Regulation of the Bank of Italy on Prudential Supervision for SIMs

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Digitally signed by

THE BANK OF ITALY

Having regard to Legislative Decree No. 58 of 24 February 1998 (Consolidated Act on Financial Intermediation, hereinafter "Consolidated Act"). In particular, having regard to Articles:

• Article 6, paragraph 1, letter a) of the Consolidated Act, which attributes to the Bank of Italy the power to issue, after consulting CONSOB, provisions concerning, inter alia, capital adequacy and risk containment in its various configurations;
• Article 12, paragraph 1 of the Consolidated Act, which provides that the Bank of Italy shall issue to the parent company of a SIM group provisions referring to the set of subjects belonging to the SIM group, concerning, inter alia, the matters referred to in Article 6, paragraph 1, letter a);
• Article 12, paragraph 2 of the Consolidated Act, which provides that the parent company of a SIM group shall issue provisions to the components of the group for the execution of provisions issued by the Bank of Italy.

Considering the need to implement Directive 2010/76/EU of 24 November 2010 of the European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/EC of 14 June 2006, relating to the access to the activity of credit institutions and its exercise and to the capital adequacy of banks and investment firms;

Having regard to the Governor's Decision of the Bank of Italy of 24 October 2007, containing the Regulation on prudential supervision for SIMs (hereinafter, "Regulation");

Having conducted the consultation procedure provided for in Article 23, paragraph 2, of Law No. 262 of 28 December 2005;

Having consulted CONSOB;

ISSUES

the attached measure amending the Regulation of the Bank of Italy on prudential supervision for SIMs.

Rome, 28 December 2011

THE GENERAL MANAGER Fabrizio Saccomanni

Article 1 (General Provisions)

1. In Title I, Chapter 1, paragraph 3, after the definition of "off-balance sheet transaction", the following definition is added:

• "correlation trading portfolio", a sub-portfolio of the trading portfolio for supervisory purposes composed of positions in securitizations and nth-to-default derivatives that meet the following criteria:
• the underlying assets refer to a commonly quoted index, or a set of names, on which single-name credit derivatives can be traded in a liquid market in terms of both demand and supply. For these purposes, a market is liquid in demand and supply if there are offers to buy and sell made independently and in good faith, such that within one working day a price reasonably correlated with the last sale price or with the last competitive buy and sell offer can be determined, and the transaction can be settled within a relatively short period consistent with market practices for the transaction in question;
• they are not: i) re-securitizations (see Title II, Chapter 2, Part Two, Section I, paragraph 3 of Circular No. 263 of 27 December 2006 "New supervisory provisions for banks"); ii) options on securitization tranches; iii) any other derivative having as underlying exposures to securitizations whose pay-off is not proportional to the payments of the underlying tranche. Furthermore, they must not have as underlying assets exposures classifiable, for credit risk purposes, in the regulatory portfolios "exposures secured by real estate" or "retail exposures" defined in Chapter 7. Finally, they must not entail direct exposures to SPVs.

In the correlation trading portfolio, instruments other than positions in securitizations or nth-to-default derivatives may be included, if used with the explicit purpose of reducing risks associated with other positions in the same portfolio and provided that such instruments (or their underlying assets) are traded in a liquid market in terms of both demand and supply as defined above.

To identify this portfolio for prudential purposes, it is necessary that the hedging intent is explicit and documented and that the correlation between the hedging instruments and the positions being hedged is such as to justify their inclusion in the portfolio in question.

2. In Title I, Chapter 1, paragraph 1, the sixth paragraph is replaced by the following: "The requirements in question are aimed at addressing losses that may arise from market operations concerning financial instruments, currencies, and commodities. The regulations identify and discipline the treatment of various types of risk with reference to the supervisory trading portfolio (position and concentration risks) and to the entire balance sheet of the SIM (foreign exchange, commodity, and settlement risk)."

3. In Title I, Chapter 1, paragraph 4, in the second sentence of the first paragraph, after the words "investment advisory service", the following are inserted: "without holding money or securities belonging to clients".

