Recommendation R on rules for identifying impaired on-balance-sheet credit exposures, determining impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures

Annex to Resolution No. 151/2011 of the Financial Supervision Authority of 7 June 2011 Financial Supervision Authority Recommendation R concerning the rules for identifying on-balance-sheet credit exposures that have lost value, determining impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures Warsaw, 2011

Recommendation R Page 2 of 26 I. Introduction The purpose of this document is to indicate to banks applying IFRS/IAS good practices regarding the identification of on-balance-sheet credit exposures that have lost value, the determination of the amount of impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures, within the framework of credit risk management policy. Recommendation R is addressed to banks operating in Poland, preparing consolidated or individual financial statements in accordance with IFRS/IAS. The guidelines contained in the recommendation also apply to branches of domestic banks located outside Poland and to entities dependent on the bank, taking into account legal conditions in local markets and the possibility of achieving compliance with the good practices contained in the recommendation. The recommendation is based primarily on the provisions contained in:

• IAS 39 "Financial Instruments: Recognition and Measurement",
• IAS 37 "Provisions, Contingent Liabilities and Contingent Assets",
• IFRS 7 "Financial Instruments: Disclosures".

Recommendation R Page 3 of 26 II. Definitions

1. Active market1 – an area for the exchange of goods and services, including financial instruments, simultaneously meeting the following conditions: • items being traded are homogeneous or considered homogeneous; • at any time interested buyers and sellers can be found, and transactions entered into are not incidental; • buy and sell offers and information about concluded transactions are publicly available.

2. On-balance-sheet credit exposure – includes financial assets classified into categories: "loans and receivables", "investments held to maturity".2

3. Effective interest rate – the rate that discounts expected future cash flows over the period to the maturity of the on-balance-sheet credit exposure, and in justified cases over a shorter period, to the net book value of the credit exposure.3

4. Credit exposure – on-balance-sheet or off-balance-sheet credit exposure.

5. Counterparty / client – borrower, or another party appearing in a contract concluded with the bank or obligated to the bank.

6. Expected future cash flows – future repayments resulting from the credit exposure (principal amount and related additional receivables and liabilities, including costs incurred to recover receivables) and any cash flows resulting from the realization of collateral. They also include, among others, proceeds from enforcement and bankruptcy proceedings and flows that may not result directly from the credit agreement or collateral, but are related to the credit exposure. Future repayments should not include credit losses resulting from events that have not yet occurred, regardless of the probability of their occurrence.

7. Impairment provision – a provision for the loss of value by an on-balance-sheet credit exposure. The amount of the impairment provision equals the difference between the book value of the on-balance-sheet credit exposure and the present value of expected future cash flows.

8. Off-balance-sheet credit exposure includes off-balance-sheet granted financial and guarantee obligations (e.g., granted but unused credit lines, guarantees, letters of credit).4

9. Restructuring of on-balance-sheet credit exposure5 – renegotiation or change of credit agreement, receivable, or investment held to maturity terms, resulting from the financial difficulties of the debtor or issuer.

10. Reserve for off-balance-sheet credit exposures – the anticipated and estimable loss of value of economic benefits resulting from an off-balance-sheet obligation.6

1 IAS 38 with the inclusion of IAS 39 Implementation Guidance 71. 2 Specified in § 9 IAS 39. 3 § 9 IAS 39. 4 Exposures to which valuation in accordance with IAS 37 or IAS 39 applies. 5 IAS 39 Implementation Guidance 84. 6 with the inclusion of provisions of IAS 37 and IAS 39.

