to pay all investors, the securitisation continues as normal and the investors in the junior securities suffer a loss. In the case of project finance (and normal corporate exposures), all debt must be satisfied contractually. If the project generates insufficient funds, the exposure is in default and the project is wound up. This distinction between project finance and securitisation will not always be wholly clear-cut. That is why financial undertakings are encouraged to consult with the supervisory authority when there is uncertainty about whether a given transaction should be considered a securitisation or project finance (also see the notes to Article 6:2). Real estate is a case in point, being a category of assets where such uncertainty could arise. Asset-backed securities, credit enhancements, liquidity facilities, etc. are referred to as securitisation exposures or securitisation positions. Any exposure within a securitisation, including interest rate and currency swaps with the SSPE as counterparty, is regarded as a securitisation position. Interest rate and currency swaps and other derivative contracts with the SSPE are treated as exposures to the SSPE, which must be risk-weighted. Explanatory notes to individual Articles Article 6:1 Most of the definitions have been taken from Annex IX, Part 1 of the recast Banking Directive. The other definitions regarding securitisation from the recast Banking Directive (Article 4(36) to (44)) can be found in Article 1 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). 248

249 In Chapter 6 a financial undertaking acting as originator is denoted as originator financial undertaking. In Chapter 6 the securitised assets are denoted as exposures, pool of exposures or underlying exposures. In a securitisation, the credit risk associated with these exposures is divided into tranches. In a traditional securitisation, the tranches consist of the securities issued by the SSPE; in a synthetic securitisation, they consist of the credit derivative contracts with the originator and for the rest of funded or unfunded credit enhancements. Hence, a tranche may also consist of a credit enhancement in the form of excess spread retained (up to a certain level) by the SSPE to absorb first losses. Each exposure within a securitisation is denoted by the term securitisation position. Thus, the term encompasses: - tranches in the securitisation; - exposures on account of derivative contracts with an SSPE, such as currency and interest rate derivatives, repurchase agreements and other financial instruments with an SSPE as the counterparty; - guarantees and liquidity facilities in support of a securitisation. Article 6:1 (a) ABCP programme (asset-backed commercial paper programme) An asset-backed commercial paper programme is a securitisation where an SSPE issues commercial paper and uses the proceeds to purchase exposures. An asset-backed commercial paper programme (also referred to as an ABCP conduit) usually serves as a funding vehicle to provide customers of a financial undertaking (the sponsor) with a means to access the capital markets. Asset-backed commercial paper SSPEs issue short-term debt instruments (commercial paper) and use the proceeds to purchase exposures, often short-term trade receivables. Such conduits are also used to securitise exposures originated by a financial undertaking or to re-securitise existing securitisation positions. (b) (clean-up call option) A clean-up call option entitles the originator to end the securitisation before all securitised exposures have been amortised (before contractual maturity or otherwise). In a traditional securitisation, the securitised exposures are repurchased by the originator when the amount of underlying exposures has fallen below a certain level. In a synthetic securitisation, the cleanup call option may take the form of a clause terminating the credit protection. (c) (excess spread) Excess spread is equal to gross finance charge collections and other fee income received from the securitised exposures net of costs and expenses. The costs and expenses for the determination of excess spread are defined in the transaction documentation and may consist of, for instance, charge-offs, payments made to the investors, servicing fees and other expenses incurred by an SSPE. (d) (K irb ) The capital requirement under the internal ratings based (IRB) approach for securitised exposures had they not been securitised is calculated in accordance with Chapter 3 of the present Regulation. Chapter 3 also provides in which exceptional cases an IRB financial undertaking is permitted to use the standardised approach for calculating the capital charge for certain exposures. These provisions are applicable mutatis mutandis for the determination of K irb. 249

250 (e) (K irbr ) K irbr is the ratio of (a) K irb to (b) the sum of the exposure values of the exposures that have been securitised. K irbr is expressed in decimal form (e.g. K irb equal to 15% of the pool would be expressed as K irbr of 0.15). (f) (liquidity facility) A liquidity facility is used to address cash flow mismatches between the securitised exposures and the securities issued. Liquidity facilities provided by sponsors to an asset-backed commercial paper conduit may be used to cover short-term market disruptions that prohibit the roll-over of commercial paper or the issuance of new notes, but may at the same time constitute a (second loss) credit enhancement. Article 6:2 Chapter 6 of the present Regulation relates to the determination of the regulatory capital requirements for the credit risk (including dilution risk) in respect of securitised exposures and securitisation positions, and to the determination of the risk weights on account of the counterparty risk associated with securitisation positions, such as interest rate and currency swaps in the trading book. These provisions are underlain by Article 83 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). For a financial undertaking acting as originator or sponsor of a securitisation, Title 6.2 and possibly Title 6.6 are relevant. For a financial undertaking which invests in tranches of a securitisation as originator, sponsor or third party, or holds other securitisation positions, Titles 6.3 to 6.5 are relevant. When determining the regulatory capital requirement for a securitisation position, a financial undertaking will tend to be guided by the position s economic substance rather than its legal form. Similarly, De Nederlandsche Bank will mainly consider the economic substance of a transaction when assessing whether it should be subject to the provisions of the securitisation framework for determining the regulatory capital requirement. Financial undertakings are encouraged to consult with the supervisory authority when there is uncertainty about whether a given transaction should be considered a securitisation. Interest rate and currency swaps and other derivative contracts with an SSPE are treated as an exposure to the SSPE, which must be risk-weighted. The exposure value of the position is determined as the exposure at default (EAD) in accordance with the provisions of Chapter 5 of the present Regulation (see Article 6:14(4)). Where derivate contracts with an SSPE in the trading book are concerned, the applicable risk weight for the counterparty credit risk is also governed by the provisions of that Chapter. This follows from the provisions for the trading book as contained in Article 3:30(1) of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico), which states that a financial undertaking must hold capital against counterparty credit risk ensuing from a position in OTC derivatives and credit derivatives. Article 3:30(2) of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) provides that the exposure value of a position and the risk-weighted exposure amount for OTC derivatives and credit derivatives is to be calculated in accordance with the provisions of Articles 76 to 101 of the recast Banking Directive. Article 85(1)(f) of the recast Banking Directive defines securitisation positions as a separate exposure class, and Article 87(10) provides that the risk-weighted exposure amounts for securitisation positions must be calculated in accordance with the securitisation framework (Articles 94 to 101 of the recast Banking Directive). 250

251 The risk weighting for position risk of such securitisation positions in the trading book is not dealt with in this Chapter; instead, it has been provided for in the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). Asset-backed securities held in the trading book are not subject to a risk weight for counterparty credit risk but are subject to a risk weight for position risk. Articles 6:3 to 6:6 These Articles specify the conditions for recognition of significant risk transfer for the purposes of determining the regulatory capital requirements. These conditions apply under both the standardised and the internal ratings based approach and do not allow for national discretion. These supervisory regulations are underlain by Article 84 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). If an originator financial undertaking transfers significant credit risk to third parties and satisfies the minimum conditions for recognition of the transfer, it may exclude the relevant risk from the calculation of the regulatory capital requirements. This is, incidentally, unconnected with the question whether the relevant assets have actually been removed from the commercial balance sheet. Considering a financial undertaking s involvement in a securitisation, for instance in the form of entitlements to excess profits, an SSPE is on occasion consolidated. If a financial undertaking does not satisfy all minimum conditions for recognition of significant credit risk transfer, all risk-weighted exposure amounts must be calculated as if there had been no securitisation. Hence, in such cases, the capital charge will not be reduced. Article 6:3(a) Qualified legal counsel is understood to be a legally trained natural person or a legal entity with legal expertise who/which, on the basis of his/her/its statutory or professional task, is able to guarantee fulfilment of the requirement that certain exposures, securitisation positions, securities, collateral or other economic assets remain beyond the reach of the originator financial undertaking and its creditors, also in the event of bankruptcy, debt rescheduling, suspension of payments (surséance van betaling) or receivership. Examples are a receiver, a civil-law notary, a corporate lawyer or an attorney-at-law, or offices where such professionals are employed. The independence of the natural person or legal entity concerned must be beyond doubt. This implies that, in the event of in-house legal counsel, in-house procedures must be in place warranting independent judgment. Article 6:3(b) The originator financial undertaking is not allowed to maintain effective or indirect control over the transferred exposures, except for its powers under a permitted clean-up call option. A financial undertaking is only considered to have maintained effective control over the transferred exposures if it has the right to repurchase the previously transferred exposures from the transferee in order to realise their benefits or if it is obliged to re-assume the transferred risk. This means that the originator financial undertaking may not have a call option on the transferred exposures, apart from permitted clean-up call options. The originator financial undertaking s retention of servicing rights to the exposures does not necessarily constitute indirect control over the exposures. Article 6:3(c) Acknowledgement by the SSPE that the originator is not liable for losses may be achieved by including an explicit and clear statement in the prospectus (or similar documentation) to the 251

252 effect that the originator will not support the securitisation positions or the SSPE, and will not offset any losses on the underlying exposures. Article 6:3(d) Investors may be informed by including an explicit and clear statement in the prospectus (or similar documentation) to the effect that the originator is under no obligation to repurchase a securitised exposure. A put option written by the originator constitutes an obligation to repurchase and is therefore not allowed. An originator is allowed to give security and issue warranties in respect of the securitised exposures at the time of the risk transfer, possibly resulting in an obligatory repurchase of securitised exposures, provided that such security and warranties are not in respect of the future credit quality of the underlying exposures and do not go beyond those customary in a sale of assets. Article 6:3(f) Repurchase after the risks have been transferred because a securitised exposure did not meet the eligibility criteria is allowed only if the ineligibility already existed at the time of the transfer. If ineligibility is the result of a restructuring of the agreement after the risk transfer, this is for the risk of the investors. A possible repurchase has to be effected on market terms reflecting the deterioration of the credit quality. Only thus can an effective risk transfer be achieved, losses being borne by the investors and not by the originator. It is the originator s responsibility to make sure that clauses that provide for a possible repurchase do not provide credit enhancement. Article 6:3(g) After the risk transfer, an originator is not allowed to bear any (recurring) costs ensuing from the securitisation. However, an originator may use excess spread to pay for the costs of the securitisation, but only if that excess spread is received. If the excess spread is not received, the SSPE must pay the costs, not the originator. If an originator pays some of the costs, but receives a compensation, this is not regarded as bearing costs. Article 6:3(h) The fact that the originator financial undertaking is not allowed to remit funds to the SSPE unless and until these have been received is without prejudice to cash advance facilities and liquidity facilities. Article 6:4 If an SSPE is not financially independent, an originator financial undertaking may feel compelled to support the SSPE and repurchase the securitised exposures. Article 6:5(2) One important condition is that any clause that would lead to additional credit enhancement after the inception of the transaction is ruled out, including clauses that allow for increases in a retained first loss position by the originator financial undertaking after the transaction s inception. The volume of the credit enhancement by the originator is maximised at the transaction s inception and any excess over this maximum is ruled out by this Article. An early amortisation provision as such is not regarded as a clause allowing additional credit enhancement. Substitution by the originator financial undertaking of exposures within the pool is permitted, provided that this does not involve (hidden) credit enhancement. The substitution or removal of an exposure from the pool ends the protection on that exposure. Since the 252