4. In Title I, Chapter 2, Section II, paragraph 1, letter b) is replaced by the following: "b) specific risk, which consists of the risk of losses caused by an adverse change in the price of traded financial instruments, due to factors related to the situation of the issuer. For the purposes of this regulation, within the scope of specific risk, a distinction is made between:

• idiosyncratic risk: price variation due to daily trading activity. It therefore expresses the risk of adverse price movements of the issuer's securities not correlated with the performance of the reference market and attributable to events that do not generate a change in rating class (see migration risk);
• migration risk: price movement connected to a change in rating class;
• default risk: default by the issuer."

5. In Title I, Chapter 2, Section II, paragraph 3.1, the third paragraph is replaced by the following: "The capital requirement for specific risk applies to the sum of the absolute values of the weighted long and short net positions. For positions in securitizations and those included in the correlation trading portfolio, the rules respectively provided for in paragraphs 3.5 and 3.6 apply."

6. In Title I, Chapter 2, Section II, paragraph 3.3, the fourth paragraph is suppressed.

7. In Title I, Chapter 2, Section II, in paragraph 3, the following paragraphs are added:

"3.5 Positions in securitizations and re-securitizations For net positions allocated in the trading portfolio for supervisory purposes, calculated in accordance with the provisions on netting, the capital requirement for specific risk is equal to 8% of the weighted exposures. For these purposes, weighted exposures are determined by applying the prudential rules (standardized method or internal ratings-based methods) that would have been applied had the positions in question been included in the banking book.

The supervisory formula approach may be used by SIMs that use it for positions included in the banking book. The PD and LGD estimates used in the supervisory formula method must be determined within an IRB model authorized for prudential purposes. If the SIM does not use the supervisory formula in the banking book, but is authorized to use the Incremental Risk Charge methodology (see Part Three, Section III, paragraph 3 of Circular No. 263), it may use the supervisory formula with estimates obtained in the IRC; the latter must be consistent with the quantitative requirements provided for the IRB method.

SIMs that intend to assume or assume positions in securitizations or re-securitizations comply with the obligations regarding the maintenance of net economic interest (1) and the organizational requirements set out in Circular No. 263 of 27 December 2006, Title II, Chapter 2, Part Two, Sections VI, VII and VIII (2), regardless of the portfolio in which such positions are allocated (banking book or trading portfolio for supervisory purposes). In cases where the obligations in Section VII are not met, the Bank of Italy may impose an additional weighting factor on positions in securitizations held, as provided for in paragraph 3 of the aforementioned Section VII.

The capital requirement for specific risk for positions in securitizations, until 31 December 2013 (3), is equal to the greater of the following two values: (i) 8% of the weighted net long positions; (ii) 8% of the weighted net short positions.

From 1 January 2014, the capital requirement for specific risk is equal to 8% of the sum of the absolute values of the weighted net long and short positions.

3.6 Correlation Trading Portfolio The capital requirement for specific risk relating to the correlation trading portfolio is equal to the greater of the following two values: (i) 8% of the weighted net long positions belonging to the correlation trading portfolio;

(1) The only exception consists of positions in securitizations allocated in the correlation trading portfolio, for which the obligations set out in Title II, Chapter 2, Part Two, Section VI of Circular No. 263 do not apply. (2) The provisions of Sections VI, para. 3, VII para. 4 and VIII are understood to refer to securitizations completed before 1 January 2012. (3) During this period, the SIM communicates to the Bank of Italy the amounts of capital requirements referred to the two subsets divided by type of underlying asset.

(ii) 8% of the weighted net short positions belonging to the correlation trading portfolio."

8. In Title I, Chapter 2, Section II, paragraph 4, the first paragraph is replaced by the following: "For the calculation of the capital requirement for position risk, the notional amount of the credit derivative contract shall be used unless otherwise specified. This amount may be reduced by an amount equal to the reduction in the market value of the credit derivative in question occurring since the date of inception (notional value minus depreciation)."

9. In Title I, Chapter 2, Section III, paragraph 1, letter b) is replaced by the following: "b) specific risk, which consists of the risk of losses caused by an adverse change in the price of traded financial instruments, due to factors related to the situation of the issuer. For the purposes of this regulation, within the scope of specific risk, a distinction is made between:

• idiosyncratic risk: price variation due to daily trading activity. It therefore expresses the risk of adverse price movements of the issuer's securities not correlated with the performance of the reference market and attributable to events that do not generate a change in rating class (see migration risk);
• migration risk: price movement connected to a change in rating class;
• default risk: default by the issuer."

