Agreement No. 006-2019: Modification of Agreement No. 003-2018 Establishing Capital Requirements for Financial Instruments in the Trading Book

Republic of Panama Banking Superintendence AGREEMENT No. 006-2019 (of May 28, 2019) "By means of which Agreement No. 003-2018 is modified, which establishes the capital requirements for financial instruments registered in the trading portfolio."

THE BOARD OF DIRECTORS in the exercise of its legal powers, and

CONSIDERING:

That following the issuance of Law Decree No. 2 of February 22, 2008, the Executive Branch prepared a systematic ordering in the form of a single text of Law Decree No. 9 of February 26, 1998, and all its modifications, which was approved through Executive Decree No. 52 of April 30, 2008, hereinafter the Banking Law;

That in accordance with the provisions of numerals 1 and 2 of Article 5 of the Banking Law, the objectives of the Banking Superintendence are to ensure the maintenance of the solidity and efficiency of the banking system; as well as to strengthen and foster the conditions conducive to the development of the Republic of Panama as an international financial center;

That in accordance with numerals 3 and 5 of Article 11 of the Banking Law, it is the technical competence of the Board of Directors to approve the general criteria for the classification of risk assets and the guidelines for the constitution of reserves for risk coverage, and to fix, within the administrative scope, the interpretation and scope of legal or regulatory provisions in banking matters;

That in accordance with numeral 10 of Article 11 of the Banking Law, it is the competence of the Board of Directors to issue technical norms necessary for the compliance with the Law;

That in accordance with what is established in Article 72 of the Banking Law, the Superintendence may take into consideration and value other risks for the determination of the capital adequacy index, among which are market risk, operational risk, and country risk, which serve as a measure to value the requirement of capital funds to achieve adequate risk management;

That through Agreement No. 003-2018 of January 30, 2018, the capital requirements for financial instruments registered in the trading portfolio are established;

That through Article 19 of Agreement No. 003-2018, the date of entry into force of the Agreement is established, as well as the deadline for the delivery of the first report to the Superintendence;

That through the Technical Annex of Agreement No. 003-2018, the methodology for the calculation of capital requirements for financial instruments registered in the trading portfolio is established;

That in working sessions of this Board of Directors, the need and convenience of modifying some articles of Agreement No. 003-2018 has been manifested, in order to include and expand

Agreement No. 006-2019 Page 2 of 18 aspects related to the scope of application, definitions, entry into force, and to specify certain calculations of the Technical Annex.

AGREES:

ARTICLE 1. Article 1 of Agreement No. 003-2018 is hereby amended as follows:

"ARTICLE 1. SCOPE AND APPLICABILITY. The provisions of this Agreement shall apply in their entirety to the regulated entities indicated in Article 1 and Article 18 of the Capital Adequacy Agreement issued by this Superintendence. However, in the case of branches of general license banks, only the aspects related to market risk management contemplated in Chapters I and II of this Agreement shall apply to them.

In the case of international license banks over which the Superintendence exercises host supervision, they must establish under their internal mechanisms an adequate market risk management, which shall be subject to review by this Superintendence. Nevertheless, the Superintendent may require the local management, when deemed convenient, the market risk management requirements established in this Agreement."

ARTICLE 2. Article 2 of Agreement No. 003-2018 is hereby amended as follows:

"ARTICLE 2. TRADING PORTFOLIO. The trading portfolio of a financial entity is composed of financial instruments that the bank holds with one or more of the following purposes:

1. To close the position in the short term with gains, either through sale or purchase depending on the initial position in the financial instrument.
2. To obtain short-term valuation gains.
3. To obtain arbitrage benefits.
4. To cover risks arising from instruments that meet any of the previous criteria.

Furthermore, financial instruments that this Banking Superintendence decides to include in the trading portfolio based on their special characteristics, and whose economic substance responds to the purposes indicated above, shall be included, regardless of the classification of the financial instrument according to International Financial Reporting Standards (IFRS).