253 originator financial undertaking will again be exposed to the credit risk, the possibility to effect such transactions poses a threat to an effective risk transfer. Moreover, substitution may be a way to provide additional credit enhancement to the securitisation and support investors. This is true of substitutions, replenishments, removals and similar transactions, such as the (back-to-back) refinancing of a securitised exposure which would effectively constitute a removal (irrespective of the new loan conditions). Originator financial undertakings should exercise restraint in substituting or removing exposures and should limit such transactions to a minimum. If the financial undertaking changes the composition of a pool frequently (for example, compared to other securitisations), or without clear necessity, this may prompt De Nederlandsche Bank to impose restrictions. Within the conditions set, it may be legitimate to replace a securitised exposure to comply with contractual requirements, for example with respect to diversification of the pool. Article 6:5(3) If a clean-up call option does not meet the conditions set in this paragraph, the risk transfer is not recognised. Article 6:5(3)(b) This means that at least 90% of the original pool of securitised exposures must have been amortised when the clean-up call option is exercised. Article 6:5(3)(c) and (d) If the clean-up call option proves to act as credit enhancement, it is regarded as implicit support provided by the originator, as referred to in Article 87(1) and (2) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). Article 6:6(b) In a synthetic securitisation, the credit derivatives used must meet the requirements for the recognition of credit protection as set out in Chapter 4. Guarantees and credit derivatives must comply with the requirement that they provide for timely settlement. Timely settlement means that, in the event of default by the obligor, the financial undertaking providing the protection is compensated for its losses at short notice. For instance, bankruptcy proceedings may take years to complete, and it is not considered prudent if a financial undertaking has to wait so long before receiving compensation for the losses incurred. Article 4:80 provides that, in the case of cash settlement of credit derivatives, settlement should be completed as soon as possible in line with market standards and the valuation procedures used must be sound. In the case of (bilateral) loans, for which no reliable market price can be obtained, a longer period may be needed to determine the amount of the pay-out. The settlement amount must represent a reasonable and sufficiently conservative estimate of the expected losses, based on the financial undertaking s experience, and may require an independent third party view. This does not preclude the originator from performing a full work-out of the position. Timely settlement only refers to the pay-out to the originator by the protection seller (the SSPE or the counterparty to the swap). This is independent of the relations between the originator and the obligor, which may continue after settlement. Article 6:6(c) Qualified legal counsel is understood to be a legally trained natural person or a legal entity with legal expertise who/which, on the basis of his/her/its statutory or professional task, is able to guarantee fulfilment of the requirement of enforceability of the credit protection in all 253

254 relevant jurisdictions. Examples are a receiver, a civil-law notary, a corporate lawyer or an attorney-at-law, or offices where such professionals are employed. The independence of the natural person or legal entity concerned must be beyond doubt. This implies that, in the event of in-house legal counsel, in-house procedures must be in place warranting independent judgment. Article 6:6(d)(i) A materiality threshold explicitly does not mean a deduction from or discount on a contractual payment when a credit event has taken place. A materiality threshold can take the form of either a payment requirement or a default requirement. De Nederlandsche Bank is of the opinion that, in principle, a non-substantial materiality threshold entails (a) a contractual default requirement smaller than the notional amount of the underlying asset and (b) a contractual payment requirement smaller than one interest payment on the underlying asset or a contractual payment requirement smaller than 3% of the notional amount of the underlying asset. In individual cases, a materiality threshold may be effectively put out of action, for example through cross default or cross acceleration provisions. It is the responsibility of the financial undertaking to determine whether or not a materiality threshold is substantial, taking into account the characteristics of the underlying asset. It should be noted that the definition of materiality threshold refers to the individual securitised exposures and not to the pool as a whole. Article 6:6(d)(iii) One important condition is that any clause that would lead to additional credit enhancement after the inception of the transaction is ruled out, including clauses that allow for increases in a retained first loss position by the originator financial undertaking after the transaction s inception. The volume of the credit enhancement by the originator is maximised at the transaction s inception and any excess over this maximum is ruled out by this subparagraph of this Article. An early amortisation provision as such is not regarded as a clause allowing additional credit enhancement. Article 6:7 One major condition for recognition of a securitisation for the calculation of risk-weighted exposure amounts is constituted by significant risk transfer. This condition seeks to guard against the risk that a financial undertaking may deliberately or otherwise structure a securitisation in such a manner that the operational conditions are met but that in a material sense no or little risk is transferred in proportion to the original credit risk. In such cases, the capital charges applying after the securitisation would be out of proportion to those applying before the securitisation. The originator financial undertaking must be able to show that this condition is satisfied. It must check compliance with the condition at the transaction s inception and when material changes are effected. There is no single numerical criterion for significant risk transfer, but De Nederlandsche Bank allows for the following aspects in its assessment. The transaction must involve the transfer of a proportional part of the credit risk to at least one independent third party from the transaction s inception and on an ongoing basis. The criterion for testing compliance with this requirement, as stated in the Article, is that the proportion of the credit risk transferred to third parties should be at least commensurate with the proportional reduction of the risk-weighted exposure amounts. The financial undertaking calculates this measure for a securitisation, so that it may submit the results to De Nederlandsche Bank on 254

255 request. The financial undertaking applies the measure at the entity level subject to the capital charge. The proportion of the credit risk transferred to third parties concerns the ratio of the credit risk transferred to third parties to the original credit risk. The originator financial undertaking quantifies the risks before securitisation and those after securitisation using an in-house method which is suited to the specific securitisation and consistent with its internal processes. It may do so on the basis of an in-house capital allocation model; alternatively, it may quantify the credit risks using (elements from) the standardised approach or the internal ratings based approach for the determination of riskweighted exposure amounts. The financial undertaking determines the proportional reduction of the risk-weighted exposure amounts by comparing (i) the regulatory capital requirement before securitisation (which is, in principle, known to the financial undertaking) and (ii) the total regulatory capital requirement after securitisation. This shows the percentage reduction in capital charges. The financial undertaking determines the two capital requirements using the standardised approach or the internal ratings based approach, as applicable. Subsequently, the originator financial undertaking may check whether the proportion of the credit risk transferred to third parties is approximately commensurate or more than commensurate with the proportional reduction of the risk-weighted exposure amounts. If, after securitisation, a financial undertaking retains x% of the credit risk, the risk-weighted exposure amounts must be at least equal to x% of the risk-weighted exposure amounts of the exposures had they not been securitised, in order to satisfy the criterion of significant risk transfer. The calculation of this measure is illustrated in the example below. Example A portfolio of receivables has a value of 100 and is subject to a regulatory capital charge of 4. The securitisation has four tranches of 80, 15, 4 and 1. Using its in-house method, the financial undertaking quantifies the credit risks as follows: Class A: 1.28 Class B: 0.60 Class C: 0.32 Class D: 1.00 Hence, the total risk in respect of the four tranches has been determined at If the originator financial undertaking transfers classes B and C to third parties and retains Classes A and D, 0.92/3.20 = 28.75% of the risk is transferred, so that the proportion of the transferred risk is 28.75%. Example 1. Suppose that the capital charge after securitisation (that is, in respect of the retained tranches in classes A and D) is 3. In that case, the reduction in the capital charge is ( 4-3)/ 4 = 25%, meaning that the proportion of the transferred risk is more than commensurate with the reduction in the risk-weighted exposure amounts, so that the condition of significant risk transfer set in paragraph 1 is satisfied. Example 2. Suppose that the capital charge for the retained tranches in classes A and D is In that case, the reduction in the capital charge is 1.50/ 4 = 37.5%, which is more than commensurate with the reduction in risk-weighted exposure amounts. In that case, the originator financial undertaking sets the risk-weighted exposure amounts at 71.25% (that is, 100% %) of the risk-weighted exposure amounts of the exposures had they not been securitised, or 71.25% * 4 = By setting the risk-weighted exposure amounts at a level not below that commensurate with the retained credit risk, the financial undertaking yet satisfies the criterion. 255

256 With due observance of the principle of significant risk transfer, a financial undertaking may invest in its own securitisation positions. Situations are conceivable where a financial undertaking does not wish to transfer risk, because it wants to retain the senior position for liquidity purposes and because market conditions for more junior tranches are unfavourable. If no risk is transferred, the capital charge remains 4. Hence, at first the capital charge is not reduced, but such reduction remains possible in the future upon the sale of junior tranches. Article 6:8(1) If a synthetic securitisation is recognised for the purposes of calculating the regulatory capital requirements, the originator financial undertaking retains the underlying exposures on its own balance sheet but these exposures are now subject to the securitisation framework. Under this Article, the originator financial undertaking must calculate the risk-weighted exposure amounts for all tranches of the securitisation in accordance with the provisions of this Chapter, including the provisions regarding recognition of credit risk mitigation, instead of calculating them in accordance with the provisions of Articles 78 to 89 of the recast Banking Directive. This means that, in the event that a tranche is transferred to a third party by means of unfunded credit protection, the originator financial undertaking must, when calculating the risk-weighted exposure amounts, apply to the tranche the risk weight of the third party concerned. Article 6:8(2) Owing to the treatment in the context of the securitisation framework, the expected loss amount of the securitised exposures is set at zero in the calculation of the regulatory capital requirement and is, hence, excluded from the calculation of the expected loss amounts for all exposures of the financial undertaking. It should be noted that the expected loss amount of the underlying exposures is, however, always included in the definition of K irb. Among other uses, this constitutes an important input for the supervisory formula method (see Article 6:37) as well as the cap for the maximisation of the capital charge (see Article 6:29). The expected loss amounts of the underlying exposures must also be included in the calculation of the Risk-Weighted Assets (RW(Ass)) under Article 6:9. Article 6:9 In a synthetic securitisation, maturity mismatches may limit the risk transfer and may thus lead to an additional capital charge. If the maturity of the underlying exposures differs from the duration of the securitisation, a maturity mismatch arises. This may mean that the securitisation ends before the exposures have been repaid. Hence, after the end of the securitisation, the originator financial undertaking receives the remaining risk back. Against this risk, it must build up capital, in order to be ready for the return of the exposures. The method requires the build-up of the capital buffer to be completed three months (represented in the formula by t* = 0.25) before the end of the protection in accordance with a weighting factor which increases over time and is applied to the current outstanding amount. The capital build-up against a synthetic securitisation involving an incomplete hedge (over time) is effected in the same manner as for a maturity mismatch in respect of credit risk mitigating techniques, as provided for in Chapter 4. A provision which is of particular significance for securitisations concerns the determination of the effective maturity of a credit derivative if the receiver of the protection (that is, the originator financial undertaking) has an option to terminate the protection (that is, the securitisation) and the conditions of the agreement underlying the protection include 256