Recommendation R Page 4 of 26 11. Present value of expected future cash flows7 – the value of expected future cash flows discounted using the original effective interest rate of the credit exposure (i.e., the effective interest rate established at initial recognition)8 or the current effective interest rate. 12. Impairment – a situation in which an on-balance-sheet credit exposure has lost value, and a loss from impairment has been incurred when two conditions are met: − there is objective evidence (indicators) of impairment resulting from one or more events that occurred after the initial recognition of the on-balance-sheet credit exposure in the accounting records; − the event (or events) causing the loss has an impact on expected future cash flows resulting from the on-balance-sheet credit exposure or group of on-balance-sheet credit exposures, the reliable estimation of which is possible.9 13. Fair value – the amount for which an asset could be exchanged or a liability settled between knowledgeable and willing parties in a direct transaction.10 Fair value is determined based on adjusted prices on an active market or, if there is no active market for a given type of exposure or collateral, it is determined using valuation techniques11. 14. Book value of on-balance-sheet credit exposure – the value of the on-balance-sheet credit exposure in the accounting records, valued in accordance with the method applicable to the category of financial assets to which this exposure is classified. 15. Incurred but not reported loss – a loss that has occurred but has not been identified by the bank at the level of a single exposure (it cannot yet be attributed to a specific on-balance-sheet credit exposure). 16. Amortized cost – is the amount at which the on-balance-sheet credit exposure is valued at the time of initial recognition, reduced by principal repayments and increased or decreased by the cumulative amortization of any differences between the initial value and the value at maturity, established using the effective interest rate, and reduced by any provisions (directly or through a reserve account) for impairment or uncollectibility.12 17. Significantly significant individual credit exposure – an exposure defined by the bank, adjusted to the nature of the activity conducted and consistent with the approach adopted in credit risk management in the bank.

7 IAS 39 Implementation Guidance 84. 8 § 63 IAS 39. 9 § 59 IAS 39. 10 § 9 IAS 39. 11 Method of determining fair value IAS 39 WP 18; techniques for determining fair value and price corrections according to § 48 lit. A and points 69-82 Annex A to IAS 39. 12 According to § 9 IAS 39.

Recommendation R Page 5 of 26 III. Recommendations

1. General principles of credit risk management regarding the impairment of on-balance-sheet credit exposures, determination of the amount of impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures 1.1 Management Board and Supervisory Board The Supervisory Board, in fulfilling its functions, approves (accepts) the general assumptions of the business strategy developed by the Management Board and exercises supervision over the implementation of the internal control system and evaluates its adequacy and effectiveness. The strategy assumptions should take into account the occurrence of credit risk resulting from the bank's activity, and in particular, the principles of managing this risk. The Management Board, in fulfilling its functions, ensures that the recommendations are reflected in the bank's policy rules governing the identification of on-balance-sheet credit exposures that have lost value, the determination of the amount of impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures. The Management Board ensures that policy rules are also implemented and applied in the bank regarding financial instruments measured at fair value not covered by the recommendation, including in terms of: procedures, internal control system, documentation, and reporting, adequate to those presented in the document below. Policy rules should be reviewed by the Management Board at least once a year for the purpose of their update. In addition to the annual verification of credit risk management policy rules, the bank's Management Board, after each change in IFRS/IAS or their interpretation, assesses the impact of this change on the bank's policy and introduces appropriate updates to the bank's policy rules. The Management Board's responsibility for credit risk management includes designing, implementing, and ensuring the functioning of the credit risk management system. This policy, with regard to the recognition of impairment of on-balance-sheet credit exposures and reserves for off-balance-sheet credit exposures, should refer to, among others, the principles of: • conducting regular (at least once a year) reviews of policy rules for identifying on-balance-sheet credit exposures that have lost value, determining the amount of impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures, to ensure their adaptation to the activity conducted by the bank and current economic conditions; • approving processes and systems for monitoring and managing the quality of credit exposures, including methods for identifying on-balance-sheet credit exposures that have lost value, determining the amount of impairment provisions for on-balance-sheet credit exposures, and reserves for off-balance-sheet credit exposures; • ensuring adequate valuation of on-balance-sheet credit exposures, taking into account the appropriate level of impairment provisions and reserves; • defining formalized procedures and scopes of responsibility and control related to the use of own expert judgments to estimate, among others, expected future cash flows, losses from impairment of on-balance-sheet credit exposures, the value of collateral, and reserves for off-balance-sheet credit exposures;

