Recommendation B regarding the limitation of investment risk in banks

1 Financial Supervision Commission Warsaw, March 2019 Recommendation B regarding the limitation of investment risk in banks

2 Introduction The following recommendation constitutes an amendment to Recommendation B from 2002 regarding the limitation of investment risk in financial institutions. Recommendation B was issued pursuant to Article 137(1)(5) of the Act of 29 August 1997 – Banking Law (consolidated text: Journal of Laws of 2018, item 2187, as amended). The purpose of the amended Recommendation B is to indicate good practices to banks regarding selected aspects of investment risk management (analysis, identification, execution, supervision, assessment, monitoring, and reporting), excluding loans and credits, derivative instruments, cooperative banks' involvement in the capital of the affiliated bank, and the involvement of protection system participants in protection system instruments. The Recommendation emphasizes the role of the management board and the supervisory board and formulates supervisory expectations regarding these bodies in the process of managing and limiting investment risks conducted by the bank; it contains provisions regarding the prevention and limitation of investment risk, monitoring, and reporting on the risks of undertaken investments, and also takes into account the supervisory authority's expectations regarding the bank's organizational structure in the context of investments made by the bank, including the Investment Policy Committee. The Recommendation should be applied to investments made on one's own account. In situations where such activity is subject to regulations governing brokerage activity, the provisions of the Recommendation should be applied with due regard to the priority of regulations governing brokerage activity, including the Act of 29 July 2005 on the trading of financial instruments (Journal of Laws of 2018, item 2286, as amended), as well as other regulations, including guidelines from ESMA and the Financial Supervision Commission regarding this type of activity. The Recommendation fits into the system of recommendations issued by the KNF. The provisions of the Recommendation cover the issue of limiting investment risk in banks, but are complementary to areas indicated in other recommendations; thus, for example, in the area of concentration risk, Recommendation C applies, in the area of internal control – Recommendation H, and in the area of liquidity risk – Recommendation P. The Recommendation formulates supervisory expectations not only regarding the content but also the scope and mutual relationships of investment strategy and policy. Both the strategy and the investment policy should constitute integrated approaches in which individual investment areas will be taken into account. For practical purposes and to maintain full transparency, it would be appropriate for both the strategy and the investment policy to be documents synthesizing individual aspects related to investing. This issue is not definitively settled in the content of the Recommendation, so individual solutions are possible. With regard to the strategy, this may involve placing individual elements of the investment strategy in other documents of strategic rank. Supervisory expectations formulated with regard to the strategy and investment policy, apart from the issue of documented form, concern in particular organizational aspects, having appropriately qualified employees, conducting training, and having appropriate internal systems and procedures. Attention should be drawn to the changed scope of investments, which now includes, among others, investments in real estate (not previously covered by the scope of Recommendation B), while simultaneously excluding involvement in derivative instruments from the definition of investments. In the content of the Recommendation, with regard to certain provisions, the principle of proportionality has been applied directly, directing these provisions exclusively to significant banks. It should be emphasized that the implementation of Recommendation B may be carried out with due regard to the principle of proportionality understood as adapting adopted solutions to the individual specificity and profile of the bank's activity. This means that a bank, when making investments, within the meaning of this recommendation, should comply with regulations, but the number and scope of policies and procedures should be adequate to the scale and degree of complexity of this activity. Due to the special nature of banking activity, associated with burdening funds entrusted by depositors with risk, banks, when implementing investments, should not acquire assets that generate excessively high risk in relation to the risk appetite adopted in the strategy or policy, the ability to assess this risk, and the possibility of hedging against its consequences. Banks operating within association structures and institutional protection systems may benefit from the facilities provided by associations or protection systems, but such an approach may be used only within the limits of applicable regulations regarding the risk management of the conducted activity. Although part of the transactions (banking activities) for which the affiliated cooperative bank is a party are carried out with the consent of the affiliated bank, as well as through the affiliated bank, the process of managing these transactions, including risk management, remains within the competence of the cooperative bank. Investments are realized on the order of the cooperative bank, and it bears the risk associated with them. It should be emphasized that the cooperative bank bears the obligation to organize the investment management process and the risk associated with them. It is not permissible to transfer to other entities, including the affiliated bank and the protection system, the responsibility resting on cooperative banks for organizing the investment management process and the risk associated with them. The functioning of internal regulations within the association and protection system does not exempt cooperative banks from liability for the risk associated with investments; thus, cooperative banks are obliged to create their own procedures. The functioning of analogous regulations at the level of the association and protection system aims to improve the quality and effectiveness of solutions introduced by cooperative banks in this area. The KNF expects that Recommendation B regarding the limitation of investment risk in banks, constituting an annex to Resolution No. 107/2019 of the Financial Supervision Commission of March 26, 2019 (Journal of Laws of KNF item …….), will be implemented no later than December 31, 2019.