257 incentives that would make it attractive for the financial undertaking to terminate the transaction before contractual maturity. Article 4:98 in Chapter 4 provides that the maturity of the protection is considered to be the period until the first possible date on which that option can be exercised. Examples of incentives that might prompt the originator financial undertaking to terminate the securitisation, are the following situations: - the originator financial undertaking must pay an interest step-up, either directly or indirectly through a swap; - excess spread is collected in a reserve account, and the originator financial undertaking can claim the funds only after termination of the securitisation. These are all examples of situations that make it very likely, though formally not compulsory, for the originator financial undertaking to terminate the securitisation, making it necessary for the originator financial undertaking to build up capital. An interest step-up is an increase in the interest payments to one or more holders of securitisation positions that becomes effective after a certain time, if the originator financial undertaking (or the SSPE, as applicable) does not exercise the right to terminate the securitisation before its legal maturity date. The main purpose of an interest step-up is to signal to the market that that right will be exercised. The resulting market perception that the securitisation has a shorter maturity than its legal maturity will influence the pricing of the securitisation, putting pressure on the originator financial undertaking or the SSPE to actually exercise the call option. Call options that explicitly refer to predefined unforeseen events other than events related to the credit quality of the securitised exposures or the creditworthiness of the originator, such as an unforeseen change in the tax or regulatory regime that would render a securitisation uneconomical, do not result in a shortening of the effective maturity. These call options may be exercised because the occurrence of the event cannot be influenced by the financial undertaking. Moreover, they bear no relation to the credit quality of the securitised exposures. In addition, the market will not have expectations regarding the exercise of the option at the time the securitisation is effected. When determining the maturity mismatch, the financial undertaking must ignore the risk-weighted exposure amounts for tranches which have been assigned a risk weight of 1250%. Hence, these securitisation positions retain their risk weight of 1250% (or are deducted from regulatory capital). It should be noted that this Article refers to a situation where the termination of the credit protection leads to the termination of the division into two or more different tranches and, hence, to the termination of the securitisation. This situation arises when all tranches have the same maturity mismatch relative to the underlying exposures. However, if the maturity mismatch does not concern all tranches, termination of the credit protection on the tranches with the shortest effective maturity does lead to fewer tranches but does not lead to termination of the division into tranches. In that case, there is credit protection on a securitisation position instead of credit protection under which the division into tranches has been effected. In such a situation, those tranches where the termination does not lead to termination of the securitisation are not subject to the provisions of this Article but to the provisions on credit risk mitigation (Chapter 4). This is explained in more detail in the notes to Article 6:26. Article 6:10(1) The provisions of this Article are applicable when an originator financial undertaking retains an exposure under a credit agreement of which another part is securitised. This situation arises, for example, if an exposure of 50 out of a total loan of 100 is securitised. These 257

258 provisions also apply if a loan of 50 is securitised in full, but another loan shares the same security rights. In both cases, the retained exposure may be funded, i.e. a cash position, as well as unfunded, i.e. an off-balance sheet commitment. It is important that the documentation should clearly state how the security right is shared between the originator financial undertaking and the SSPE. If the conditions set out in this paragraph are not met, the risk transfer is not recognised and all securitised exposures must be included in the calculation of the originator financial undertaking s risk-weighted exposure amounts. Article 6:10(2) This paragraph is applicable when an originator financial undertaking retains a newly created exposure while another exposure (whether or not under the same credit agreement) has already been securitised. Further advances may arise if a mortgage loan agreement provides for the possibility to increase the amount drawn up to the amount stated in the mortgage deed or if the borrower were to re-draw amounts repaid previously. This refers to situations where there is no obligation to grant this further advance and where a normal credit review is conducted before the amount of the mortgage loan is increased. Article 6:11 The basic principle is that a true service must be established, meaning that the agreement is such that the servicer s legal and economic liability is limited to the risks ensuing from the servicing agreement. The servicer may demonstrate to investors that it has no (reputational) obligations to support losses by including a clear and unambiguous statement to that effect in the prospectus. The restrictions in respect of a servicer s role in a securitisation are without prejudice to the fact that the financial undertaking may be involved in the securitisation in other capacities, such as counterparty to a derivative contract with the SSPE. Article 6:12 An originator financial undertaking may be given the possibility to repurchase the securitised exposures from the SSPE, for instance if the SSPE is able to exercise a call option to terminate the securitisation. If the conditions set out in this Article are satisfied, repurchase of the securitised exposures on market terms may be effected without the prior consent of De Nederlandsche Bank. Hence, a temporary or non-recurring decrease in the regulatory capital ratio need not preclude repurchase. Nor does a structural decrease to a level which is not highly adverse preclude repurchase. De Nederlandsche Bank assesses the structural effect of the repurchase of securitised exposures on the regulatory capital ratio in the light of the financial undertaking s capital planning process. This assessment is effected in the context of the assessment of the Internal Capital Adequacy Assessment Process (ICAAP), which forms part of the Supervisory Review (pillar 2). Article 6:13 This Article outlines how a financial undertaking must determine the risk-weighted exposure amounts for retained securitisation positions under Article 85(1) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). The provisions regarding recognition of credit risk mitigation (see Articles 80 to 82(3) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft)) apply mutatis mutandis to the individual tranches of the securitisation. Article 6:13(3) 258

259 Article 94(2), opening sentence, in conjunction with Article 94(2)(h) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) offers financial undertakings the option to deduct securitisation positions which have been assigned a risk weight of 1250% from tier 1 capital and tier 2 capital (to the extent of one-half from each). In this context, reference is made to Article 6:27(1) and Article 6:47(3) as well as the notes to these Articles. It should be noted that this is without prejudice to the provisions of Article 94(2), opening sentence, of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), which states that the originator financial undertaking must deduct the value of a certain type of securitisation position from tier 1 capital. This refers to an asset item which the originator financial undertaking has included in its balance sheet by capitalising expected income from a securitisation transaction where this income serves as credit enhancement. In some cases the credit enhancement is provided in the form of a deferred purchase price, an interest-only strip or excess spread collected in a reserve account. These have in common that they will result in future income for the originator, provided that the pool of exposures performs well. If an originator financial undertaking has included such expected, but uncertain, future income in its balance sheet (a so-termed gain-on-sale), this has resulted in an increase in tier 1 capital. If they serve as credit enhancement, the originator financial undertaking must deduct such items from tier 1 capital. When determining the amount to be deducted, the effects of taxes on profits may be taken into account. Hence, for a securitisation position the deduction from capital may, in appropriate cases, take precedence over the calculation of risk-weighted exposure amounts under Titles 6.3 to 6.5. Article 6:14 For the determination of the risk-weighted exposure amounts, risk weights are applied to the exposure value of a securitisation position or to a converted value. Such a converted value is determined with the aid of a conversion figure. For example, subject to certain conditions, some off-balance sheet securitisation positions, such as liquidity facilities, have a conversion figure of less than 100%. Derivative contracts which are concluded by a financial undertaking with an SSPE as counterparty are treated in accordance with the securitisation framework as set out in Chapter 5 of the present Regulation and Annex B to the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft). This means that the position of a derivative contract in the seniority of the tranches of a securitisation determines the credit quality step applying to the contract. For instance, a swap agreement is used to immunise the risk-transferring entity from interest rate risk as the SSPE itself has no capital base which may serve as a buffer. The originator or sponsor often acts, directly or indirectly, as swap counterparty. It is not allowed to use the swap to provide credit enhancement, for instance by subordinating the amounts due under the swap agreement to payments to investors. In the case of a swap concluded on market terms, the payments to the most senior securitisation position are subordinated to payments under the swap agreement. Failure of the originator or sponsor to charge appropriate fees or other compensation is also regarded as credit enhancement. A swap agreement on market terms also implies that, at the time of its conclusion, it has a positive or zero value (on a net present value basis) for the financial undertaking. If a swap is also used to exchange other amounts, these amounts are separately identified and tested against this provision. If a swap also provides for the possible payment of an interest step-up, the risk of paying this step-up must be taken into account in an appropriate manner. 259

260 Paragraph 5 concerns the application of credit risk mitigation by means of funded credit protection, reducing the exposure value of the position in proportion to the value of the collateral, allowing for any haircuts (volatility adjustment). The term overlapping as used in paragraph 6 of this Article means that the securitisation positions are wholly or partly subject to the same risk, so that, to the extent that the positions overlap, there is just one single securitisation position. This feature is notably found in ABCP programmes, where pool-specific and programme-wide facilities may partly overlap. Article 6:15 In the same way as under the standardised approach to credit risk, the securitisation framework relies on external credit assessments or ratings assigned by External Credit Assessment Institutions (ECAIs). For securitisations, external ratings may be relied on both under the standardised and under the IRB approach. The use of external ratings offers an advantage in that such ratings constitute an assessment of both the structure of the securitisation and the credit quality of the underlying exposures as such. In securitisations, the use of external ratings is subject to the same requirements as under the standardised approach to credit risk. This means that the supervisory authority must recognise a credit assessment institution before a financial undertaking may rely on that credit assessment institution as a nominated credit assessment institution. The supervisory authority must publish its recognition procedure and a list of eligible credit assessment institutions (Article 88 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), which refers to Article 97(2) of the recast Banking Directive, among other provisions). Supervisory authorities within the EU may take over each other s recognitions. The same holds for the mappings of the external ratings in risk weights: they must be determined by the supervisory authority and, within the EU, they may be taken over by other supervisory authorities. Considering the major significance of external ratings in the securitisation framework, their treatment is stricter than under the standardised approach to credit risk (Chapter 3). This is reflected in the following supplementary requirements: (a) in the securitisation framework, external ratings must be publicly available and must be included in the credit assessment institution s transition matrix. This serves to prevent a credit assessment institution from being overly compliant when assigning a rating on a bilateral basis, since in such cases there is no great need for transparency. Ratings are only considered to be publicly available if they have been made public in a forum which is accessible to the public and are included in the transition matrix of the credit assessment institution. Ratings which have been made available to a limited number of entities only are not regarded as publicly accessible. This also means that an adjustment of an external rating (upgrade or downgrade) must be publicly accessible forthwith; (b) the rating must reflect all payments and not just some of them. In practice, this means that the rating must cover at least interest payments and principal repayments. Hence, an external rating which merely covers the principal amount is not permitted; (c) furthermore, the credit assessment institution must have demonstrated ability (Article 88 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), which refers to Article 97(2) of the recast Banking Directive, among other provisions) in the area of securitisation, since assessing a securitisation is different from assessing a corporation; (d) within a single securitisation, a financial undertaking must consistently use the ratings of one and the same credit assessment institution so as to prevent cherry-picking. 260

261 In view of the almost identical procedures for recognition and use of external ratings, De Nederlandsche Bank has opted for the same procedures as under the standardised approach to credit risk. This means that: (a) a financial undertaking wishing to use a certain external rating may ask the supervisory authority to recognise the credit assessment institution concerned, and (b) financial undertakings must first themselves evaluate the eligibility of a credit assessment institution. By virtue of the provisions of Annex IX, part 3 (points 8 and 9) of the recast Banking Directive, De Nederlandsche Bank determines with which credit quality step in the tables in Titles 6.4 and 6.5 each rating of an eligible credit assessment institution should be associated. In doing so, it differentiates between the relative degrees of risk expressed by each rating. De Nederlandsche Bank considers quantitative factors, such as default and/or loss rates, and qualitative factors, such as the range of transactions assessed by the credit assessment institution and the meaning of the rating. De Nederlandsche Bank seeks to ensure that securitisation positions to which the same risk weight is applied on the basis of the ratings of eligible credit assessment institutions are subject to equivalent degrees of credit risk. This includes modifying, as appropriate, its determination as to the credit quality step with which a particular rating should be associated. Article 6:18 For long-term credit assessments, the risk weights based on external ratings under the standardised approach are as follows: 13 External rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ and below or unrated Risk weight 20% 50% 100% 350% Deduction from regulatory capital or 1250% risk weight For short-term credit assessments, the risk weights are as follows: External rating A1/P1 A2/P2 A3/P3 All other ratings or unrated Risk weight 20% 50% 100% Deduction from regulatory capital or 1250% risk weight Article 6:19 It is possible that, on the grounds of the risk weights attaching to retained securitisation positions, a financial undertaking would have to hold more capital after than before securitisation. This Article provides for a cap on the capital charge after securitisation. In order to be able to calculate the cap, a financial undertaking must permanently monitor the securitised exposures. The introduction of a cap is underlain by two reasons. First, it is strange that a financial undertaking might have to hold more capital against credit risk after than before a securitisation, since it has transferred part of the risk and is thus subject to less credit risk. A 13 The external ratings mentioned in these explanatory notes are for illustration purposes only and do not denote any preference for or approval of a certain rating system employed by a credit assessment institution. 261

