Recommendation B on Limiting the Risk of Banks' Financial Investments

NATIONAL BANK OF POLAND BANKING SUPERVISION COMMISSION General Inspectorate of Banking Supervision

RECOMMENDATION B concerning the limitation of the risk of banks' financial investments

Updated text Warsaw, 2002

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I. INTRODUCTION The following recommendation replaces "Recommendation B of March 3, 1997, concerning the limitation of the risk of banks' capital investments."

Financial investments (commitments) can be defined as the investment of bank funds with the aim of increasing their value (achieving financial benefits) through any long-term commitment to capital market instruments, money market instruments, real estate, or any other ventures that may generate profits for the bank.

Banks engaged in conducting financial investments should have a written strategy for current, medium-term, and long-term investment policy, approved by management, ensuring the safety of the bank and the financial funds deposited by clients. Any changes to the bank's investment strategy must be approved by its management and adequately justified in writing.

Banks are advised to conduct periodic reviews of their investment policy rules to adapt them to current and forecasted market conditions and the bank's needs. Investment strategy rules should be based on an analysis of current and expected changes in inflation levels, interest rates, exchange rates, and other factors. The construction of the investment portfolio should reflect the investment goals adopted and approved by the bank, as well as the safety of funds collected from depositors. The investment portfolio should be properly diversified. The structure of the bank's investment portfolio should allow for appropriate liquidity management. Periodic analyses of the capital market should be conducted by appropriate organizational units within the bank.

When assessing the reliability of entities, banks should take into account all events that could significantly impact the assessment of a given investment and its future profitability. The bank should also have appropriate procedures for the current maintenance, circulation, and archiving of all documentation.

Management of the institution bears responsibility for approving all high-value investments.

It is recommended that management monitor, at least on a monthly basis, the overall state, liquidity, and achieved profitability of the bank's investment portfolio.

This monitoring also serves to prevent the potential exceedance of any permissible internal and external limits regarding investment concentration on a bank-wide scale.

It is further recommended that independent persons within the bank (e.g., employed in the Internal Control Department) conduct additional studies and tests regarding the correctness of accounting and valuation of securities, deposits, shares, capital contributions, derivative instruments, and studies concerning any undesirable practices.

Additionally, banks are recommended to develop internal definitions and rules for identifying risks associated with so-called large concentrations in the context of conducted investments, and to establish appropriate internal limits for all identified large concentrations in these investments.

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II. DEFINITIONS

1. Investments (commitments) - investing bank funds with the aim of increasing their value (achieving financial benefits) through any long-term commitment to capital market instruments, money market instruments, real estate, or any other ventures that may generate profits for the bank.

These instruments include, for example, all securities, units of participation in investment funds, deposits and shares in companies and cooperatives, capital contributions to companies, other investments in money and capital market instruments (commercial paper, KWITs, etc.), guaranteeing issuances, acquiring real estate, and other commitments.

2. Guaranteeing the issuance of securities - an obligation to subscribe (purchase), at a pre-established price and within a pre-established timeframe, securities (debt or equity) from a new issuance in the event that they are not subscribed by other entities through subscription.

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III. RECOMMENDATIONS

A. BANK INVESTMENT STRATEGY AND POLICY

1. The bank should possess a written strategy for current, medium-term, and long-term investment policy, approved by management (Board of Directors, Supervisory Board of the Bank), ensuring the safety of the bank and the financial funds deposited by clients, taking into account in particular:

• short, medium, and long-term investment goals,
• determination of the investment area recognized by the bank as safe,
• rules for constructing the investment portfolio and methods for managing it,
• methods for adjusting appropriate investment strategies to changes occurring in the market,
• risk and profitability measurement techniques used,
• accounting record-keeping rules adequate to the type of investment,
• rules for the current valuation of completed investments,
• rules for allocating appropriate powers and responsibilities to specific persons at various decision-making levels,
• the level and tolerance of risk accepted by the bank (e.g., maximum daily loss limit),
• the amount of funds available for investment,
• future capital requirements,
• prevailing norms for the concentration of the bank's commitments and rules for monitoring them (especially in the context of coordinating information flow between, e.g., the Capital Investments Department, a separately organized and financed banking brokerage office, and the Difficult Loans Department),
• rules and mechanisms protecting against the exceedance of permissible concentration limits on a bank-wide scale,
• rules for granting powers to represent the bank in the bodies of entities in which capital is invested, and rules for preparing and presenting recommendations for the bank's representatives in the bodies of these entities,
• rules and frequency for preparing periodic information and assessing entities in which the bank is capital-invested,
• rules for managing real estate acquired by the bank as an investment and their efficiency,

2. Any changes to the bank's investment strategy must be approved by its management and adequately justified in writing.

Banks are advised to conduct periodic reviews of investment policy rules to adapt them to current and forecasted market conditions and the bank's needs.

3. Investment strategy rules should be based on an analysis of current and expected changes in inflation levels, interest rates, exchange rates, and other factors.

B. INVESTMENT PORTFOLIO MANAGEMENT

1. The construction of the investment portfolio should reflect the investment goals adopted and approved by the bank, as well as the safety of funds collected from depositors in banks.

2. The investment portfolio should be properly diversified.

Portfolio diversification should ensure the highest possible safety of invested funds.

When diversifying the investment portfolio, the bank should take into account in particular:

• the type of financial investments (including, e.g., the legal form of the entity in which the bank invests capital),
• the current and forecasted economic-financial situation of entities (access to information sources - particularly important when making investments in foreign markets),
• the economic-financial situation of the entity whose securities the bank intends to guarantee,
• organizational and capital links between entities in which the bank invests capital,
• the bank's credit exposure to these entities,
• the maturity date of debt securities issued by the issuer, taking into account the potential possibility of presenting them for early redemption by both the issuer and the purchaser,
• the liquidity of completed financial investments,
• expected profitability,
• geographical, sectoral, etc., diversification,

3. The structure of the bank's financial investment portfolio should allow for appropriate liquidity management.

4. Appropriate organizational units of the bank should conduct periodic analyses of the capital market (including the international market), and in particular: a) analyses of the general situation prevailing in the capital market (bear market, bull market, stagnation), divided into the stock market and over-the-counter market,

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b) investigation of investors' willingness to invest, c) investigation of the economic-financial situation of entities that are the subject of the bank's interest from the perspective of potential capital commitment (in particular, analyses of offering prospectuses and information memoranda), d) investigation of the economic-financial situation and all potential future threats of entities in the context of the appropriateness of the bank's involvement in them, e) analyses of the scope and direction of changes in interest rates, f) comparison of the efficiency and profitability of all investment opportunities in the market, g) analyses of exchange rates of currencies in which foreign investments have been or will be made, h) searching for new investment opportunities consistent with the assumptions of the bank's investment policy,

5. Persons from the team responsible for conducting market analysis should not participate directly in making investment decisions and conducting transactions.

This team should possess its own, currently updated, independent information base enabling the conduct of proper analyses. It should assess the predicted impact of changes in selected macroeconomic and microeconomic factors on the formation of the economic-financial situation of entities in which the bank is invested and which may influence the change in expected profits.

6. When assessing the reliability of entities, banks should take into account all events that could significantly impact the assessment of a given investment and future profitability, in particular: a) acquisition, disposal, or loss of assets of significant value, b) declaration of bankruptcy, opening of restructuring proceedings, opening of liquidation proceedings for an entity, c) decision or plan to merge with another entity, d) change of auditor, e) changes in the shareholding of the entity, f) changes in management positions, particularly among members of supervisory and management bodies in individual entities, g) changes in the business activity profile of entities.