10. In Title I, Chapter 2, Section III, paragraph 2, Table 2 is replaced with the following: "

RISK TYPE GENERIC RISK SPECIFIC RISK EQUITY SECURITIES short long SHORT TRANSACTIONS OFF-BALANCE SHEET long

GENERAL NET POSITION (a) GENERAL GROSS POSITION (b) COEFFICIENTS (c) 0.08 0.08 TOTAL CAPITAL COVERAGE (d) = (a) x (c) CAPITAL (d) = (b) x (c) ADDITIONAL CAPITAL COVERAGE FOR DERIVATIVE CONTRACTS (e) INDEX DERIVATIVES

GLOBAL CAPITAL COVERAGE (f) = (d) + (e)

".

11. In Title I, Chapter 2, Section III, paragraph 3, number 3) is replaced by the following: "on the general gross position, a coefficient of eight percent is applied, thus determining the capital coverage required for specific risk on equity securities."

12. In Title I, Chapter 2, Section III, paragraph 3, the second and third paragraphs are suppressed.

13. In Title I, Chapter 3, paragraph 1, the first paragraph is replaced by the following: "Settlement risk expresses the risk associated with the failure of the counterparty to deliver at the maturity of the contract the securities, money amounts, or commodities due, for all transactions (regardless of the portfolio to which they belong)."

14. In Title I, Annex A, paragraph 1, letter b) becomes c) and the new letter b) is added: "b) guidelines for the use of unobservable data, capable of ensuring the consistency of the SIM's assumptions with market practices for the determination of prices of the instruments in question or of comparable instruments;"

15. In Title I, Annex A, paragraph 2, the first paragraph is replaced with the following: "SIMs must value their positions based on market prices whenever this is possible. Valuation based on market prices implies a valuation at least daily of positions based on closing prices promptly available from independent sources. Examples include stock exchange prices, screen quotes, or those provided by different highly reputable independent brokers."

16. In Title I, Annex A, paragraph 2, the third paragraph is replaced with the following: "When it is not possible to obtain a valuation based on market prices, SIMs must prudently value their positions or their portfolios based on a valuation model (mark-to-model), before subjecting them to capital requirements for market risks. Valuation based on a model means any valuation based on: (i) a market benchmark instrument; (ii) an extrapolation from market data; (iii) a calculation on market data."

17. In Title I, Annex A, paragraph 2, fourth paragraph, letter a) is replaced with the following: "the senior management must be aware of the instruments in the trading portfolio for supervisory purposes, or other positions at fair value, valued based on a model, and be aware of the uncertainty this creates in risk and economic performance reporting of business operations;"

18. In Title I, Annex A, paragraph 3.2 is replaced with the following: "Illiquid positions may result from both market events and specific situations of the SIM; examples include concentrated and/or matured positions.

SIMs establish and maintain procedures for calculating valuation allowances against illiquid positions. Such allowances reflect the illiquidity of the position and are made, if necessary, in addition to any accounting allowances. SIMs continuously verify whether such allowances are adequate.

Within these procedures, to decide whether a supervisory valuation allowance is necessary for illiquid positions, SIMs consider various factors. Among them are the time necessary to cover the position or its risks, the average bid-ask spread and its volatility, the availability of market quotes, the average trading volumes and their volatility (also in adverse market conditions), the degree of market concentration, the age of the risk positions, the possibility that the valuation is performed based on an internal model, and the incidence of other "model risks".

If the SIM uses valuations based on a valuation model or, in the case of valuation of OICR shares, valuations performed by third parties, SIMs consider whether it is appropriate to apply supervisory valuation allowances. In particular, in the case of complex products, such as positions in securitizations, re-securitizations, and credit derivatives of the nth-to-default type, SIMs explicitly assess the need for supervisory valuation allowances to reflect the model risk associated with incorrect valuation methodologies, or the use of calibration parameters not observable in the market and potentially incorrect.

The amounts of profits or losses arising from supervisory valuation allowances are included in the calculation of "net profits of the trading portfolio" or deducted from supplementary own funds admissible for covering market risk.

When supervisory valuation allowances give rise to significant losses in the period of requirement calculation, these are deducted from core capital."