262 cap does away with this objection and, hence, prevents situations where a financial undertaking would be forced to refrain from a securitisation and would thus be hampered in its operations. Moreover, this treatment is in line with Chapter 4, which likewise includes a stipulation to the effect that such techniques must never be allowed to lead to a higher capital charge. Articles 6:20 to 6:25 General Despite the fact that many traditional and synthetic securitisation exposures are assigned external ratings by credit assessment institutions, notably synthetic securitisations also include externally unrated elements. Externally unrated securitisation positions are subject to a number of treatments, which are briefly set out below: - the financial undertaking may look through to the underlying exposures, after which the average risk weight within the pool should be applied, multiplied by a concentration ratio (see Section 4.2); - letters of credit (LOC) granted by a sponsor to an ABCP conduit as second loss tranche that are demonstrably equivalent to an investment grade external rating are risk-weighted at a minimum of 100% (see Section 4.3); - in the case of liquidity facilities meeting a number of conditions (such as the presence of an asset quality test), a conversion figure must be applied, after which the financial undertaking may look through to the underlying exposures. Subsequently, the highest risk weight attaching to any exposure in the pool must be applied (see Section 4.4). Article 6:20 This Article provides for a so-termed gross-up treatment for externally unrated securitisation positions. The treatment may be suitable for, for instance, unrated mezzanine securitisation positions. An example may help to clarify the method. Example Suppose that a securitisation has the following, simple structure: Senior 90 Mezzanine 6 First loss 4 + Total 100 Furthermore, suppose that the average risk weight of the underlying exposures is 75%. Under the method set out in this Article, the risk weight of an unrated mezzanine securitisation position must be calculated as if all the risk were concentrated in the 6 mezzanine and the 4 first loss securitisation position. Thus, the risk weight for the mezzanine securitisation position is: 100 / 10 * 75% = 750%. Article 6:21(2)(b) A second loss credit enhancement may be of a relatively high credit quality. In most cases, no external rating is available for second loss credit enhancements provided to asset-backed commercial paper conduits, although they usually are of investment grade quality. In such cases, a financial undertaking may use internal ratings to show that the securitisation position is of investment grade credit quality. Article 6:21(2)(d) 262

263 The exception set out in subparagraph (d) is intended to deal with situations where new pools of exposures are added to an existing asset-backed commercial paper conduit, causing the credit enhancement to increase. However, the new credit enhancement may not be used to increase or improve the credit enhancement for the existing pools. It is not permitted to increase or improve the credit enhancement for other securitisations. Articles 6:22 to 6:25 Two exceptions apart, liquidity facilities are not eligible for a 0% conversion figure and, hence, a 0% risk weight. Moreover, operational requirements are set in order to make sure that liquidity facilities provide no credit enhancement to the securitisation. In effect, this concerns liquidity facilities granted to securitisations by sponsor financial undertakings. Although many of these liquidity facilities are structured in such a way that the risk is limited, a certain capital charge is desirable, as they may be drawn in some cases. The treatment is as follows: Conversion figures for liquidity facilities Liquidity facility Conversion figure Maturity < one year 20% Maturity > one year 50% General market disruption 0% Cash advance facility 0% Article 6:22 This Article sets out the conditions for an eligible liquidity facility for the calculation of the risk-weighted exposure amount. One of the conditions is that the facility cannot be used to provide credit support to cover losses. This includes losses that have already been sustained when the facility is drawn, for instance because liquidity is provided in respect of exposures that are already in default at the time of the draw or because exposures are acquired at a price in excess of their fair value. A liquidity facility is also drawn when the exposures were acquired under an asset purchase agreement or when a loan (loan liquidity agreement) is extended funding the securitisation positions. A pool-specific liquidity facility for an ABCP programme is usually provided by the sponsor, and may not be used to provide liquidity support to other pools. The facility may amount to approximately 80% to 90% of the liquidity needs of (the specific pool in) the ABCP conduit. In most cases, the sponsor also provides a programme-wide facility covering all of the pools in the conduit up to a certain percentage of the outstanding commercial paper, for example 10%. The facility may take the form of an irrevocable or a standby credit facility. Article 6:24 This Article concerns liquidity facilities that may be drawn only in the event of a general market disruption. A general market disruption arises when more than one SSPE across different transactions is unable to roll over maturing commercial paper and that inability is not the result of an impairment of the SSPE s creditworthiness or the credit quality of the securitised exposures. Article 6:25 Under the standardised approach, there is a possibility to assign a risk weight of 0% to servicer cash advance facilities, provided that certain conditions are met. A servicer cash advance is an advance granted by the servicer, mostly the originator, to the SSPE to ensure timely payment to investors, for instance in cases of timing differences between collections 263

264 and payments. The zero risk weight is only permitted if the facility is unconditionally cancellable and if the servicer s securitisation position is senior to investors securitisation positions. A servicer cash advance is structured in such a way as to minimise risk. The funds are only lent to the SSPE under very strict conditions and, if the SSPE collects funds, the servicer is among the first to be repaid, in any case prior to the investors in AAA securities. As a result, the risk of such a facility may be rated as super AAA. Moreover, such facilities are limited in terms of amount, coming to 2-3% of the overall pool. The 0% conversion is consistent with the treatment of other off-balance sheet facilities under the standardised approach. Facilities which are cancellable without prior notice are also converted at 0%. De Nederlandsche Bank permits a financial undertaking to apply the 0% conversion figure to a cash advance facility if it has ascertained on the basis of in-house procedures that the credit risk is negligible. Article 6:26 Credit protection on a securitisation positions may be obtained by, for instance, guarantees or credit derivatives on a securitisation position. In that event, the risk weight for the tranche is replaced by the risk weight attaching to the credit protection. The determination of the risk weight differs depending on whether the credit protection is funded or unfunded. In the case of funded credit protection, the nature of the collateral is among the factors determining the risk weight of the tranche on which credit protection has been obtained. In the case of unfunded credit protection, the risk weight of the tranche on which the credit protection has been obtained is set equal to that of the credit protection provider. This Article also applies when credit protection has been obtained on a tranche where termination of the credit protection does not lead to termination of the division into tranches. In that case, a financial undertaking which has obtained credit protection calculates an additional risk-weighted exposure amount for the maturity mismatch in accordance with Article 4:99 of the present Regulation. This is equivalent to applying the following formula: RW* = [RW(protected) x (t-t*)/(t-t*)] + [RW(unprotected) x (T-t)/(T-t*)] where t* = 0.25; RW* represents the risk-weighted exposure amounts for the securitisation position; RW(protected) represents the risk-weighted exposure amounts for the securitisation position with credit protection, as if there were no maturity mismatch; RW(unprotected) represents the risk-weighted exposure amounts for the securitisation position after termination of the protection on the securitisation position; T represents the effective maturity of the securitisation, expressed in years, and t represents the effective maturity of the credit protection, expressed in years. The following example may help clarify the application of this formula. Suppose that a synthetic securitisation with a maturity of five years consists of three tranches, with the mezzanine tranche, contrary to the senior and the first loss tranche, having a maturity of three years. The underlying exposures also have a maturity of five years. When the credit protection on the mezzanine tranche is terminated, the credit risk on the mezzanine tranche returns to the originator financial undertaking. However, the division into tranches remains unchanged. Suppose that the synthetic tranches are externally rated. The ratings and the nominal amounts are as follows: 264

265 Senior A 90 Mezzanine BBB 6 First loss B 4 + Total 100 The credit protection has been obtained by means of unfunded credit protection. Suppose that the credit protection provider has a risk weight of 20%. The senior and the first loss position are subject to the risk weight attaching to the credit protection provider, which is 20% in this example. The mezzanine tranche would also have been subject to a 20% risk weight if there were no maturity mismatch. When the credit protection on the mezzanine tranche is terminated, the risk is returned to the originator financial undertaking. The risk weight for this tranche is derived from the rating and is 100% for a BBB rating. Thus, the risk weight for the mezzanine tranche is equal to: 20% x (3 0.25)/(5 0.25) + 100% x (5 3)/(5 0.25) = 53.7%. Article 6:27 For certain securitisation positions (credit enhancements), this Article permits a financial undertaking to choose between deduction from regulatory capital and application of a 1250% risk weight. De Nederlandsche Bank expects financial undertakings to pursue a consistent policy in this respect, meaning that they are not allowed to opportunistically choose one method in some cases and the other in other cases, depending on which of the two produces the most favourable results in a particular case. Article 6:28 This Article lays down the hierarchy of methods, which must be observed when calculating the capital charge for a securitisation exposure under the internal ratings based approach. The hierarchy is schematically shown below. Hierarchy Internal ratings based approach 1 External rating (externally rated positions) 2. Inferred rating 3 Internal assessment approach (IAA) for ABCP programmes 4 Supervisory formula (SF) 5 Fallback option liquidity facilities 6 Deduction from regulatory capital or 1250% risk weight A financial undertaking using the internal ratings based approach must use external ratings, if available. If an external rating is not available, the financial undertaking must consider whether an inferred rating may be used. If this is also impossible, three options remain for the treatment of securitisation exposures without an external (inferred) rating. In the event that these options cannot be used either, a choice must be made between deduction from regulatory capital and the application of a 1250% risk weight. If, in respect of a securitisation position in an ABCP conduit, it is possible for a financial undertaking to use both the internal assessment approach and the supervisory formula method, De Nederlandsche Bank expects this financial undertaking to pursue a consistent policy in this respect, meaning that it is not allowed to opportunistically choose one method in some cases and the other in other cases, depending on which of the two produces the most favourable results in a particular case. Article 6:29 265

266 It is possible that, on the grounds of the risk weights attaching to retained securitisation positions, a financial undertaking would have to hold more capital after than before securitisation. This Article provides for a cap on the capital charge after securitisation; cf. Article 6:19. However, contrary to Article 6:19, its application is not restricted to a financial undertaking acting as originator or sponsor, but also extends to other financial undertakings which are capable of calculating K irb. Article 6:30 If a securitisation position has no external rating, a financial undertaking must, where possible, attribute an inferred rating. The externally rated position (the reference position) from which the rating may be inferred must meet the following requirements: - the reference position is subordinate in all respects to the unrated position; - the maturity of the reference position is equal to or longer than that of the unrated position, and - the inferred rating is updated on an ongoing basis. Inferring an external rating is frequently necessary for an externally unrated senior swap in a synthetic securitisation, in which the mezzanine effects are externally rated and sold to investors. In that case, the inferred rating is equal to the external rating of the mezzanine tranche. Article 6:31 For securitisation positions with an external rating, or for which an external rating can be inferred, the risk weights apply as shown in the tables, multiplied by External rating 1 Risk weights for senior tranches backed by granular pools Base risk weights AAA 7% 12% 20% AA 8% 15% 25% A+ 10% 18% ) A 12% 20% ) 35% A- 20% 35% ) BBB+ 35% 50% BBB 60% 75% BBB- 100% BB+ 250% BB 425% BB- 650% Risk weights for tranches backed by non-granular pools Below BB- and unrated Deduction from capital or 1250% risk weight 1 The external ratings mentioned in these explanatory notes are for illustration purposes only and do not denote any preference for or approval of a certain rating system employed by a credit assessment institution. A financial undertaking may use the risk weights shown in the left-hand column (senior tranches) if the effective number of underlying exposures (N) in the pool is larger than or equal to 6 and the securitisation position meets the definition of seniority. A securitisation position is considered senior if it is secured by a first claim on the entire amount of the assets in the pool. In this regard, claims on account of currency and interest rate swaps and contractual servicer s fees may be disregarded, as may similar payments, such as interest payments and amounts due to liquidity facilities which are contractually senior to the securitisation position concerned. Examples of senior securitisation positions are: - in a synthetic securitisation, the super-senior tranche is treated as the senior tranche, provided the conditions for inferring an external rating are fulfilled; 266