Generally, any financial instrument that can be identified with any of the following sections forms part of the trading portfolio:

1. Instrument held for accounting purposes, according to IFRS, as an asset or liability for trading purposes (so that it would be valued daily at market prices, recognizing valuation differences in the income statement).
2. Instruments arising from market-making activities.
3. Instruments arising from securities issuance underwriting activities.
4. Investment in a fund, except when it is not possible to obtain daily market prices to know the valuation of the fund.
5. Quoted capital representative value.
6. Short position in naked short sales, including any short position in treasury instruments.
7. Derivative contracts, except those that fulfill hedging functions for positions not registered in the trading portfolio and whose contracts are adequately documented, and with evidence that the hedge is effective, not necessarily based on accounting standards criteria, but from the financial economic point of view. This implies that, for the evaluation of effectiveness, both the similarity between the characteristics of the derivative and the covered instruments must be considered, as well as

Agreement No. 006-2019 Page 3 of 18 the extent to which the real variations of their fair values (or cash flows) are compensated over the defined coverage period. 8. Financial instruments that include derivatives, whether explicit or implicit, that are part of the banking book and whose underlying is related to equity risk or credit risk. It is understood that these instruments must be considered for the purposes of calculating capital requirements for market risk.

Positions in the trading portfolio must be adequately documented and are not transferable to other portfolios without the authorization of this Banking Superintendence. For a financial instrument to be registered in the trading portfolio, it must be able to be valued daily at market price or, alternatively, with models that use the maximum amount of information from the markets and sensitive to the underlying factors that determine the fair value of the instrument.

The degree of liquidity of an instrument is a very relevant factor for the classification of the financial instrument in the trading portfolio."

ARTICLE 3. Article 4 of Agreement No. 003-2018 is hereby amended as follows:

"ARTICLE 4. MARKET RISK MANAGEMENT. Banks shall update daily at market prices the valuation of the instruments included in the trading portfolio.

Banks must have clearly defined policies and procedures and documented practices to determine which instruments to include or exclude from the trading portfolio for the purposes of calculating their regulatory capital.

The bank's internal control must analyze instruments both inside and outside the trading portfolio, in order to evaluate if they are initially classified appropriately.

Compliance with these policies and procedures must be completely documented and subject to periodic internal audit, remaining available for supervisory review.

Financial instruments included in the trading portfolio must be subject to clearly defined policies and procedures approved by the board of directors. These policies and procedures must, at a minimum, address the issues indicated below:

1. The activities that the bank considers as trading or hedging of instruments included and, therefore, included in its trading portfolio for regulatory capital purposes.
2. Trading strategies (including the expected holding horizon and possible reactions if this limit is exceeded) for each portfolio or instrument included.
3. The establishment of limits and the permanent verification of their adequacy.
4. The process to keep the board of directors and senior management informed, as an integral part of the institution's risk management process.
5. In the case of financial instruments included in the trading portfolio that are valued through a model, it must at least: a. Identify the significant risks of the included instruments. b. Have valuation methodologies, which must be explicit in the corresponding valuation manuals, such that valuations can be replicated following the manual's instructions. In particular, provide the detail of the databases used and, in general, the sources of information, assumptions, and estimation methodologies, if any, of the parameters necessary for the use of the model. c. Determine to what extent the risks of financial instruments valued through models can be easily covered, or the position in the financial instrument can be liquidated quickly."

Agreement No. 006-2019 Page 4 of 18

ARTICLE 4. Article 16-A is added to Agreement No. 003-2018:

"ARTICLE 16-A. SUBMISSION OF CERTIFICATION. In the case of banks that do not have investment portfolios to which this Agreement applies, they must submit to this Superintendence a certification from their board of directors accrediting that after the review carried out by the risk area and based on the criteria established in this Agreement, the banking entity does not have in its trading portfolios instruments that apply for the calculation of capital requirements in accordance with Chapter III. Nevertheless, they recognize that the management aspects contained in Chapters I and II of this Agreement are applicable to them.

