Communications - Assignment of the Fifth of Salary or Pension and Similar Operations (CQS)

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AREA BANKING AND FINANCIAL SUPERVISION
Classification VII 2 8
Subject
Assignment of the Fifth of Salary or Pension and Similar Operations (CQS). Communication.

In recent years, the Bank of Italy has paid specific attention to the sector in question.

In particular, with the communication of November 10, 2009, the most widespread deficiencies were recalled to the system, relating to controls on the sales network, early renewals in violation of sectoral provisions, methods of accounting for commissions, transparency of applied conditions, and correctness of relationships with customers1.

Subsequently, the main banking and financial intermediaries operating in the sector were invited to illustrate their operational practices and initiatives adopted to comply with the recommendations of this Institute.

From the responses provided by intermediaries, it generally emerged an increased awareness of the sector's critical issues. Intermediaries communicated the launch of organizational initiatives for progressive alignment with the legislation under various profiles: network controls, transparency of contractual conditions, early renewals and related refunds to customers, financing for elderly customers.

The most significant results observed following the awareness-raising action are:
a) a generalized revision of operational practices in light of the Bank's indications; b) a general abandonment of the widespread practice of not refunding customers for unearned commissions in case of early loan closure; c) the commitment to improve transparency documents, through the clear allocation of commissions received in advance by intermediaries between up-front and recurring shares. The latter, being subject to accrual, will be refunded, for the unaccrued portion, in case of early termination; d) the general declaration of having interrupted the practice of early renewals, in violation of existing legal provisions.

1 From the perspective of financial education, an explanatory sheet on assignment of the fifth operations and their main implications for customers has been published on the Bank of Italy website.

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Divergences in behavior and practices that are still unsatisfactory remain – summarized in the attachment – with reference to significant aspects concerning:

1. relationships with the network;
2. transparency and pricing setting;
3. refunds to customers;
4. accounting profiles.

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All this being premised, while recalling that by June 1, 2011, intermediaries must comply with the new legislation on consumer credit, the reminder is renewed to strictly respect sectoral legislation and to promptly implement the necessary initiatives to conform to what has been communicated by this Institute.

In particular, all intermediaries active in the CQS sector are urged to:
a) give greater impetus to the action of rationalizing the network. The streamlining and simplification of the distribution structure, particularly limiting the use of pyramid structures, facilitate compliance controls and allow costs borne by customers to be contained; b) adopt organizational safeguards to prevent customers from being directed towards operations inconsistent with their economic-financial conditions, as required by the Transparency Measure of July 29, 2009. In this context, the adoption of tools, including IT tools, should be evaluated to verify the coherence of the product with the economic-financial and actuarial characteristics of different categories of customers (this evaluation must be carried out with particular attention in cases of renewal and financing to be granted to elderly persons). It is also necessary to strengthen internal procedures aimed at assessing the sustainability of the operation by the customer, in accordance with the provisions on creditworthiness assessment; c) ensure adequate standards of correctness even when, in one or more stages of commercialization, third parties external to their organization intervene (e.g., "capping companies"). In these cases, in particular, intermediaries ensure that the pricing and commercial policies followed by the third party are not such as to expose them, in addition to credit risks, to legal risks (e.g., non-compliance with usury provisions) and reputational risks (e.g., if the costs borne by customers are disproportionate); d) ensure adequate oversight of delegated activities, verifying their extent and safeguarding the prerogatives of intermediaries in terms of credit assessment and