267 - in a traditional securitisation where all tranches above the credit enhancement are externally rated, the most highly rated securitisation position is treated as the senior tranche. However, when there are several tranches that share the same external rating, only the least junior tranche is treated as senior; - usually, within an ABCP conduit, the commercial paper will be the most senior. However, if a liquidity facility takes the place of the commercial paper and thus benefits to the same extent from the outstanding credit enhancement, it may be viewed as being the most senior. The 7% risk weight shown in the table for the most senior tranches may be replaced by 6% if the following conditions are met: - all other tranches are subordinate to this most senior tranche; - relative to that most senior tranche, there is a subordinated tranche with an external or inferred AAA rating. The following example may help clarify the determination of risk weights in a securitisation with two AAA tranches, one being subordinated to the other (most senior) tranche. The most senior AAA tranche is assigned a 6% weight. The senior AAA tranche which is junior to the most senior AAA tranche is then assigned a risk weight of 12% (column B in the table). In the hypothetical case that there would have been no most senior AAA tranche, the 12% weight would have been 7%. Articles 6:32 to 6:36 De Nederlandsche Bank may allow a financial undertaking to use the internal assessment approach (IAA) for, for instance, credit enhancements and liquidity facilities to ABCP conduits. The IAA is an in-house methodology that should reflect the assessment methodology of one or more credit assessment institutions which rate the ABCP. An ABCP conduit is defined as an SSPE which predominantly issues commercial paper with a maturity of one year or less. Some of the conditions which must be satisfied by a financial undertaking if it is to use the IAA are: - the internal assessment is based on criteria set by credit assessment institutions for the relevant asset category; - the internal assessment is used in the financial undertaking s risk management processes, including its management information process and internal capital adequacy assessment process (ICAAP), and generally meets the requirements of the IRB framework; - the internal assessment is, to the extent that this can be ascertained, at least as conservative as the rating processes of the credit assessment institutions that rate the transaction. If, for instance, two credit assessment institutions use different stress factors, the financial undertaking must apply the most conservative of these factors; - the system is reviewed regularly by internal or external auditors or by a credit assessment institution. Most of these conditions are qualitative; there are no absolute quantitative standards. Any application to use the methodology will therefore be discussed with the financial undertaking concerned and be assessed mainly on that basis. Only if, given the specific features of the securitisation such as its unique structure no publicly accessible rating methodology of a credit assessment institution is available, may De Nederlandsche Bank depart from the condition that the rating methodology of the credit assessment institution must be publicly accessible. Article 6:34(1)(e) 267

268 The procedures regarding exposures in the context of an ABCP programme must form part of a more comprehensive set of procedures and must satisfy the relevant standards. Article 6:34(1)(f) One of the conditions is that internal or external auditors, a credit assessment institution, or the financial undertaking s internal credit review or risk management function must perform regular independent reviews of the internal assessment process and of the quality of the internal assessments of the credit quality of the financial undertaking s exposures to an ABCP programme. If the financial undertaking s internal auditing, credit review or risk management function performs such reviews, these functions must be independent of the division in charge of the ABCP programme as well as of the division in charge of customer relations. It might be noted that, although this is not explicitly required under the present Regulation, the external auditor will probably have to become involved in assessing the reliability of Basel II systems. Given the materiality of these systems for the BIS ratio and their importance for the financial undertaking s continuity, the external auditor will have to assess the design, existence and operation of the financial undertaking s Basel II systems. The exact nature of this work must be based on the results of a risk analysis and also depend on the function segregations effected within the financial undertaking and the robustness of the reviews performed by the internal auditing function. Article 6:35(a) Credit and investment guidelines are understood to provide for the following. In the consideration of an asset purchase, the programme servicer must examine the type of asset being purchased, the type and monetary value of the exposures arising from the provision of liquidity facilities and credit enhancements, the sharing of losses and the legal and economic isolation of the transferred assets from the entity selling the assets. An analysis of the asset seller s risk profile must be performed and should consider past and expected future financial performance, current market position, expected future competitiveness, leverage, cash flows, interest coverage and debt rating. In addition, a review of the seller s underwriting standards, debt servicing capabilities and collection processes must be performed. Article 6:35(c) This Article sets out the qualitative conditions that must be met by an ABCP programme for the IAA to be used. One of these conditions is that the programme should mitigate seller/servicer risk through various methods, such as triggers based on current credit quality that preclude co-mingling of funds. Article 6:36 The rating for the externally unrated securitisation position, internally derived by means of the IAA, must be at least equivalent to investment grade if it is to be applied under the ratings based method referred to in Article 6:31. In the event that the IAA leads to a lower derived rating, this rating must not be used. In that case, the financial undertaking must, where possible, use the supervisory formula method or, alternatively, apply a 1250% risk weight to the securitisation position. Article 6:37 In respect of exposures having no (inferred) external rating, the capital charge must be determined with the aid of the supervisory formula (SF). The risk weight to be applied is equal to the outcome of the SF, unless it is lower than 7%, in which case a risk weight of 7% must be applied. The SF is consistent with the manner of calculating capital charges under the 268

269 internal ratings based approach. For more details, reference is made to the explanatory notes to Annex 6, Formula A. Paragraph 3 provides for a simplified method if the largest securitised exposure, C1, is no larger than 3% of the total of securitised exposures. This may be the case in, for instance, CDO transactions. For more details, reference is made to the explanatory notes to Annex 6, Formula B. Paragraph 4 provides for a simplification for retail exposures. If a pool includes a large number of exposures, N tends towards infinity and the supervisory formula becomes much more simple because in that case the variables h and v tend towards nil. Moreover, in that case: C = Kirbr, f = (1-Kirbr) Kirbr/τ and g = τ-1. This also means that the LGD need not be calculated (the LGD is only relevant if the pool is insufficiently diversified). High values of N (only) occur in securitisations of retail exposures. Hence, the rules provide for the possibility of setting h and v at nil. This simplification is useful in cases where it would be difficult to ascertain the exact amounts of all exposures and to estimate the LGD. Although the results differ depending on the specifics of the situation, 500 effective exposures represents a fair lower limit for the use of this simplification. At that level, the differences in capital charges are often no more than marginal. If a financial undertaking ascertains that, in a specific securitisation, the differences in capital charges are immaterial at a lower number of effective exposures than 500, it may use the simplification for a securitisation of retail exposures. Articles 6:38 to 6:40 Reference is made to the explanatory notes to Articles 6:22 to 6:25. Article 6:39 In respect of externally unrated liquidity facilities meeting the requirements set out in this Article, a conversion figure of 20% may be applied. It should be noted that, in respect of an externally rated liquidity facility, a financial undertaking must use the ratings based approach, applying a conversion figure of 100% to the nominal value of the facility. Article 6:40 If the conditions set out in Article 6:25 are not satisfied, the general rule applies as set out in Article 6:14(3), which specifies a conversion figure of 100%. Article 6:41 This Article provides for a fallback option for IRB financial undertakings which are unable to calculate K irb. In such situations, De Nederlandsche Bank may, on an exceptional and temporary basis, permit an IRB financial undertaking to apply the standardised approach to credit risk (Chapter 2) instead of the internal ratings based approach (Chapter 3) when determining the risk weight of a liquidity facility. This possibility serves as a fallback for financial undertakings which: - are unable to calculate K irb for such facilities; - cannot use (inferred) external ratings, and - do not (or are not allowed to) use the IAA. This situation may arise in the case of securitisation positions where the underlying exposures partly consist of securitised exposures of third parties, to which the investing financial undertaking cannot apply the IRB approach owing to a lack of data or other limitations. De Nederlandsche Bank will assess a financial undertaking s application to use this fallback option on the basis of the following criteria: - the financial undertaking has done all that is in reason possible to try to calculate K irb ; 269

270 - the financial undertaking has a sound plan under which it will be able to calculate K irb in the near future, and - the financial undertaking is able to demonstrate that the use of the standardised approach (Chapter 2) instead of K irb does not lead to the credit risk being underestimated. Articles 6:45 and 6:46 These Articles describe the manner in which credit protection is taken into account under the supervisory formula method. For complex numerical examples, reference is made to Annex 5 in the Basel framework. Article 6:47 Reference is made to the explanatory notes to Articles 6:27. Articles 6:48 to 6:57 Title 6.6 contains the provisions concerning the additional capital charge for revolving exposures with early amortisation provisions. These provisions are underlain by Article 86 of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft): If a securitisation of revolving exposures is subject to an early amortisation provision, a financial undertaking as referred to in Article 73 which is the originator shall calculate an additional risk-weighted exposure amount. In securitisations of revolving exposures, as in the case of credit cards, use is often made of provisions that may trigger early amortisation of the securitisation. In the case of credit cards, it is, for instance, usual for the securitisation to be amortised early when the excess spread received falls below a certain level. Early amortisation means that the SSPE redeems the securities issued and that the financial undertaking re-includes the (undrawn) credit lines in its balance sheet. The losses incurred until that time are settled, but new draws are for the account of the financial undertaking re-including the exposures in its balance sheet. This general rule is elaborated in Title 6.6. The capital charge referred to here is supplementary to the capital charges for the securitisation positions which the originator financial undertaking may hold; the latter are treated in Title 6.3. If the risk transfer is not recognised and the originator financial undertaking calculates risk-weighted exposure amounts for the exposures as if they had not been securitised (see Articles 6:3 and 6:6), it need not calculate the additional capital charge. When early amortisation provisions are included in securitisations and if they are triggered when the quality of the underlying exposures or of the originator financial undertaking deteriorates, this leads to an additional capital charge being imposed on the financial undertaking. The fact is that the exposures are re-included in the balance sheet at a time when there are signals of deteriorating exposure quality or worsening economic conditions. If early amortisation is linked to, say, an unforeseen change in the tax regime, no additional capital charge is imposed because there is no link with underlying exposure quality or economic conditions. For the purposes of the determination of the risk-weighted exposure amount, the securitised exposures are taken to be the sum of drawn and undrawn credit lines. The additional capital charge is determined by the product of (a) investors interest, (b) the appropriate conversion figure, and (c) the risk weight for the underlying exposures had they not been securitised. The conversion figure differs depending on whether the securitisation contains controlled or non-controlled early amortisation features and depending on whether the underlying exposures consist of uncommitted retail credit lines or other revolving exposures. 270