19. In Title I, Annex D, paragraph 1, point v), the last paragraph is replaced by the following: "If the derivative with a basket of debtors as underlying has an external rating from a recognized ECAI, the counterparty selling protection calculates the capital requirement for specific risk using the rating of the derivative and applying the corresponding weighting factor as if it were a position in securitization (4);

(4) In the case of CLN, the provision in question applies only to CLNs other than those referred to in the previous point iv (proportional protection).

Article 2 (Prudential Supervision Process)

1. In Title II, Chapter 2, paragraph 6.2 is replaced by the following:

"6.2. Frequency of ICAAP Information SIMs and SIM groups shall transmit the ICAAP report to the Bank of Italy annually, by 30 April (5), referring to 31 December of the previous year. Starting from the capital endowment at the close of the previous year, the ICAAP document plans risk-taking strategies and their relative capital coverage for the current fiscal year, until the end thereof."

Article 3 (Public Information)

1. In Title III, Chapter 1, paragraph 1, after the third paragraph, the following is added:

"SIMs must also adopt policies to assess whether the information transmitted adequately conveys their risk profile to market participants; in the absence thereof, SIMs communicate to the public the necessary information in addition to that provided in the Annex. However, they are required to publish only information that is relevant and not exclusive or confidential."

(5) For SIMs whose fiscal year-end date differs from 31 December, the transmission deadline for the report is 120 days from the accounting close of the fiscal year.

2. In Title III, Chapter 1, Annex, the following table is inserted: "

Table 10 Securitization Transactions (6)(7)(8) Description of Information Qualitative Information (a) i) Description of the SIM's objectives regarding securitization activity; ii) nature of risks, including liquidity risk, inherent in securitized assets; iii) for own or third-party positions in re-securitizations, the type of risks in terms of: o degree of subordination of positions in underlying securitizations; o underlying assets of such positions in securitizations; iv) roles played in the securitization process (9) and, for each of them, indication of the extent of the SIM's involvement; v) description of procedures put in place to monitor changes in credit and market risks of positions in securitization (e.g., how the performance of underlying assets impacts such positions) and re-securitization; vi) description of risk hedging policies relating to positions in securitization and re-securitization, including indication of main protection providers for each type of risk; vii) indication of methods for calculating the amounts of risk-weighted exposures that the SIM applies to securitization activity (standardized method, rating-based approach, supervisory formula approach), including the types (10) of positions in securitization to which each approach applies; viii) the types of special purpose vehicles that the SIM, as originator, uses to securitize third-party exposures, including whether, in what form, and to what extent the SIM holds exposures towards said special purpose vehicles, distinguishing between on-balance sheet and off-balance sheet exposures; ix) a list of entities (11) that the SIM establishes and manages and that invest in positions in securitization of assets originated by the SIM or in securitization special purpose vehicles of which the SIM is the originator.

(6) Unless otherwise specified, this information must be provided separately for positions in the trading portfolio for supervisory purposes and for those in the banking book. (7) The reference to securitizations is understood to include re-securitizations. Where the distinction is specified, information must be provided separately for securitizations and re-securitizations. (8) Credit derivatives that are treated, for the purposes of these provisions, as elements of synthetic securitization structures must be excluded from information on CRM instruments and included in those relating to securitizations. (9) For example: "originator", investor, "servicer", credit support provider, ABCP sponsor, liquidity provider, swap counterparty. (10) Securities, liquidity lines, guarantees provided on positions in securitizations, etc. (11) For example, money market funds and trusts.

(b) Summary of accounting policies followed by the SIM with reference to securitization activity, specifying: i) whether transactions are treated as sales or as financing; ii) recognition of revenue from sales; iii) methods, assumptions, key data, and changes from the previous period for the valuation of positions; iv) treatment of synthetic securitizations, if not covered by other accounting rules (e.g., on derivatives); v) criteria for valuing assets awaiting securitization and whether they are allocated in the trading portfolio for supervisory purposes or not; vi) accounting policies regarding agreements that could impose on the SIM the obligation to provide financial support for securitized assets (e.g., recognition of liabilities in the balance sheet). (c) Names of external credit rating agencies used for securitizations and the types of exposures for which each agency is used. (d) The description of the "internal assessment approach", including:

• the internal assessment procedure;