5 Glossary of Terms Used Investments (involvements) – acquisition of assets, including financial instruments and others, e.g.: real estate, shares in limited liability companies. Investments within the meaning of this recommendation do not include banking credit-loan activity1, cooperative banks' involvement in the capital of the affiliated bank, and the involvement of protection system participants in protection system instruments (e.g., interbank deposits, mandatory deposits), nor do they include operations using derivative instruments. Significant bank – a bank as referred to in Article 4(1)(35) of the Banking Law.

1 Investments do not include banking credit-loan activity, excluding loan activity conducted on the interbank market. The latter is covered by the subject Recommendation B.

6 List of Recommendations I. Management Board and Supervisory Board Recommendation 1 The Management Board of the bank is responsible for approving and introducing a written policy regarding investing in the bank (Investment Policy). The Investment Policy should result from the Investment Strategy approved by the Supervisory Board. Recommendation 2 When developing the Investment Strategy and Investment Policy, the Management Board of the bank should take into account the cyclical nature of economic processes, changes occurring in the exposure portfolio, and, if the bank's Strategy and Investment Policy include real estate, also the cyclical nature of economic processes in the real estate market, in its investment objectives. Recommendation 3 The Management Board of the bank should appoint persons responsible for introducing and implementing the bank's Investment Policy. Recommendation 4 The Management Board of the bank should assess the adopted Investment Policy of the bank at least once a year from the perspective of the effectiveness of achieving investment objectives, the manner of its application, and the possible need to introduce changes. The Management Board of the bank should inform the Supervisory Board about the results of the assessment. Recommendation 5 The Supervisory Board, in fulfilling its supervisory functions over the process of limiting investment risk in the bank, should supervise the implementation of the Investment Policy based on periodically received reports.

7 Recommendation 6 The Management Board of the bank should ensure that, with due regard to the principle of proportionality, the bank's organizational structure corresponds to the scale of activity and the profile of investment risk undertaken. Recommendation 7 A significant bank should have in its organizational structure a unit responsible for conducting periodic market analyses (analytical unit), within which the bank conducts investments, especially the capital market and the real estate market. Recommendation 8 The Management Board of a bank conducting investments should implement, monitor, and control a consistent investment risk management system, adequate to their scope, size, and complexity. II. Investment Portfolio Management, including principles of identification, prevention, and limitation of investment risk Recommendation 9 The bank should ensure that the composition of the investment portfolio reflects the investment objectives adopted and approved in the Strategy and Investment Policy, and ensure the safety of funds collected from depositors. To this end, the bank should ensure that its investment portfolio is properly diversified. Recommendation 10 Before making a decision regarding the involvement of financial resources, the bank should conduct an analysis, taking into account events that could significantly affect the assessment of a given investment and its future profitability. Recommendation 11 The bank should have a reliable and effective process for identifying and measuring investment risk.

8 Recommendation 12 The bank should ensure that the risk limitation system is adequate, feasible, and fully understandable by the appropriate bank employees. III. Monitoring and Reporting on the Risk of Undertaken Investments Recommendation 13 The bank should have monitoring systems for conducted investments that enable the rapid acquisition of managerial information and ensure compliance with legal requirements and internal regulations. Recommendation 14 The bank should have reporting rules in the area of risk factors related to investments conducted by the bank. These rules should ensure the provision to the Management Board and the Supervisory Board of accurate, comprehensive, and current information allowing for the assessment of the risk of conducted investments and enabling the taking of corrective or preventive actions if necessary. IV. Internal Control System Recommendation 15 The existing internal control system in the bank should take into account the bank's activity regarding conducted investments and ensure compliance with risk management principles resulting from conducted investments.