271 Conversion figure Controlled early amortisation Non-controlled early amortisation Uncommitted retail credit lines In accordance with building-up scheme in table 5 In accordance with building-up scheme in table 5 Other revolving exposures 90% 100% For uncommitted retail credit lines (mainly credit cards), the additional capital charge has been designed as a building-up scheme. The more exposure quality is seen to deteriorate and the likelier it becomes that the amortisation provisions will be triggered, capital must be built up by applying increasing conversion figures. A distinction is made between controlled and non-controlled (rapid) early amortisation provisions. In the event of controlled early amortisation, the investors are repaid less rapidly and are thus exposed to more risk of loss than in the event of non-controlled early amortisation. Controlled early amortisation is thus assigned lower conversion figures than rapid early amortisation, because the risk for the originator is smaller. The difference between controlled and non-controlled (rapid) early amortisation may be illustrated with the aid of an example. Suppose that 100 in credit card receivables is transferred to a trust. Securities are issued to an amount of 90 (investors interest) while the originator retains a share of 10 (originator s interest). The originator s interest is necessary in order to absorb fluctuations in the amounts outstanding under the credit cards. If the transaction proceeds to early amortisation, there are two possibilities for dividing the funds received between originator and investor: - In the event of rapid early amortisation, the funds received are divided in accordance with a fixed allocation method. In the table below, 10 in principal amount is collected each month. Of the first 10, 9 is used to redeem securities and 1 to repay the originator. The second collection of 10 is divided in exactly the same way. During the amortisation period, the investor runs no more risk in respect of the credits which have been repaid; that risk is borne entirely by the originator. The fact is that, if a credit card receivable has been paid, a new card payment may be made so that a new risk arises. It is not realistic to assume that a financial undertaking could (or would wish to) block such credit cards in the short run. - In the event of controlled early amortisation, the first 10 is divided in the same way as under rapid early amortisation. The second 10, however, is divided on the basis of the outstanding balances, which is known as floating allocation. The investors have an interest of 81 and thus receive 81% ( 8.10), the originator has a remaining interest of 9 and thus receives The amount of 1 which remains is re-invested in the securitisation. With each new amount of funds collected, the system continues in the same way. This situation is shown in table 1 below. Table 1 Fixed versus floating allocation Floating allocation / controlled early amortisation Month Principal collections Originator s interest Investors interest Invested as % of pool Fixed allocation / rapid early amortisation Originator s Investors interest interest Invested as % of pool 271

272 % 72.90% 65.61% 59.05% 53.14% 47.83% 43.05% 38.74% 34.87% 31.38% % 72.00% 63.00% 54.00% 45.00% 36.00% 27.00% 18.00% 9.00% 0.00% After a period of ten months, under floating allocation, the investors still have an interest of 31.38% of the original outstanding balances, whereas under fixed allocation they have been repaid in full. Consequently, under floating allocation the investors run a greater risk during the amortisation period. Suppose that the average repayment percentage is 19.17% a month. Based on that pace of repayment, the clean-up call level (10%) is reached after 4.7 months under rapid early amortisation, whereas under controlled early amortisation this takes months. This explains the comparatively favourable treatment of controlled early amortisation. Controlled early amortisation Early amortisation is controlled if a number of conditions are met: - the financial undertaking has an appropriate liquidity/capital plan in place; - there is a pro rata sharing between originator and investors of losses incurred; - the financial undertaking has set a period for amortisation that is sufficient for at least 90% of the pool to be recognised as in default, and - the pace of repayment is not any more rapid than under straight-line amortisation over the period set out above. Article 6:49(b) Where certain forms of securitisation are concerned, originator financial undertakings are exempt from the additional capital charge referred to in Article 6:48. This concerns, for instance, securitisations where an early amortisation clause is only triggered by an event unrelated to (a change in) the credit quality of the securitised exposures or the creditworthiness of the originator. An example of such an event is a major change in tax laws or regulations. Article 6:51(3) and Article 6:52(3) The originator's interest may not be subordinate to the investors interest. If the originator s interest is subordinate to the investors interest, the originator s exposure is no longer regarded as a pro rata interest in the securitised exposures in the form of drawn amounts. In that event it is regarded as a credit enhancement. Article 6:52 For IRB financial undertakings, the investors interest consists of the drawn balances plus the EAD (exposure at default) associated with the undrawn balances related to the securitised exposures. For determining the EAD, the undrawn balances are fictitiously allocated between the originator s interest and the investors interest on a pro rata basis, based on an allocation formula equal to the proportions of the originator s and investors shares of the drawn 272

273 balances. For IRB financial undertakings, the additional capital charge is equal to the product of (a) the investors interest, (b) the appropriate conversion figure, and (c) K irb. Article 6:53 This Article ensures that the cap on the capital charge (as set out in Articles 6:19 and 6:29) applies to the total of: (a) the capital charge for the originator s interest; (b) the additional capital charge in respect of the investors interest under Article 6:48, and (c) the capital charge for retained or purchased positions in the investors interest. For instance, if the capital charge for retained positions in the securitisation exceeds the capital charge on the underlying exposures (so that (a) is larger than (b) in Article 6:53(1)), the additional capital charge under Article 6:48 is capped at nil. Subsequently, the capital charge for retained positions is subject to the cap under Articles 6:19 and 6:29. If the capital charge for retained positions in the securitisation is smaller than the capital charge for the underlying exposures (so that (b) exceeds (a) under Article 6:53(1)), the additional capital charge in respect of the investors interest (that is, the capital charge for retained positions plus the additional capital charge under Article 6:48) is capped at the capital charge for the underlying exposures as if they had not been securitised.. This is in line with application of the cap. Article 6:56 Article 86(3) of the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) provides that De Nederlandsche Bank may permit a financial undertaking to depart from the method outlined in Article 6:55 and to calculate the riskweighted exposure amount in a manner which closely approximates that method. Article 86(3) of the Decree provides that, if De Nederlandsche Bank intends to grant permission to depart from the conversion figure referred to in Article 6:56 for a certain securitisation, it must first inform the competent authorities of the other Member States accordingly. Before such an approach to securitisations with this type of early amortisation clauses becomes an element of standard policy, De Nederlandsche Bank must seek the advice of the competent authorities of the other Member States and allow for the positions taken by them in this respect. De Nederlandsche Bank must publicly announce the views expressed during the consultation and the approach chosen by it.. Explanatory notes to Annex 6 to Section 6.5.5, providing for the supervisory formula and simplified inputs Formula A The supervisory formula (SF) provides a method for calculating the capital charges for externally unrated securitisation positions. The SF is a formula which is consistent with the manner of calculating capital charges under the IRB approach. The capital charge for a full tranche is calculated by taking the difference between S[L+T and S[L]. The SF has five inputs: (1) Kirbr is the ratio of (a) K irb, being the capital charge including the expected loss portion of the underlying pool of exposures had they not been securitised to (b) the amount of exposures in the pool. K irb can be calculated by taking the sum of the individual capital charges for the underlying exposures, for instance using the rules for exposures to corporates, or for the pool as a whole using the top-down receivables approach; 273

274 (2) L represents the level of credit protection and is defined as the ratio of (a) the amount of all securitisation positions subordinate to the securitisation position in question to (b) the amount of exposures in the pool. For instance, if a certain securitisation position suffers losses after the pool has already incurred 5% losses, its L is 5%; (3) T is the thickness of the tranche, measured as the ratio of (a) the amount of the tranche to (b) the amount of exposures in the pool; (4) N is the effective number of exposures in the pool and is calculated as follows: 2 ( EADi ) i N = 2 EAD i i where EADi represents the exposure at default associated with the i th instrument in the pool; (5) ELGD is the exposure-weighted average LGD of the exposures in the pool and is calculated as follows: LGD EAD i i i ELGD = EAD i i If a financial undertaking does not purchase the entire tranche but merely part of it, the charge is lowered proportionally. The inputs τ and ω in the formula have been set in the recast Banking Directive as follows: τ = 1000 and ω = 20. τ expresses the uncertainty regarding the amount of economic loss to be suffered by the pool before the securitisation position concerned incurs a loss. A value of τ equal to infinity means that there is zero uncertainty, whereas a value equal to 0 means that there is full uncertainty. ω is a non-risk-related variable ensuring that the curve representing the marginal risk weight corresponds to a value of 1250% when a securitisation position exceeds Kirbr. The chart below illustrates how the formula distributes the capital charge among the various tranches. All securitisation positions up to K irb are deducted from regulatory capital and are thus assigned a risk weight of 1250%. Subsequently, the capital charge decreases rapidly. The capital charge is equal to the area below the curve between the positions L+T and T. Marginal capital charge 100% Reference capital level (K IRB ) Formula B 274

275 Formula B is used under Article 6:37(3): the simplified method if the largest securitised exposure, C 1, is not more than 3% of the total of securitised exposures. This may be the case in, for instance, CDO transactions. In that case, the LGD may be put at 50% and the effective number of exposures may be calculated as follows: Cm C1 N = C1 Cm + max{1 mc1,0} m 1 or, if only C 1 is available, N = 1/ C 1 may be used. 1 Generally, the sponsor in CDO securitisations announces the amount of C 1. C m is the share of the pool corresponding to the sum of the m largest exposures. For instance, if the 10 largest securitised exposures jointly account for 15% of the pool, C m is equal to 0.15 and m is equal to 10. If C m is known, the capital charge will generally be lower than if only C 1 is known. This will prompt investors to seek more information from the sponsor. Chapter 7 General Chapter 7 serves to determine and control risk concentrations in respect of individual counterparties of groups of connected counterparties. The underlying consideration is that the capital charges under the Financial Supervision Act (Wet op het financieel toezicht) assume financial undertakings with well-diversified portfolios, so that undue concentrations in respect of a single counterparty or group of connected counterparties may involve unacceptable financial risks. That is why the system of capital charges is supplemented with an arrangement for monitoring and controlling concentrations of positions in respect of individual counterparties or groups of counterparties. In conjunction with the Decree of Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), a consistent system has thus been set up for covering financial risks. Article 102 of the Decree sets the following limits to the risks that a bank, an investment firm or a clearing institution may incur: a limit of 25% of regulatory caporal for large exposures to an individual counterparty or group of connected counterparties, after set-off, where applicable, and after application of a weighting percentage, and a limit of 80% of regulatory capital for the aggregate value of large exposures. The 25% limit may be exceeded if the excess arises in its entirety on the trading book and the conditions with regard to the magnitude and duration of the excess are satisfied and the additional capital charges with regard to the excess are met, as these requirements have been detailed in Subsection 3.11 of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico). Large exposure is defined in Article 1 of the Decree as the non-risk-weighted assets and off-balance sheet items relating to an individual counterparty of group of connected counterparties, whose value is at least 10% of regulatory capital, except for the items which a financial undertaking deducts from regulatory capital and the non-risk-weighted assets and off-balance sheet items held for the normal settlement of foreign exchange transactions within 48 hours after payment has been effected and of securities transactions within five working days after payment has been effected or after the securities have been delivered, whichever is earlier. Positions in derivatives are calculated using the methods described in Chapter 5 of the present Regulation. Under Article 1 of the Decree, a group of connected counterparties is understood to be two or more persons who: 275