Additionally, in said certification, they must accredit that in the event of incorporating into their investment portfolio instruments to which capital requirements apply in accordance with the provisions of this Agreement, the bank's board of directors has ensured that they have the adequate systems necessary to support the new operations and sufficient technical capacity in the different functional areas."

This certification must be delivered at the close of each fiscal year."

ARTICLE 5. Article 19 of Agreement No. 003-2018 is hereby amended as follows:

"ARTICLE 19. VALIDITY. This Agreement shall enter into force as of December 1, 2019, with compliance corresponding to the quarter closing on December 31, 2019, and the date of delivery of the first report to this Superintendence shall be until January 31, 2020."

ARTICLE 6. The Technical Annex of Agreement No. 003-2018 is hereby amended as follows:

"TECHNICAL ANNEX The following instruments are considered within this norm:

• Bonds
• Securitization bonds
• Shares
• Forwards
• Swaps
• Options

For any other instrument different from the above, the entity must consult the Banking Superintendence regarding the methodology for calculating the capital requirement.

I. Capital requirement for interest rate risk of bonds

I.1. Risk-free interest rate

1. For each currency, the entity must have the risk-free zero-coupon interest rate curve, and said curve must be the same one used by the entity for the valuation of financial instruments.
2. For each issuer, the entity must have the credit differential curve consistent with the valuation of each financial instrument.
3. The market price of the bond must be available, or, in its case, the fair value.
4. The instrument is decomposed into as many zero-coupon bonds as independent liquidity flows are present during the residual term of the bond until maturity. The sum of the present values of the zero-coupon bonds into which the instrument has been decomposed must coincide with the market price or, in its case, the fair value of the bond.
5. Subsequently, for the calculation of capital requirements for interest rate risk, only the fixed liquidity flows present in the financial instrument will be considered. This implies that for instruments with floating coupons, only the portion of the flow corresponding to the fixed spread defined over the reference rate will be considered.
6. Each flow of each zero-coupon bond will be assigned to one of the vertices detailed below. The vertices are: 0.25, 0.5, 1, 2, 3, 4, 5, 10, 15, 20, and 30 years.
7. In the case where the term of the zero-coupon bond does not coincide with the vertex, the cash flow will be distributed inversely proportional to the distance between the date where the liquidity flow is located and the date of each vertex.

Let F_t be the liquidity flow located at the residual term t and let T_i and T_{i+1} be the previous and subsequent vertices to t. The amount F_t is distributed in the amounts F_i and F_{i+1} according to:

F_i = F_t * (T_{i+1} - t) / (T_{i+1} - T_i) F_{i+1} = F_t * (t - T_i) / (T_{i+1} - T_i)

8. The delta sensitivity to the risk-free interest rate of the present value flow VA_i at vertex T_i is defined by the following expression:

SLR_{k,i} = (VA_{k,i}(z_i + 0.0001, d_i) - VA_{k,i}(z_i, d_i)) / 0.0001

SLR_{k,i} is the delta sensitivity of instrument k at vertex i when the zero-coupon interest rate z_i corresponding to said vertex is perturbed by one basis point (0.0001=0.01%), keeping the credit differential constant.

VA_{k,i}(z_i, d_i) is the present value of the liquidity flow of instrument k at vertex T_i, function of the risk-free interest rate z_i and the credit differential d_i, which, as a particular case, can be null.

9. All sensitivities of the financial instruments, in total M, of the trading portfolio, which can be positive or negative, are added at vertex T_i, which gives rise to the net risk-free sensitivity at vertex T_i:

SLRN_i = \sum_{k=1}^{M} SLR_{k,i}

10. The capital requirement for the previous aggregated magnitude is determined according to vertex T_i, by multiplying the magnitude SLRN_i by the weight defined in Table 1 below:

Table 1. Weights according to the vertex Vertex 0.25 0.50 1 2 3 4 Weight 2.40% 2.40% 2.25% 1.88% 1.73% 1.62% Vertex 5 10 15 20 30 Weight 1.50% 1.50% 1.50% 1.50% 1.50%

The capital requirement for the net exposure at vertex T_i is:

KLR_i = SLRN_i * p_i

Where p_i is given in Table 1 above.