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conclusion of contracts. Specific control responsibilities shall be assigned to the competent corporate structures, with particular reference to the compliance function; e) correctly define – in line with the new provisions on consumer credit – the allocation between upfront and recurring commissions, including in the latter the economic components subject to accrual over time; f) define rigorous criteria, linked to a reasonable estimate of costs, to identify any sums to be refunded to customers who have previously terminated operations early, evaluating the feasibility of using IT procedures to promptly calculate the amount due. In this context, in accordance with the indications provided with the communication of November 10, 2009, intermediaries adopt procedures that allow them to promptly satisfy refund requests and, within the context of ongoing relationships with customers who have replaced a contract with another still in effect, to proceed proactively with restitutions. Customer refund requests are in any case treated as complaints, also for the purpose of possible recourse to the Banking and Financial Arbitrator; g) ensure full respect of accounting rules in the recognition of commissions and costs related to CQS. In particular, the principle of economic accrual must be correctly applied in the recognition of commissions received in relation to CQS operations, distinguishing those that accrue due to time (so-called recurring), to be recognized pro rata temporis, from others, to be recognized when received2. With reference to accounting behaviors adopted in the past, it is necessary to proceed, where necessary, to make the consequent corrections in the balance sheet3. Furthermore, adequate provisions must be made in the balance sheet for sums to be refunded to customers and not yet paid. These provisions must cover the entire sum that the intermediary has decided to refund proactively and a reasonable estimate of sums that may be requested by customers in respect of contracts terminated in the past;

2 Provided that they are not to be included in the calculation of the effective interest rate, in accordance with IAS 39.
3 Such corrections shall be made in compliance with IAS 8 "Accounting Policies, Changes in Accounting Estimates and Errors", for intermediaries preparing the balance sheet according to international accounting standards, and with Legislative Decree no. 87/92 (and with the Measure of July 31, 1992 "Instructions for the preparation of balance sheet schemes and compilation rules for financial entities" published in ordinary supplement no. 103 to the Official Gazette no. 186 of August 8, 1992, as amended by the Measure of November 6, 1998 published in the Official Gazette no. 269 of November 17, 1998), for intermediaries under Article 106 of the Consolidated Banking Act. The latter recognize in the income statement among "extraordinary costs" an amount equal to the share of so-called recurring commissions received in the past and not yet accrued.

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h) conduct a careful evaluation, in addition to credit risks, also of legal and reputational risks connected to the assignment of the fifth sector within the next ICAAP report, also in light of the choices made regarding recipients and quantification of refunds (for example, by including among stress scenarios significantly higher refund requests than those projected so far).

Internal control functions will play an active role in verifying the adaptation process.

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The Bank of Italy reserves the right to evaluate, within the on-site and off-site intervention action, the reliability of the information provided by intermediaries, the adequacy of the interventions realized or proposed, and their actual conformity to the regulatory framework; specific corrective measures will be adopted in case of established irregularities.

Rome, April 7, 2011
F. SACCOMANNI

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Attachment
Relevant aspects emerged from the survey carried out by the Bank of Italy with operators and consequent indications.

1. Relationships with the network
   The most widespread interventions, among those launched or planned to strengthen control over the distribution network, especially if constituted by mediators and agents, concerned:

• remuneration mechanisms, usually modified to identify upfront components (retroceded at the time of disbursement) and recurring components (which are now retroceded to the network only at the time of their actual accrual);
• the control system, within which i) IT tools for remote control were adopted or strengthened; ii) codes of conduct for mediators and agents were introduced; iii) surveys were carried out to detect the level of customer satisfaction and controls were extended to assignment companies;
• the structure of the network: some intermediaries declared that they had reduced or disposed of operations through mediators.
  With reference to the above, the results achieved were not uniform, thus highlighting the need for further interventions aimed at simplifying the distribution structure and strengthening control safeguards.

2. Transparency and pricing setting
   On the issue of coherence between the offered product and customer needs, the communicated interventions concerned primarily financing for elderly persons, for which intermediaries generally adopted particular precautions.

On this point, the need to ensure scrupulous respect of the obligation imposed by current legislation to avoid that customers are directed towards operations inconsistent with their economic-financial and actuarial conditions is emphasized, as required by the aforementioned Transparency Measure of July 29, 2009. This requires that any promotional actions towards the specific category of debtors be carefully evaluated, regardless of the provision of a maximum age for them.

