Clarifications on the Prudential Treatment of Unrealized Profits and Losses from Exposures to Central Governments in the Available-for-Sale Portfolio

Clarifications on the prudential treatment of unrealized profits and losses arising from exposures to central administrations classified in the "Available-for-sale financial assets" portfolio.

Following the issuance of European Central Bank Regulation (EU) No 2016/445 on the exercise of options and discretions provided for in Union law ("ECB Regulation") and Commission Regulation (EU) 2016/2067 homologating the International Financial Reporting Standard "Financial Instruments" ("IFRS 9") ("IFRS 9 Regulation"), the following indications are provided – to the extent within the competence of the Bank of Italy – regarding the prudential treatment of the cumulative net balances of unrealized gains and losses on exposures to central administrations classified in the "Available-for-sale financial assets" portfolio, as recognized under the current IAS 39 accounting standard in the so-called Available For Sale reserve – "AFS" (hereinafter "unrealized profits and losses arising from exposures to central administrations").

Regulation (EU) No 575/2013 ("CRR") imposes on banks, as a general rule, to include in and deduct from their own funds, respectively, unrealized profits and losses on assets valued at fair value classified in the AFS portfolio. For a transitional period, the CRR allows that these profits and losses be only partially included or deducted from Core Tier 1 capital ("CET 1"), according to a gradually increasing approach, leading to full inclusion/deduction from January 1, 2018.

In derogation from this transitional regime, exclusively with reference to profits and losses arising from exposures to central administrations accounted for in the AFS portfolio, the CRR (1) – in continuity with the previous regime (2) – has granted competent authorities the option to allow banks not to include profits or not to deduct unrealized losses in any element of own funds if this treatment was applied before the entry into force of the CRR itself (January 1, 2014). By express regulatory provision, the sterilization of profits and losses may be applied until the Commission has "adopted a regulation based on Regulation (EC) No 1606/2002 approving the international financial reporting standard in replacement of IAS 39" (i.e., IFRS 9).

At the time of the first application of the CRR in Italy, this discretion was exercised by the Bank of Italy, and banks had the possibility to opt for the total sterilization of profits and losses (3).

In this context, the following have intervened:

• The ECB Regulation, which entered into force on October 1, 2016, provided that banks subject to direct supervision by the ECB ("significant banks") should not exercise the discretion and therefore apply the ordinary transitional regime also to exposures to central administrations. For banks other than those under direct supervision of the European Central Bank ("less significant banks"), national legislation continues to apply;

1 Art. 467(2) second subparagraph 2 See CEBS Guidelines On Prudential Filters for Regulatory Capital, December 2004. 3 See Circular 285/2013 "Supervisory provisions for banks", Part Two, Chapter 14, Section II, paragraph 2

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• The IFRS 9 Regulation, published in the Official Journal of the European Union on November 29 last, by which the European Commission homologated the IFRS 9 accounting standard.

It is therefore necessary to distinguish the applicable rules for "significant" banks from those applicable – at individual and consolidated level – to "less significant" banks, SIMs (Securities Investment Companies), and financial intermediaries registered in the register referred to in Article 106 of the TUB (Banking Law).

"Significant" Banks Following the entry into force of the ECB Regulation, from October 2016, significant banks must include in or deduct from CET 1, respectively, the unrealized profits and losses arising from exposures to central administrations classified in the AFS portfolio according to the following percentages: 60% for 2016 (4); 80% for 2017.

The amounts remaining from the application of these percentages (i.e., 40% for 2016; 20% for 2017) must not be computed for the purpose of calculating own funds, continuing to be subject to sterilization. In application of the transitional regime provided by the CRR, the national regime in force on December 31, 2013, indeed applies.

Circular 285/2013 will be updated at the first useful opportunity (5).

"Less significant" Banks, SIMs, and Financial Intermediaries Registered in the Register referred to in Art. 106 TUB Pursuant to Art. 467(2), second subparagraph, of the CRR, the option exercised by the Bank of Italy to allow banks to opt for the total sterilization of profits and losses arising from exposures to central administrations accounted for in the AFS portfolio has a limited temporal application, namely until the adoption of the accounting standard that replaces IAS 39 (i.e., IFRS 9).

The IFRS 9 Regulation entered into force on December 19, 2016 (the twentieth day following publication in the Official Journal of the European Union); however, pursuant to Art. 2 of the Regulation, the application of IFRS 9 must take place, at the latest, from the start date of the first financial year beginning on January 1, 2018 or later (6).

Thus, the interpretative question arises as to whether "adoption of the accounting standard that replaces IAS 39," to which the CRR refers as the moment from which the effects of the removal of the sterilization filter should run, should be understood as the date of entry into force of the IFRS 9 Regulation or the date of its actual application by the supervised entities. While in the first case the same treatment provided for significant banks would apply, in the second case banks could continue to apply the sterilization filter to the entire amount of unrealized profits and losses arising from exposures to central administrations (AFS).

Given the interpretative doubt determined by the text of the CRR and its relevance for the calculation of capital requirements and the performance of supervisory reporting, the Bank of Italy will formally consult the competent European authorities in the matter, to request confirmation that the correct reading of Art. 467, paragraph 2, second subparagraph, implies that the removal of the filter must occur no earlier than the actual application of the new accounting standard.

Pending a formal clarification from European authorities, the discretion will continue to apply; therefore, "less significant" banks, SIMs, and financial companies registered in the Register referred to in Art. 106 TUB will be allowed not to include in own funds the profits and losses arising from exposures to central administrations accounted for in the AFS portfolio.

4 The Regulation entered into force on October 1, 2016, therefore from the reporting of December 31, 2016, "significant" banks will have to apply the percentages provided by the ECB Regulation. 5 With reference to profits and losses arising from all other exposures valued at fair value other than exposures to central administrations accounted for in the AFS portfolio, the amounts remaining from the application of the percentages of the transitional regime will continue to be treated according to the asymmetric approach referred to in Annex A, Chapter 14, Part Two, Annex A of Circular 285/2013. 6 There is a possibility for intermediaries to voluntarily apply the new standard from the 2017 financial year (so-called early adoption)

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sterilization to the entire amount of unrealized profits and losses arising from exposures to central administrations (AFS).

Given the interpretative doubt determined by the text of the CRR and its relevance for the calculation of capital requirements and the performance of supervisory reporting, the Bank of Italy will formally consult the competent European authorities in the matter, to request confirmation that the correct reading of Art. 467, paragraph 2, second subparagraph, implies that the removal of the filter must occur no earlier than the actual application of the new accounting standard.

Pending a formal clarification from European authorities, the discretion will continue to apply; therefore, "less significant" banks, SIMs, and financial companies registered in the Register referred to in Art. 106 TUB will be allowed not to include in own funds the profits and losses arising from exposures to central administrations accounted for in the AFS portfolio.

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