Recommendation R Page 6 of 26 • establishing internal regulations and procedures regarding the verification, monitoring, and analysis of the value of collateral and ensuring their valuation in accordance with the principle of prudent valuation; • reversing losses from impairment, as specified in part 6 of this document; • making changes to standards for granting and servicing loans and recovering receivables; • providing the Supervisory Board with regular reports on the adequacy of impairment provisions held by the bank. • applying methods for recognizing the impairment of on-balance-sheet credit exposures and creating reserves for off-balance-sheet credit exposures. 1.2 Policy and Procedures 1.2.1 Procedures and Internal Control System The Bank should possess and apply internal procedures specifying, among others, the role and responsibility of individual organizational units of the bank and employees regarding the correctness of the implementation of the bank's policy rules concerning the identification of on-balance-sheet credit exposures that have lost value and the determination of impairment provisions for them, and the creation of reserves for off-balance-sheet credit exposures. They should also contain detailed rules for the classification/rating assessment of credit exposures. This classification should take into account the specific risk characteristics of credit exposures and their diversification. The bank's internal procedures should contain a description of internal control mechanisms ensuring the inclusion of all material information both in the process of identifying on-balance-sheet credit exposures that have lost value and in the process of determining the amount of impairment provisions and reserves for off-balance-sheet credit exposures. The bank's internal procedures should also contain a description of the independent process of assessing the adequacy and effectiveness of processes related to credit risk management, including methods for identifying on-balance-sheet credit exposures that have lost value and determining the amount of impairment provisions for on-balance-sheet credit exposures and reserves for off-balance-sheet credit exposures, conducted by internal audit, indicating the frequency of this assessment. The Bank should also develop rules for the flow of information between individual cells of the bank involved in the process of identifying on-balance-sheet credit exposures that have lost value, determining impairment provisions, and the process of creating reserves for off-balance-sheet credit exposures. 1.2.2 Credit Risk Management Regarding Impairment of On-Balance-Sheet Credit Exposures The Bank should possess a description of the credit risk management system implemented in the bank regarding the impairment of on-balance-sheet credit exposures, which should include, among others, policy rules and procedures relating in particular to: • definition of loss on on-balance-sheet credit exposure; • frequency of monitoring and reviewing on-balance-sheet credit exposures for impairment, including the frequency of monitoring and analysis of collateral;

Recommendation R Page 7 of 26 • application of individual and group approaches with regard to identifying credit exposures that have lost value and estimating impairment provisions; • systems for classifying on-balance-sheet credit exposures, used to determine whether impairment has occurred for given credit exposures (credit rating scales taking into account both qualitative and quantitative criteria, e.g., rating models); • conditions for applying expert methods in processes of identifying credit exposures that have lost value and estimating impairment provisions; • requirements regarding the verification and use of collateral; • where applicable: − rules for reducing credit exposure through legally effective netting;13 − rules for the use of credit derivatives and insurance of credit exposures (taking into account the impact of these instruments on the recognition and measurement of the level of losses ultimately realized by the bank); − determination of the reference rate used to calculate expected future cash flows in a currency other than zloty, e.g., flows from the sale of collateral (current rate, forward rate on the day of expected payment, buy rate, sell rate, or average). • rules for restructuring credit exposures, including decision-making competencies regarding the change of repayment terms and renewal of credit exposures; • setting internal limits on credit exposures and the method of their monitoring. 1.2.3 Identification of Impairment and Determination of Impairment Provisions for On-Balance-Sheet Credit Exposures With regard to the process of identifying impairment and determining impairment provisions for on-balance-sheet credit exposures, the bank should possess: • defined objective evidence (indicators) indicating the impairment of on-balance-sheet credit exposures; • a description of methods for identifying on-balance-sheet credit exposures that have lost value and determining the amount of impairment provisions in an individual view, including, among others: − a method defined by the bank for classifying on-balance-sheet credit exposure as significantly significant individually; − a description of the rules for estimating and verifying expected future cash flows; − a description of information systems supporting the process of identifying credit exposures and estimating impairment provisions; • a description of methods for identifying on-balance-sheet credit exposures that have lost value and determining the amount of impairment provisions in a group view, including, among others:

13 According to the rules specified in § 42-50 IAS 32.

Recommendation R Page 8 of 26 − a description of models or tools used to determine impairment provisions (including the forms and statistical methods used) and the rules for their verification; − rules for collecting and using by the bank historical data on losses ultimately incurred in different groups of on-balance-sheet credit exposures and historical data on impairment provisions created for individual groups; − rules for the approach applied with regard to incurred but not reported losses, including the period of loss identification (Loss Identification Period14); − methods of segmenting groups, including a description of the method of identifying the type of on-balance-sheet credit exposure in each group, the method of studying changes in the group structure, the method of studying trends in repayment arrears, and the level of recovered receivables; − rules for including and excluding credit exposures from the group, in particular the method of handling atypical exposures that contribute to distorting results for the entire group; − the method of taking into account current economic conditions; − the requirement to store data used to identify on-balance-sheet credit exposures that have lost value within each group; − rules for conducting quality/validation tests of the group model. It is recommended to ultimately use for groups of on-balance-sheet credit exposures at least a three-year period of observation of historical data regarding the level of incurred losses. For portfolio groups with a shorter history or new credit products, shorter observation periods or observations concerning groups of similar assets will be used accordingly. The estimation of losses should take into account current conditions affecting the credit quality of the portfolio on the day of estimation and should not be the result of averaging historical data, unless justified by other reasons. • a description of the rules and method of obtaining data in case the bank uses observations made by other institutions, by indicating, among others: − the type of institutions making observations; − the frequency of data acquisition; − the scope of data; − the bank cell responsible for data acquisition; − the methodology for assessing the adequacy of acquired data with regard to the portfolio held by the bank. • information regarding the period for which historical data on the level of losses ultimately incurred and impairment provisions created have been collected; • information regarding the corrections applied, including the justification for these corrections and their calculation.

14 Description in footnote 31.

Recommendation R Page 9 of 26 1.2.4 Verification of Losses In order to assess the adequacy of the applied methodology, the bank should conduct periodic analysis, which will allow determining to what extent previously made provisions were reflected in actually incurred losses, in particular, the bank should: • possess a description of the adopted loss verification methodology; • within the loss verification methodology, the bank should specify how the result of loss verification is included in the estimated level of impairment provisions, and also indicate the need to explain the causes of existing differences between the estimated and actual level of parameters and indicate what value of parameters results in the necessity of making changes to the methodology for calculating impairment provisions; • conduct verification of the adequacy of parameters used in calculations (in particular, PD parameters) by comparing them with the actual indicator of credit exposures being covered by impairment; • conduct loss level verification in such a way that the inclusion of verification effects is possible on the day ending the financial year; • at least once a year compare losses ultimately incurred in the previous period with estimated losses (for each exposure group,);15 • in the case of incurred but not reported losses, compare the provision/reserve balances on a given balance sheet date with provisions/reserves created in the subsequent period for credit exposures that were reclassified into the category with recognized impairment during that period; • at least once a year compare losses ultimately incurred on on-balance-sheet credit exposures in an individual view with impairment provisions created for them. 1.2.5 Valuation of Collateral In the case of collateral valuation, it is recommended that the bank investigate whether the value of the collateral is obtainable, in the amount and time taken into account in the impairment calculation. The Bank should take into account all legal, economic, and factual limitations that may affect the actual possibility of satisfaction from the subject of collateral. If in the process of assessing the impairment of on-balance-sheet credit exposures (in an individual approach or in a group approach) the bank takes into account the collateral held, expected future cash flows from these collateral or model parameters in a group view should be adjusted according to the bank's historical analyses regarding the actual possibility of satisfaction from a given type of collateral. For example, if the average period of the bank's satisfaction from collateral in the form of a vehicle, on which a registered pledge is established, is 12 months, the bank should not accept for the calculation of cash flows from the realization of this type of collateral a period shorter than one year. In particular, estimated collateral values should be subject to

15 Applies to point 89 Annex A to IAS 39.

Recommendation R Page 10 of 26 verification to historical values obtained from collateral of a given type (back-tests). The Bank should possess procedures regarding: • methods for determining the value of collateral (including taking into account collection costs, sale, etc.); • valuation models of collateral used, including, among others: − methods for determining historical recovery rates reflecting the efficiency of the collection process; − rules for validating the obtainable value of collateral; − the method of taking into account corrections resulting from changes in market factors; − a differentiated approach depending on the location and type of collateral; • procedures in the event of sudden changes in the value of collateral - simulation models and stress tests, which help in this area, allowing for the estimation of potential changes in the entire portfolio, as well as individual loans; • the requirement to possess justification for the accepted value of collateral. If the market price of collateral is used to assess its value, then its amount, source, and date of observation must be documented, and a correction for all possible costs of collateral enforcement must be made. The Bank should periodically monitor the value of accepted collateral. These collateral should be valued in accordance with the principle of prudent valuation, appropriately in periods applicable to the valuation of credit exposures. This is particularly important