276 (a) are linked in a formal or actual control structure, or (b) from a risk perspective, must be viewed as a single entity because they are interconnected to such an extent that, if one of them were to encounter financial problems, at least one of the others would probably have difficulty meeting payment commitments. Interconnection may exist in the case of common shareholders or partners, common directors, cross-guarantees or direct commercial interdependence which cannot be undone at short notice. For the purposes of this Chapter, financial undertakings are understood to be banks, investment firms and clearing institutions as referred to in Section 1:1 of the Financial Supervision Act (Wet op het financieel toezicht). The provisions of this Chapter are applied on a consolidated basis, irrespective of whether the financial undertakings concerned uses the standardised approach or the internal ratings based approach for the determination and control of credit risk. In cases where a method is mentioned explicitly, that method must be used. Any references in this Chapter to maturity are to residual maturity The reporting obligations regarding large exposures and other significant risk concentrations have been laid down in the Supervisory Regulation on Reporting Forms for Financial Undertakings (Regeling staten financiële ondernemingen Wft). The European Commission is currently conducting a review of the Directive-based rules on large exposures, as prescribed by Article 119 of the recast Banking Directive. The results of the review are expected to be available in late The provisions contained in the present Chapter apply pending this review. For this reason, the Large-Exposure Rule (Grotepostenregeling) under 4081 of the Credit System Supervision Manual (Handboek Wtk) has, where possible, been left unchanged. Determination and control of concentration risk Concentration risk in respect an individual counterparty of group of connected counterparties is determined by aggregating all assets representing exposures to, or other positions, including off-balance sheet items, in respect of, one counterparty or group of connected counterparties, irrespective of whether the assets concerned are on the trading or non-trading book and without allowing for the risk weights or risk degrees set in the provisions regarding the capital adequacy test. For non-trading book positions, concentration risk must be determined with due observance of the provisions for the calculation of credit risk as laid down in Chapter 2 and, where applicable, Chapter 5. For trading book positions, concentration risk must be determined with due observance of the provisions of the Supervisory Regulation on Solvency Requirements for Market Risk (Regeling solvabiliteitseisen voor het marktrisico) and, more specifically, the calculation of the net long positions concerned. Explanatory notes to individual Articles Article 7:2 Where an exposure to a counterparty has been guaranteed by a third party, that exposure may be treated as an exposure to that third party. This also holds when the exposure is secured by collateral in the form of securities, provided that, in the calculation of the position, the rules on excess value as laid down in Article 7:8(2)(i) are observed. Thus, an exposure secured by shares issued by a third party may be treated as an exposure to that third party, provided that those shares represent an excess value at market price of at least 150%. 276

277 Article 7:3(3) It should be noted that the eligible exposures arising on the non-trading book are, in principle, subject to the same manner of calculation as exposures arising on the trading book. However, application of the standardised approach in accordance with Article 1(1) of the Decree implies that the set-off, referred to under long positions, of all instruments issued by a single counterparty or group of connected counterparties is not allowed. Hence, a long position in one instrument may not be set off against a short position in another instrument of the same counterparty/issuer. Thus, set-off is permitted for positions in the same instruments. Opposite positions arising on the trading book and the non-trading book in respect of the same counterparty/issuer may not be set off, except for a long position on the non-trading book against a short position on the trading book in the same instruments. Article 7:5 The recast Banking Directive and the recast Capital Adequacy Directive cover three pillars, in accordance with Basel II: - pillar 1 concerns quantitative capital charges; - pillar 2 concerns the financial undertaking s assessment of its capital adequacy, the supervisory review and the possibilities for the supervisory authority to take measures, where necessary, and - pillar 3 concerns market discipline and transparency. The present Chapter forms part of the implementation of pillar 1 by the supervisory authority. However, the Decree also provides the basis for the issuance by the supervisory authority of more detailed rules under pillar 2; that is the basis underlying the obligation set out in Article 7:5 (see Article 35(4) of the recast Capital Adequacy Directive). Article 7:6 Article 102(4) of the Decree provides that De Nederlandsche Bank may, on request, permit a financial undertaking to exceed a limit referred to in the first or second paragraph of that same Article, and that De Nederlandsche Bank must set rules regarding the conditions under which it permits such excesses. The relevant conditions have been laid down in Article 7:6. The request as referred to above is considered to have been submitted and permission by De Nederlandsche Bank is considered to have been granted if and to the extent that these conditions are met. Article 7:8(2)(d)(1 o ) This also includes cash received in the context of a credit linked note issued by the bank, as well as a counterparty s loans to and deposits at the financial undertaking covered by an agreement on balance sheet netting recognised under the Decree (credit risk mitigation). Article 7:8(2)(j) For the purposes of this subparagraph, residential property is understood to be the dwelling (to be) lived in by or (to be) let to the borrower. Chapter 8 Explanatory notes to individual Articles Article 8:3 277

278 Financial undertakings which apply the Basel II Capital Accord to credit risk must also use the new Basel II securitisation framework. Financial undertakings applying Basel I to credit risk in 2007 may still apply the old securitisation regulations during that year (Solvency Regulation on Securitisation (Regeling inzake solvabiliteit bij securitisatie) of De Nederlandsche Bank of April 2004). Alternatively, they may apply the standardised approach to securitisation from the new Basel II securitisation framework in In this respect, the condition holds that the financial undertaking must consistently apply either the old or the new regulations on securitisation. Choices underlain by considerations of supervisory arbitrage are not permitted. Article 8:4 Article VIII of the Decree implementing the Basel II Capital Accord (Besluit implementatie kapitaalakkoord Bazel 2) offers two alternatives to a bank, investment firm or clearing institution which applies the old Basel I method for the calculation of capital charges in First, it may, as set out in paragraph 5 of said Article, apply the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft) (Staatsblad (Bulletin of Acts, Orders and Decrees) 2006, 519) as it was in force prior to the entry into force of the Decree implementing the Basel II Capital Accord (Besluit implementatie kapitaalakkoord Bazel 2) (hereinafter, the Decree as it was then in force is referred to as the old Decree ). Second, it may choose to avail itself of the option set out in paragraph 6 of said Article, implying that, instead of the rules regarding capital adequacy and reporting from the Decree on Prudential Rules for Financial Undertakings (Besluit prudentiële regels Wft), it may in 2007 apply in full the relevant rules from the Credit System Supervision Manual (Handboek Wtk) and the Regulations on Prudential Supervision of the Securities Trade 2002 (Nadere regeling prudentieel toezicht effectenverkeer 2002). The option offered in paragraph 5 requires further transitional arrangements at the supervisory regulation level. As is evident from the explanatory notes to Article VIII(5), this option was introduced to permit the undertakings to reap the benefits of certain features offered by the Act on Financial Supervision (Wet op het financieel toezicht) from as early as the financial year 2007 onwards. Examples listed in the explanatory notes of the advantages offered are the restoration of one-track reporting and, in part, lower reporting frequencies. If an undertaking avails itself of the possibility offered by Article VIII(5), the old supervisory regulations regarding solvency apply, to the extent that they are not been included in Chapter 10 of the old Decree. For instance, the calculation of the capital charge is included in Articles 60 and 61 of Chapter 10 and the composition of regulatory capital in Subsection 10.6 of the old Decree. The relevant supervisory regulations are contained in Annex 2 to the Regulations on Prudential Supervision of the Securities Trade 2002 (Nadere regeling prudentieel toezicht effectenverkeer 2002) and in 4002, 4004, 4011 (including annexes), 4013, 4022, 4023, 4024, 4025, 4031, 4041, 4051, 4061 and 4091 of the Credit System Supervision Manual (Handboek Wtk). The rules regarding large exposures are based on Articles 60 and 102 of Chapter 10 of the old Decree and have been elaborated in Annex 2 (under 2.5) of the Regulations on Prudential Supervision of the Securities Trade 2002 (Nadere regeling prudentieel toezicht effectenverkeer 2002) and in 4081 of the Credit System Supervision Manual (Handboek Wtk). The fixed-cost requirement for investment firms (Article 4 of the Regulations on Prudential Supervision of the Securities Trade 2002 (Nadere regeling prudentieel toezicht effectenverkeer 2002) is included in full in Article 60(4) and (5) of Chapter 10 of the old Decree. The same holds for the fixed-assets rule (4071 in the Credit System Supervision Manual (Handboek Wtk)) and the regulation on deductions from capital (4012 in the Credit 278

279 System Supervision Manual (Handboek Wtk)), which are now included in Articles 94 and 103, respectively, of Chapter 10 of the old Decree. CORRELATION TABLES Chapter 2 Recast Banking Directive Annex VI and Articles Part 2 2:2 Points 2 and 3 2:3 Points 7 and 8 2:4 Point 4 2:5 Point 5 2:6 Point 1 2:7 Point 8 and Article 80(6) 2:8 Point 9 2:9 Point 11 2:10 Points 12 and 13 2:11 Points 14 and 15 2:12 Point 16 2:13 Point 17 2:14 Point 10 2:15 Points 18 to 21 2:16 Point 22 2:17 Point 24 2:18 Points 25, 29 and 30 2:19 Points 31 and 32 2:20 Points 34 and 36 2:21 Points 37 and 38 2:22 Point 39 2:23 Point 40 2:24 Point 41 2:25 Point 42 2:26 Point 73 2:27 Point 43 and Article 79(2) 2:28 Point 44 2:29 Points 45 and 47 2:30 Point 48 2:31 DNB s Policy rule for indexation method for determining the forcedsale value of the mortgage portfolio (Beleidsregel indexatiemethode ter 279

280 bepaling van de executiewaarde hypotheekportefeuille) 2:32 Points 51 to 60 2:33 Points 61 and 65 2:34 Point 64 2:35 Point 65 2:36 Point 66 2:37 Point 67 2:38 Point 69 2:39 Point 70 2:40 Point 71 2:41 Point 72 2:42 Point 74 2:43 Point 75 2:44 Point 76 2:45 Point 77 2:46 Point 79 2:47 Point 80 2:48 Point 81 2:49 Point 88 2:50 Point 80 2:51 Points 84 and 87, second sentence 2:52 Point 84, first sentence 2:53 Points 79, 80, 83 and Article 80(6) Part 3 2:54 Points 1 and 3 2:55 Point 2 2:56 Point 4 2:57 Point 5 to 7 2:58 Point 9 2:59 Point 10 2:60 Points 13 to 16 2:61 Point 17 2:62 Point 18 Chapter 3 Recast Banking Directive Annex VII and Articles 3:1 Article 4 3:2 Article 4 3:3 Article 4 3:4 Article 86 3:5 Article 86 3:6 Article

281 3:7 Article 86 3:8 Article 86 3:9 Article 86 3:10 Article 86 3:11 Article 89(i) 3:12 Article 85(1) and (2) 3:13 Article 85(1) and (2) 3:14 Article 85(1) and (2) 3:15 Article 85(1) and (2) 3:16 Article 87(1) and (2) 3:17 Article 87(3) to (5) 3:18 Article 87(8) 3:19 Article 88 3:20 Part 1, points 3 and 5 3:21 Part 1, point 6 3:22 Part 1, points 7 and 8 3:23 Part 1, point 9 3:24 Part 1, points 10 to 13 3:25 Part 1, points 14 to 16 3:26 Part 1, points 17 and 18 3:27 Part 1, points 19 to 21 3:28 Part 1, points 25 and 26 3:29 Part 1, points 22 to 24 3:30 Article 87(11) and (12) 3:31 Article 87(11) and (12) 3:32 Article 87(11) and (12) 3:33 Part 1, point 27 3:34 Part 1, point 28 3:35 Part 1, points 29 and 30 and Article 88(2) 3:36 Part 1, point 31 3:37 Part 1, points 32 to 34 3:38 Part 1, point 35 3:39 Part 2, point 1 3:40 Part 4, point 45 3:41 Part 2, points 2 and 4 3:42 Part 2, point 3 3:43 Part 2, points 5 and 6 3:44 Part 2, points 8 and 11 3:45 Part 2, points 9 to 11 3:46 Part 2, points 13, 14 and 16 3:47 Part 2, points 17 to 20 3:48 Part 2, points 22 and 23 3:49 Part 2, point 24 3:50 Part 2, points 25 and 26 3:51 Part 2, point 27 3:52 Part 1, point 24, last sentence 3:53 Part 2, points 7 and 8(g) Part 1, point 28 (partially) 3:54 Part 3, points 1 and 4 281