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The profile of coherence with customer needs also assumes relevance with reference to the practice of proposing frequent renewals of operations. On this point, it is emphasized that – even in case of compliance with legal terms, but in the presence of a significant share of upfront commissions, not refundable in case of termination of the original loan – the renewal of operations may be convenient for the distribution network, but contrary to customer needs.

Intermediaries have assured that they have endeavored to strengthen complaint management and to revise contracts and transparency documentation, with evidence of the different cost components for customers and, in particular, those subject to accrual over time.

On these aspects, the new legislation on consumer credit4 intervenes, which redefines, inter alia, the documentation that must be prepared at the pre-contractual and contractual stages.

Practices adopted in the matter of allocation of commissions between upfront and recurring shares are not fully satisfactory, often not supported by a detailed cost analysis and characterized by a bias towards the former.

In this regard, two characteristic aspects of the nature of commissions charged in CQS must be highlighted.

First, only a part of the commissions paid entirely by customers in advance refers to non-refundable services (such as drafting or contract execution expenses) (so-called upfront share), while the remaining part (so-called recurring share) is aimed at covering retained risks (credit and liquidity risks connected with guarantees provided, such as for example the "not collected for collected" guarantee) and costs whose accrual is intrinsically connected with the passage of time of the financing (for example, management of collections and claims).

Second, the structure of commissions is often made even more complex by the unclear distinction, within the costs borne by the customer, between cost components due to the intermediary and cost components due to the distribution network. This makes the quantification of refundable costs pro quota in case of early termination uncertain5.

4 Specifically, norms have been introduced in two points (in Part VII "Consumer Credit" and Part XI "Organizational Requirements") aimed at ensuring both that costs that accrue during the relationship – and which must therefore be refunded pro quota in case of early termination of the loan – are expressly indicated, and that this is done in a clear, detailed, and unambiguous manner. 5 Some decisions of the Banking and Financial Arbitrator have recently recognized the special importance that a lack of comprehensibility of contractual conditions assumes in assignment of the fifth operations, especially given the situations of distress in which users who turn to

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Also in this case, the correct distinction of the total commission paid in advance by customers between upfront share and recurring share is fundamental. This Institute reserves the right to evaluate the adequacy of the actions undertaken by intermediaries to make this distinction.

Results achieved in containing commissions borne by customers, and thus in terms of pricing of offered products, do not appear uniformly widespread. Some intermediaries have reiterated their orientation to determine the cost of financing in a way completely disconnected from any assessment regarding the credit quality of debtors, subtracting a predetermined percentage quota (for example one percent) from the usury threshold rate, a mechanism that does not reflect appropriate financing pricing practices.

3. Refunds to customers
   With the communication of November 2009, this Institute stigmatized the practice of applying the total of commissions borne by customers at the time of disbursement, without proceeding to refund unearned shares in case of early repayment, followed or not by renewal of the financing.

To contain legal and reputational risks weighing on intermediaries, with the aforementioned communication, the invitation was formulated to recalculate commissions subject to accrual over time.

On this point, intermediaries communicated the launch of procedures to refund customers sums unduly received and to regulate the methods of retrocession to the customer of sums collected and not accrued in case of early terminations. This has emerged a wide divergence of behaviors, partly deriving from the different operational profiles of intermediaries and the different level of sophistication of information-accounting systems.

4. Accounting profiles
   In general, banks and finance companies have assured that they have correctly applied, also for the past, the economic accrual criterion for the attribution of received commissions. Some intermediaries, who in the past did not respect this criterion, have nevertheless declared that in the future they will correctly apply the principle of economic accrual.

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the sector operators. This aspect is also evident from numerous complaints received by this Institute in the last year.

In respect of commissions received in advance, to be refunded following early terminations, provisions to the 2009 income statement or in the first half of 2010 have generally been provided, which however did not concern all intermediaries.