7. In the case of acquiring debt securities, banks are obliged in particular to analyze: a) goals and conditions of issuance - determination of the venture for which funds from the issuance will be used,

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b) size of the issuance, c) nominal value and issue price of debt securities, d) redemption conditions, e) interest payment conditions, f) amount and form of any security and identification of the subject of security, g) balance sheet profit achieved in periods preceding the issuance and prospects for the formation of the issuer's financial results due to the realization of the venture financed by bond issuance until their complete redemption, h) data enabling potential bond buyers to orient themselves regarding the results of the venture to be financed by bond issuance and the issuer's ability to fulfill obligations arising from the bonds, i) financial statements of the issuer, at least for the last fiscal year, along with the auditor's opinion, both before making the investment decision and during the period until the complete redemption of the bonds.

The above-mentioned rules should also apply to securities, shares, real estate, and other assets acquired by the bank for debts as part of their restructuring, and to securities that the bank may subscribe to as a result of a guaranteeing issuance agreement.

8. The bank should also have appropriate procedures for the current maintenance, circulation, and archiving of all documentation.

9. It is recommended that banks heavily involved in transactions on the capital and money markets establish, for example, an Investment Policy Committee, which would be responsible, among other things, for approving all high-value financial investments.

The location, organizational conditions, and scope of responsibility and tasks of the Committee members are determined individually by each bank. However, in every bank, management bears responsibility for approving all high-value financial investments.

10. It is recommended that management monitor, at least on a monthly basis, the overall state, liquidity, and achieved profitability of the bank's financial investment portfolio.

This monitoring also serves to prevent the potential exceedance of any permissible internal and external limits regarding the concentration of financial investments on a bank-wide scale.

To this end, the bank should have a Management Information System, enabling the generation of information in a timely manner. Information possessed by management should enable the assessment of the implementation of investment policy tasks carried out by individual departments of the bank and indicate the safety of depositor funds located as financial investments of the bank.

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11. Persons responsible for conducting transactions on financial markets should have appropriate professional qualifications and skills to assess and monitor the risk accompanying individual investments.

12. It is recommended that additional studies and tests be conducted by independent persons within the bank (e.g., employed in the Internal Control Department), regarding the correctness of accounting and valuation of securities, deposits, shares, capital contributions, derivative instruments, and regarding any undesirable practices.

13. Banks are recommended to develop internal definitions and rules for identifying risks associated with so-called large concentrations in the context of conducted financial investments.

To this end, banks should: a) define internal rules for identifying closely related clients (including, e.g., capital and organizational links), b) define concentration rules, among others, regarding:

• the same type of securities,
• securities having the same type of security,
• securities having a similar risk profile.

Internal rules for verifying and classifying related clients should be consistent with applicable regulations in this regard.

14. It is recommended to establish appropriate internal limits for all identified large concentrations in the context of financial investments.

15. Entrusting the performance of certain activities related to banks' financial investments to external firms (outsourcing), even if these firms are organizationally or capital-linked to the bank, will be subject to special attention by banking supervision (these activities cannot include the management of the investment portfolio, nor the management of risk arising from this portfolio). The bank entrusting these activities is obliged to observe special prudence rules regarding delegating its functions to other entities. Example requirements in this regard include:

• maintaining the written form of the order and its acceptance by the bank's management,
• the bank having a contract with the contractor,
• the bank's ability to demonstrate that it has effective control over the contractor regarding the provision of services,
• the possibility for the bank to currently monitor the contractor's situation and its ability to provide services,
• having a contingency plan in case the contractor is unable to provide services.

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TABLE OF CONTENTS I. INTRODUCTION....................................................................................................................................................... 1 II. DEFINITIONS.............................................................................................................................................. 2 III. RECOMMENDATIONS ............................................................................................................................... 3 A. BANK INVESTMENT STRATEGY AND POLICY.............................................................. 3 B. INVESTMENT PORTFOLIO MANAGEMENT .................................................................. 4

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Prepared by: Department of Prudential Regulations Office of Supervisory Policy, GINB

Approved by: Wojciech Kwaśniak General Inspector of Banking Supervision

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