9 I. Management Board and Supervisory Board Recommendation 1 The Management Board of the bank is responsible for approving and introducing a written policy regarding investing in the bank (Investment Policy). The Investment Policy should result from the Investment Strategy approved by the Supervisory Board. 1.1 The Investment Strategy should take into account the need to ensure the safety of the bank as well as financial funds deposited by clients. The Investment Strategy should specify in particular: a) basic areas of conducted investments (e.g.: real estate investment market, stocks, debt instruments, investment fund participation units, closed-end investment fund certificates, etc.), b) current, medium-term, and long-term investment objectives of the bank, c) risk appetite with regard to investments undertaken by the bank (understood as the bank's current and future willingness to take risk), d) preferred techniques for measuring investment risk and profitability, including an assessment of the impact of investments on changes in the bank's exposure to various types of risk and collectively (aggregated risk), the bank's financial result, liquidity, and capital adequacy. 1.2 The Management Board of the bank should define key areas of the investment policy that will be subject to its direct control. 1.3 The Management Board of the bank should assign responsibility for the implementation of individual areas of the investment policy to individual members of the Management Board. 1.4 The Management Board of the bank may delegate functions related to the implementation of remaining (non-key) areas of the policy to persons designated by itself. 1.5 The bank's Investment Policy should include in particular: a) indication of detailed areas of investments conducted by the bank, including investment objectives regarding individual entities, b) indication of time horizons for holding investments permissible by the bank,

10 c) methods of adapting appropriate investment strategies to changes occurring in the market, d) description of techniques used for measuring investment risk and profitability, e) rules for current valuation of made investments, f) determination of rules for setting loss limits corresponding to investment objectives, g) method of determining the scale of the bank's investment activity, h) rules and mechanisms for monitoring and reporting on conducted investments, protecting against exceeding permissible limits adopted in the bank from individual investment areas, i) rules and frequency of preparing periodic information and preparing assessments of entities in which the bank is capital-involved, j) indications regarding the necessity of conducting an analysis of legal aspects related to conducted investments, including obtaining appropriate permits, licenses, approvals, or lack of objection for investments, if such a requirement is provided for in generally applicable law. 1.6 The Management Board of the bank should approve in writing, implement, and also monitor the introduction and implementation of procedures and rules regarding conducted investments resulting from the Investment Strategy and Investment Policy in the bank. The Investment Strategy and Investment Policy should be subject to periodic reviews and adapted to the needs of the bank, both current and long-term. 1.7 Procedures developed by the bank should in particular specify the procedure and methods for: a) selection of detailed investment areas indicated by the bank, b) construction of the investment portfolio and its management, including portfolio diversification rules,

11 c) adapting appropriate investment strategies to changes occurring in the market, d) adopting techniques for measuring investment risk and profitability, e) current valuation of made investments, f) granting powers of attorney and determining scopes of responsibility at individual decision-making levels, including rules for granting powers of attorney regarding representing the bank in bodies of entities in which the bank is capital-involved, g) setting investment limits, including periodic loss limits, h) determining rules and mechanisms for monitoring and reporting on conducted investments, protecting against exceeding permissible limits adopted from individual areas, i) determining procedures that the bank will apply in case of exceeding investment limits, including procedures for accepting documentation of limit exceedance in particularly justified cases, j) preparing periodic information and preparing assessments of entities in which the bank is capital-involved, k) conducting analysis of legal aspects related to conducted investments, including obtaining appropriate permits, licenses, approvals, or lack of objection for investments, if such a requirement is provided for in generally applicable law. 1.8 A bank conducting investments should, in creating its procedures, use information from databases and, as far as possible, from economic databases, including in terms of current and up-to-date information of an economic nature about individual sectors within the conducted investments. 1.9 The incentive system for employees involved in the process of making and implementing investment decisions in the bank, adopted within the bank's remuneration policy, should be linked to risk management through metrics including compliance with internal regulations aimed at limiting the risk of investments undertaken within the bank.