282 3:55 Part 3, point 6 3:56 Part 3, point 5 3:57 Part 3, points 7 and 8 3:58 Part 3, points 9 and 10 3:59 Part 3, point 11 3:60 Part 3, point 12 3:61 Part 3, point 13 3:62 Part 3, point 6 (partially) 3:63 Article 84(2)(a) to (e) 3:64 Part 4, points 31 to 35 Part 4, points 2 and 3 (point 1 in the 3:65 definitions) 3:66 Part 4, point 4 3:67 Part 4, points 5 to 12 Part 4, points 13 to 16 and point 44 3:68 (partially) 3:69 Part 1, points 17, 18 and 25 3:70 Part 4, point 30 3:71 Part 4, points 19 to 23 and Part 4, points 26 to 28 3:72 Part 4, point 24 and Part 1, point 29 3:73 Part 4, point 36 3:74 Part 4, points 37 and 38 3:75 Part 4, point 39 3:76 Part 4, points 49 to 52 Part 4, points 54 to 58 and point 92 3:77 Part 4, point 46 3:78 Part 4, point 47 Part 4, points 59 to 66 (except points 60 and 61) 3:79 3:80 Part 4, points 67 to 72 3:81 Part 4, points 73 to 86 (except point 85) 3:82 Part 4, points 87 to 95 (except point 92) Part 4, points 97 to 104 (point 96 is not relevant) 3:83 3:84 Part 4, points 105 to 109 3:85 3:86 Part 4, points 53, 60, 61, 69 (last sentence), 85 and 101 (partially) Part 4, point 115 (except (a), middle part, and except point 115(g)) Part 4, points 40 to 42 and 115(a) middle part) and 115(g) 3:87 3:88 Part 4, points 110 to 114 and 117 to 123 3:89 Part 4, point 116 3:90 Part 4, points 124 to

283 Chapter 4 Recast Banking Directive Annex VIII 4:1(d) Part 3, point 58 4:1(g) Part 3, point 12 4:2 Part 2, points 1 and 2 4:3 Part 1, points 10 and 38 4:4 Part 3, points 3 and 4 4:5 Part 2, point 3 4:6 Part 2, point 3 4:9 Part 3, point 4 4:10 Part 1, point 5 4:11 Part 2, points 4 and 5 4:12 Part 3, points 5, 12 and 21 to 23 4:13 Part 3, points 12 and 13 4:14 Part 3, points 14 and 15 4:15 Part 3, point 16 4:16 Part 3, points 16, 18 and 19 4:17 Part 3, point 16 4:18 Part 3, point 16 4:19 Part 3, point 16 4:20 Part 3, point 16 4:21 Part 3, point 12 4:21 Part 3, point 17 4:22 to 4:24 Part 1, point 7 4:25 Part 1, point 8 4:26 Part 1, point 9 4:27 Part 1, point 11 4:28 Part 2, point 6 4:29 Part 2, point 6 4:30 Part 2, point 6 4:31 Part 2, point 6 4:32 Part 3, point 24 4:33 Part 3, point 2 4:34 Part 2, points 7 and 25 4:35 Part 3, point 26 4:36 Part 3, point 27 4:37 Part 3 point 28 4:38 Part 3, point 29 4:39 Part 3, points 33 and 35 4:40 Part 3, points 60 and 61 4:41 Part 3, points 30 to 32 4:42 Part 3, points 36, 39, 40, 41 and 57 4:43 Part 3, points 37 and 38 4:44 Part 3, points 42 to 46 4:45 Part 3, points 47, 52 and 57 4:46 Part 3, points 48 to 50 and 54 4:47 Part 3, point

284 4:48 Part 3, points 53, 55 and 56 4:49 Part 3, points 34 and 35 4:50 Part 3, point 57 4:51 Part 3, points 58 and 59 4:52 Part 3, point 58 4:53 Part 3, point 58 4:54 Part 3, point 58 4:55 Part 1, point 12 4:56 Part 1, points 13, 14 and 19 4:57 Part 2, point 8 4:58 Part 2, point 8 4:59 Part 3, points 62 and 65 4:60 Part 1, points 9 and 20 4:61 Part 2, point 9 4:62 Part 2, point 9 4:63 Part 3, point 66 4:64 Part 1, point 21 4:65 Part 2, point 10 4:66 Part 2, point 10 4:67 Part 3, point 68 4:68 Part 1, point 22 4:69 Part 2, point 11 4:70 Part 3, points 68 to 72 4:71 Part 4, point 7 4:72 Part 1, point 23 Part 2, point 12 Part 3, point 79 4:73 Part 1, point 24 Part 2, point 13 Part 3, point 80 4:74 Part 1, point 25 Part 3, points 81 and 82 4:75 Part 1, points 26 and 27 4:76 Part 1, point 29 4:77 Part 1, points 30 and 31 4:78 Part 1, point 32 4:79 Part 2, points 14 and 15 4:81 Part 2, points 16 and 17 4:82 Part 2, point 18 4:83 Part 2, point 19 4:84 Part 2, point 20 4:85 Part 2, point 20 4:86 Part 2, point 20 4:87 Part 2, point 21 4:88 Part 2, point 22 4:89 Part 2, point 22 4:90 Part 3, point 3 4:91 Part 3, point 86 4:92 Part 3, point

285 4:93 Part 3, points 85, 87, 88 and 90 to 92 4:94 Part 3, point 89 4:95 Part 6, point 1 4:96 Part 6, point 2 4:97 Part 4, points 1 and 2 4:98 Part 4, points 3 to 5 4:99 Part 4, points 6 to 8 4:100 Part 5, points 1 and 2 4:101 Part 3, points 76 to 78 Formulas and explanatory notes to formulas formula 1a, b and Part 3, point 33 c formula 2 Part 3, point 61 formula 3 Part 3, point 6 formula 3 Part 3, point 8 formula 3 Part 3, point 9 formula 3 Part 3, point 10 formula 3 Part 3, point 11 formula 4 Part 3, point 20 formula 5 Part 3, point 35 formula 6 Part 3, point 49 formula 7 Part 3, point 57 formula 8 Part 3, point 84 formula 9 Part 3, point 88 formula 10 Part 4, point 7 formula 11 Part 4, point 8 Tables and explanatory notes to tables tables 1 to 4 Part 3, point 38 table 5 Part 3, point 72 Chapter 5 Recast Banking Directive Annex III 5:1 Part 1 5:2 Part 2 5:3 Part 6, point 1 5:4 Part 2, point 3 5:5 Part 2, point 4 5:6 Part 3 5:7 Part 4 5:8 Part 5, point 1 5:9 Part 5, point 1 285

286 5:10 Part 5, points 2 to 4 5:11 Part 5, point 5 5:12 Part 5, point 10 5:13 Part 5, point 11 5:14 Part 5, point 12 5:15 Part 5, points 13 to 15 5:16 Part 5, point 17 5:17 Part 5, point 18 5:18 Part 5, point 19 5:19 Part 5, point 20 5:20 Part 5, point 21 5:21 Part 6, point 1 5:22 Part 6, point 1 5:23 Part 6, point 2 5:24 Part 6, point 4 5:25 Part 6, point 4 5:26 Part 6, point 12 5:27 Part 6, point 13 5:28 Part 6, point 15 5:29 Part 6, point 15 5:30 Part 6, point 17 5:31 Part 6, point 18 5:32 Part 6, point 20 5:33 Part 6, point 22 5:34 Part 6, point 24 5:35 Part 6, point 25 5:36 Part 6, point 26 5:37 Part 6, point 27 5:38 Part 6, point 29 5:39 Part 6, point 31 5:40 Part 6, point 32 5:41 Part 6, point 33 5:42 Part 6, point 34 5:43 Part 6, point 36 5:44 Part 6, point 37 5:45 Part 6, point 38 5:46 Part 6, point 39 5:47 Part 6, point 40 5:48 Part 6, point 41 5:49 Part 6, point 42 5:50 Part 6, point 42 5:51 Part 6, point 42 5:52 to 5:65 Part 7 286

287 Chapter 6 Recast Banking Directive Annex IX and Articles 6:1 Part 1, point 1 6:2 6:3 Part 2, point 1b 6:4 Article 4(44) Part 2, point 1d 6:5 Part 2, points 1(a), 1(f) and 1(g) 6:6 Part 2, point 2 6:8 Part 2, points 3 and 4 6:9 Part 2, points 5 to 8 6:10 Article 20 of DNB s Solvency Regulation on Securitisation (Regeling inzake solvabiliteit bij securitisaties) 6:11 Article 31 of DNB s Solvency Regulation on Securitisation (Regeling inzake solvabiliteit bij securitisaties) 6:12 Article 9(4) of DNB s Solvency Regulation on Securitisation (Regeling inzake solvabiliteit bij securitisaties) 6:13 Article 96(2), last sentence, (3) and (4) 6:14 Part 4, points 1 to 5 6:15 Part 3, point 1 6:16 Part 3, points 2 to 6 6:17 Part 3, point 7 6:18 Part 4, points 6 and 7 6:19 Part 4, point 8 6:20 Part 4, points 9 and 10 6:21 Part 4, point 12 6:22 Part 4, point 13 6:23 Part 4, point 13 6:24 Part 4, point 14 6:25 Part 4, point 15 6:26 Part 4, point 34 6:27 Part 4, points 35 and 36 6:28 Part 4, points 37 to 41 6:29 Part 4, point 45 6:30 Part 4, point 42 6:31 Part 4, points 46 to 51 6:32 Part 4, point 43, first sentence 287

288 6:33 Part 4, point 43(a) 6:34 Part 4, point 43(b) to (h) and last sentence 6:35 Part 4, point 43(i) to (m) 6:36 Part 4, point 44 6:37 Part 4, points 52 to 54 6:38 Part 4, point 55 6:39 Part 4, point 56 6:40 Part 4, point 57 6:41 Part 4, points 58 and 59 6:42 Part 4, point 60 6:43 Part 4, point 61 6:44 Part 4, point 62 6:45 Part 4, points 63 to 65 6:46 Part 4, points 66 and 67 6:47 Part 4, points 72 to 76 6:48 Part 4, points 16 and 68 6:49 Part 4, point 21 6:50 Part 4, points 17 and 18 6:51 Part 4, points 19 and 20 6:52 Part 4, points 69 to 71 6:53 Part 4, points 22 and 23 6:54 Part 4, points 24 and 25 6:55 Part 4, points 26 to 29 6:56 Part 4, point 30 6:57 Part 4, points 32 and 33 Chapter 7 Article in the Decree Article in Directive serving as a basis 7:1(b) Article 102(3) Article 32(2), recast Capital Adequacy Directive 7:2 Article 102(3) Article 117, recast Banking Directive 7:3(1) Article 102(3) Article 28(2), recast Capital Adequacy Directive 7:3(2) Article 102(3) Article 29, recast Capital Adequacy Directive 7:3(3)(4) Article 102(3) Article 30, recast Capital Adequacy Directive 7:4 Article 102(3) Article 29(1), paragraph 6, recast Capital Adequacy Directive 7:5 Article 102(3) Article 110(3), recast Banking Directive 7:6 Article 102(4) Article 31, recast Capital Adequacy Directive 7:7 Article 102(3) Article 112, recast Banking Directive 7:8 Article 102(3) Articles 113 and 115 (second sentence), recast Banking Directive 288

289 7:9 Article 102(3) Article 115 (except second sentence), recast Banking Directive De Nederlandsche Bank N.V., /s/ A. Schilder Executive Director /s/ D.E. Witteveen Executive Director 289