11. Correlations. The existence of correlations between the magnitudes KLR_i and KLR_j assigned to vertices T_i and T_j is assumed. The correlation coefficient is defined by:

\rho_{ij} = Max[exp(-\theta * |T_i - T_j| / Min(T_i, T_j)); 0.4] where \theta = 3% is a parameter that the Superintendence may change according to the situation of the markets.

12. The capital requirement for risk-free interest rates for financial instruments denominated in currency b is obtained through the following expression:

K_b = \sum_{i=1}^{V} KLR_i^2 + 2 \sum_{i<j} \rho_{ij} * KLR_i * KLR_j

where V is the number of vertices.

13. In the case that there are bonds denominated in several currencies, the same calculation process is performed using the risk-free zero-coupon interest rate curve of the currency. All obtained magnitudes are expressed in USD, using the spot exchange rate of each currency.

14. Let K_a, K_b, K_c, ..., K_n be the regulatory capital amounts obtained for each currency, expressed all in the functional currency, that is, in Balboas. The capital requirement is defined by the expression:

K = \sum_{b=1}^{n} K_b^2 + 2 \sum_{b<c} \gamma_{bc} * S_b * S_c

With S_b = \sum KLR for currency b and S_c = \sum KLR for currency c.

In the particular case that the expression \sum_{b=1}^{n} K_b^2 \neq \sum_{b=1}^{n} S_b^2 + 2 \sum_{b<c} \gamma_{bc} * S_b * S_c were a negative number, the expression:

K = \sum_{b=1}^{n} R_b^2 + 2 \sum_{b<c} \gamma_{bc} * R_b * R_c

Where R_b = Max(Min(S_b, K_b), K_b) and R_c = Max(Min(S_c, K_c), K_c).

In all cases \gamma_{bc} = 0.5.

15. Correlation scenarios. For the calculation of capital requirements, three values must be calculated depending on three correlation scenarios. The scenarios are defined as follows:

Scenario 1. The correlation coefficients \rho_{ij} and \gamma_{bc} are multiplied by 1.25 with a limit of 100%. Scenario 2. The correlation coefficients \rho_{ij} and \gamma_{bc} are kept at their original values. Scenario 3. The correlation coefficients \rho_{ij} and \gamma_{bc} are multiplied by 0.75.

16. Capital requirement for risk-free interest rate risk. It is determined by the highest amount obtained using each of the scenarios.

I.2. Yield differential for credit risk

17. Three modalities are distinguished: a) Non-securitizations b) Securitizations of the trading portfolio with correlation c) Other Securitizations

a) Non-securitizations

18. The vertices are 0.25, 0.5, 1, 2, 3, 4, 5, 10, 15, 20, and 30 years.

19. The delta sensitivity to the increase in the yield differential of each present value VA_i assigned to vertex T_i is calculated through the expression:

SDR_{k,i} = (VA_{k,i}(z_i, d_i + 0.0001) - VA_{k,i}(z_i, d_i)) / 0.0001

SDR_{k,i} is the sensitivity of instrument k at vertex i when the yield differential d_i corresponding to said vertex is perturbed by one basis point (0.0001=0.01%), keeping the risk-free zero-coupon interest rate constant.

VA_{k,i}(z_i, d_i) is the present value of the liquidity flow of instrument k at vertex T_i, function of the risk-free interest rate z_i and the credit differential d_i.

20. The risk factors considered for the calculation of capital requirements are: i) issuer, ii) rating, iii) sector, and iv) vertex.