12 1.10 The bank's economic-financial plan should reflect the assumptions of the Investment Strategy and Investment Policy. Recommendation 2 When developing the Investment Strategy and Investment Policy, the Management Board of the bank should take into account the cyclical nature of economic processes, changes occurring in the exposure portfolio, and, if the bank's Strategy and Investment Policy include real estate, also the cyclical nature of economic processes in the real estate market, in its investment objectives. 2.1 A bank, bearing in mind the need to build an investment portfolio based on as reliable and objective economic information as possible regarding the current situation in the financial market, the real estate market, information about the creditworthiness of counterparties, should also take into account information from banking databases and, as far as possible, from economic databases, economic information bureaus. 2.2 The bank should have a reliable and trustworthy managerial information system in the area of conducted investments. Recommendation 3 The Management Board of the bank should appoint persons responsible for introducing and implementing the bank's Investment Policy. 3.1 The Management Board of the bank should ensure that persons responsible for conducting and implementing transactions within the bank's investments have appropriate professional preparation and skills for assessing and monitoring the risk accompanying individual investments. 3.2 The Management Board of the bank should ensure that persons employed in units responsible for monitoring and controlling risk possess the knowledge and experience necessary for their positions and are equipped with technical means, especially information systems allowing for effective performance of their functions.

13 Recommendation 4 The Management Board of the bank should assess the adopted Investment Policy of the bank at least once a year from the perspective of the effectiveness of achieving investment objectives, the manner of its application, and the possible need to introduce changes. The Management Board of the bank should inform the Supervisory Board about the results of the assessment. 4.1 The assessment of the investment policy should in particular include checking the correctness of conducted activity and studying the reliability of submitted reports and information. Recommendation 5 The Supervisory Board, in fulfilling its supervisory functions over the process of limiting investment risk in the bank, should supervise the implementation of the Investment Policy based on periodically received reports. 5.1 The Supervisory Board should receive reports on the level of risk borne by the bank due to investments and on the quality and effectiveness of the risk management system for conducted investments, including the use of internal limits, at least once every six months. In the case of significant banks, the Supervisory Board should receive reports on the level of risk borne in quarterly periods. 5.2 The Supervisory Board should receive management reports containing information on the implementation of the investment policy at least once a year. Recommendation 6 The Management Board of the bank should ensure that, with due regard to the principle of proportionality, the bank's organizational structure corresponds to the scale of activity and the profile of investment risk undertaken. 6.1 The bank's organizational structure should in particular ensure the separation of functions: a) concluding transactions constituting the bank's investments and their approval, b) monitoring and controlling risk associated with investments conducted by the bank.

14 6.2 Subject to Recommendation 6.4, significant banks should establish an Investment Policy Committee, which would be responsible, among other things, for approving all high-value investments and investments generating a high level of risk. 6.3 The bank independently defines the level of "high-value investments" taking into account the principle of proportionality, i.e., the scale and profile of conducted investments. 6.4 The bank should individually determine the location, organizational conditions, and scope of responsibility and tasks of the members of the Investment Policy Committee. However, in every bank, the Management Board bears responsibility for approving all high-value financial investments. In justified cases due to the scale of activity and the profile of investment risk undertaken by the bank, including in the case of limited investment activity of the bank, the bank's Management Board may refrain from appointing an Investment Policy Committee and entrust the performance of the functions of this Committee to another committee operating in the bank, including a committee responsible for managing assets and liabilities in the bank. Recommendation 7 A significant bank should have in its organizational structure a unit responsible for conducting periodic market analyses (analytical unit), within which the bank conducts investments, especially the capital market and the real estate market. 7.1 The scope of conducted analyses includes: a) analyses of the general situation on the capital market divided into regulated markets and so-called over-the-counter markets, b) study of investors' willingness to invest, c) study of the economic-financial situation of entities of interest to the bank from the perspective of potential capital involvement,

15 d) study of the economic-financial situation and potential, future threats of entities in the context of the justification of the bank's involvement in them, e) analyses of the general situation on the real estate market divided into segments defined by the bank, f) analyses of market and macroeconomic factors influencing the bank's investments, including analyses of price trends in the real estate market, g) comparison of the efficiency of selected investment areas available on the market for analysis, h) search for new investment areas consistent with the assumptions of the bank's Investment Policy. 7.2 The analytical unit should have access to up-to-date and independent economic information databases, enabling the conduct of appropriate analyses, adequate to the scale and profile of the bank's investments. Recommendation 8 The Management Board of a bank conducting investments should implement, monitor, and control a consistent investment risk management system, adequate to their scope, size, and complexity. 8.1 The investment risk management system should guarantee proper measurement, monitoring, and control of factors influencing the size of the risk undertaken. 8.2 Factors influencing the size of the risk undertaken should be understood in particular as interest rates