21. The delta sensitivities calculated in 19 must be assigned to a category, from 1 to 16, defined in Table 2 below:

Table 2. Yield differential categories Investment Grade (IG) No. Sector 1 Sovereign issuers, central banks, and multilateral development banks 2 Public administration, Local administrations, non-financial enterprises of the public sector 3 Financial, including financial entities of the public sector 4 Basic materials, energy, industrial goods, agriculture, manufacturing, mining, and extraction 5 Consumer goods and services, transport and storage, support activities for the service sector 6 Technology, Communications 7 Health, public utilities, professional and technical activities 8 Covered bonds

High Yield (HY) and No Rating (NR) No. Sector 9 Sovereign issuers, central banks, and multilateral development banks 10 Public administration, Local administrations, non-financial enterprises of the public sector 11 Financial, including financial entities of the public sector 12 Basic materials, energy, industrial goods, agriculture, manufacturing, mining, and extraction 13 Consumer goods and services, transport and storage, support activities for the service sector 14 Technology, Communications 15 Health, public utilities, professional and technical activities 16 Other sectors

22. The risk-weighted sensitivity, KDR_{ij} = SDR_i * p_j is defined through the product of each delta sensitivity i that belongs to a certain category j, by the weight p_j established in Table 3 for category j, j = 1,2,...,16.

23. The risk weights for categories 1 to 16 are:

Table 3. Weights by yield differential Category No. Weight 1 0.5% 2 1.0% 3 5.0% 4 3.0% 5 3.0% 6 2.0% 7 1.5% 8 4.0% 9 3.0% 10 4.0% 11 12.0% 12 7.0% 13 8.5% 14 5.5% 15 5.0% 16 12.0%

24. Correlations. The correlation coefficient between two risk-weighted sensitivities, k and l, considering the issuer and vertex factors, of the same category j, is defined as follows:

\rho_{kl} = \rho_{kl}^{issuer} * \rho_{kl}^{vertex}

\rho_{kl}^{issuer} = { 1 if issuers k and l coincide; 0.35 otherwise } \rho_{kl}^{vertex} = { 1 if vertices k and l coincide; 0.65 otherwise }

25. There is an exception to the previous criterion for the "Other sector" category. The capital requirement within the "Other sector" category is the simple sum of the absolute values of the net weighted delta sensitivities assigned to this category:

K_{b(other sector)} = \sum_i |KDR_i|

The resulting capital requirement from the "other sectors" category will be added to the general capital level for all risk classes.

26. The capital requirement K_h within each category h is established through the expression:

K_h = \sum_{i=1}^{n_h} KDR_{ih}^2 + 2 \sum_{i<j} \rho_{ij} * KDR_{ih} * KDR_{jh}

Given category h, which contains n_h risk-weighted sensitivities, \sum_{i=1}^{n_h} KDR_{ih}^2 is the sum of the squares of the risk-weighted delta sensitivities assigned to category h. \sum_{i<j} \rho_{ij} * KDR_{ih} * KDR_{jh} is the sum of the products of the correlation coefficient by the risk-weighted sensitivities different from category h.

27. The correlation coefficient between the capital requirements of two different categories is defined, using the rating and sector factors. The correlation coefficient \gamma_{bc} is established as follows:

\gamma_{bc} = \gamma_{bc}^{rating} * \gamma_{bc}^{sector}

\gamma_{bc}^{rating} = { 1 if categories b and c have the same rating (IG or HY/NR); 0.50 otherwise }

\gamma_{bc}^{sector} = { 1 if categories b and c are of the same sector; determined in Table 4 otherwise }

Table 4. Correlations between sectors 1/9 2/10 3/11 4/12 5/13 6/14 7/15 8 1/9 0.75 0.10 0.20 0.25 0.20 0.15 0.10 2/10 0.05 0.15 0.20 0.15 0.10 0.10 3/11 0.05 0.15 0.20 0.05 0.20 4/12 0.20 0.25 0.05 0.05 5/13 0.25 0.05 0.15 6/14 0.05 0.20 7/15 0.05 8

28. The capital requirement, taking into account the rating and sector factors, is defined by the expression:

K = K_{b(other sector)} + \sum_{b=1}^{15} K_b^2 + 2 \sum_{b<c}^{15} \gamma_{bc} * S_b * S_c

With S_b = \sum_i KDR_{ib} for category b and S_c = \sum_i KDR_{ic} for category c