Exposures to be Classified as High Risk

FINANSTILSYNET
Postboks 1187 Sentrum
0107 Oslo
Circular
Exposures to be Classified as High Risk
CIRCULAR:
2/2021
DATE:
26.5.2021
THE CIRCULAR APPLIES TO:
Banks
Credit institutions
Financing companies
Securities companies
Holding companies in financial groups that are not insurance groups Management companies for securities funds with permission to provide active management Alternative investment funds with permission to provide active management Parent companies covered by the Securities Trading Act § 9-46 first paragraph no. 3

Exposures to be Classified as High Risk
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1 Background
This circular replaces circular 5/2020.
The capital requirement rules follow from the CRR/CRD IV Regulation and the Capital Requirements Regulation (CRR), in addition to the Financial Enterprises Act and Regulation, cf. CRR/CRD IV Regulation § 2. According to Article 128 in the CRR, exposures associated with particularly high risk must have a risk weight of 150 percent under the standard method for credit risk. The European Banking Authority (EBA) published guidelines on 17 January 2019 regarding which types of exposures are associated with particularly high risk under the provision in Article 128. 1 Furthermore, the EBA has published several answers to questions regarding the provision on high-risk exposures. The answers also concern the provision in Article 4(1) point 79 regarding financing of speculative investment in real estate. The Finanstilsynet will place emphasis on the content of the guidelines and answers from the EBA in the implementation and enforcement of the regulations in this area. The Ministry of Finance communicated to the Finanstilsynet in a letter dated 25 May 2021 how the provisions on financing of speculative investment in real estate should be implemented in Norway. This circular provides further details on the provision in the Capital Requirements Regulation and the EBA's guidelines and answers related to the provision in Article 128, as well as the Ministry of Finance's assessment of how the provision on financing of speculative investment in real estate should be implemented in Norway. 2 Details on the provision on high risk
Article 128 of the Capital Requirements Regulation applies inter alia to the following exposures,
cf. point 2:
a) Investments in venture capital companies. b) Investments in alternative investment funds (AIF) as defined in Article 4(1) letter a) of Directive 2011/61/EU, except when the fund's mandate does not allow a higher debt ratio than that required in accordance with Article 51 no. 3 of Directive 2009/65/EF. c) Investments in active equity. d) Financing of speculative investment in real estate. Financing of speculative investment in real estate is defined in Article 4(1) point 79 in the CRR as: "… loans to finance the acquisition of land, or the development or construction of real estate on land, or of real estate, with a view to resale for profit." 1 https://eba.europa.eu/regulation-and-policy/credit-risk/guidelines-on-specification-of-types-of-exposures-to-be-associated-with-high-risk

Exposures to be Classified as High Risk
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The Finanstilsynet draws particular attention to the fact that all types of financing of speculative investment in real estate shall be considered as associated with particularly high risk. Ordinary and responsible loans are directly covered by the definition in Article 4(1) point 79 in the CRR. Furthermore, equity financing shall be included, cf. point 3.2 below regarding the EBA's guidelines. The EBA's guidelines also specify which other exposures than those listed under Article 128(2) shall be considered as exposures with particularly high risk. 3 EBA's guidelines on high risk The Finanstilsynet confirmed on 15 May 2019 to the EBA that the EBA's guidelines on high risk would be followed in Norway. The guidelines started to apply in EU countries from 1 July 2019.
3.1 Details on venture companies and active equity
The guidelines clarify which types of exposures shall be considered as investments in venture capital companies and in active equity. Such investments shall at least include:
a) Non-debt-based exposures that give a subordinated claim on a company's remaining assets or income in liquidation, and that are not listed on a stock exchange, and b) Debt-based exposures and other securities, partnerships, derivatives or instruments with equivalent economic substance as in letter a), that are not listed on a stock exchange Investments in venture capital companies include investments made with the purpose of providing financing to newly established businesses, including for the development of a new product and related research for the company to bring the product to market, to build up the company's production capacity or to expand the business. Active equity refers to investments made with the intention of creating profit through leveraged acquisitions, initial public offerings, sale of the shareholding in other ways or transactions with equivalent economic substance.
3.2 Details on other high-risk exposures
The guidelines clarify the process that companies subject to the CRR/CRD IV Regulation shall follow to identify other high-risk exposures than those listed under Article 128(2). The companies shall search for exposures that stand out as more risky in all exposure categories they have. In the review, however, the most weight shall be placed on the categories "companies", "equity positions" and "other exposures". The companies must at a minimum assess whether financing of other speculative investments than real estate, and exposures with specialized companies, should be classified as high-risk exposures according to the detailed descriptions in point 4.2 of the EBA's guidelines.

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Furthermore, equity exposures against an issuer shall be considered as high-risk exposures if the risk weight for debt exposures against the same issuer is 150 percent.
4 Details on the EBA's published answers regarding the provisions on high risk The EBA has published answers to the following submitted questions regarding high risk and financing of speculative investment in real estate:
In Q&A 2013_2152, the EBA concludes that high-risk exposures shall not be assigned to any other exposure category, not even "defaulted exposures" according to Article 127 in the Capital Requirements Regulation. This applies regardless of whether the exposures are secured. In Q&A 2013_3743, the EBA clarifies that the requirement to assess the assets that the securities fund has invested in applies in addition to the other requirements for high-risk exposures. In Q&A 2015_22684, the EBA concludes that the addition "where appropriate", i.e., "where this is relevant", means that the listing in Article 128 is not exhaustive. The addition "where appropriate" shall not be understood as qualitative criteria to give the listed exposures in Article 128 a lower risk weight than 150 percent. In Q&A no. 2017_31315, the EBA concludes that a loan to a real estate development company for the construction of real estate with the intention of selling to third parties for profit, shall be covered by the definition in Article 4 point 79. In Q&A 2017_31736, the EBA concludes that exposures with a developer of a real estate project, where contracts with future possible owners of the properties are signed, but the contracts are not irrevocable, shall be classified as high-risk exposures with a risk weight of 150 percent. 2 Q&A 2013_215: https://eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2013_215 3 Q&A 2013_374: https://eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2013_374 4 Q&A 2015_2268: https://eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2015_2268 5 Q&A 2017_3131: https://eba.europa.eu/single-rule-book-qa/ /qna/view/publicId/2017_3131 6 Q&A 2017_3173: https://eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2017_3173

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5 Details on the definition of financing of speculative investment in real estate The Ministry of Finance expressed the following in a letter to the Finanstilsynet on 25 May 2021, which shall be the basis for Norwegian practice:
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"Overall, the Ministry assumes that CRR Article 128(2) letter d, cf. the definition in Article 4 no. 1 point 79, must be understood such that the requirement to assign a risk weight of 150 pct. does not apply to financing of real estate when for the entire project, legally binding purchase agreements for pre-sales have been entered into as the buyer does not unilaterally have the right to choose to withdraw. A question is what significance it has if legally binding purchase agreements have been entered into corresponding to a certain share of the real estate project or exposure amount, but not the whole. The Ministry refers as a starting point to that CRR Article 128 seems to be based on the assumption that the entire exposure shall be assigned the same risk weight. It is thus assumed that there is no possibility to split up the exposure for capital requirement purposes. When the borrower has entered into legally binding purchase agreements that cover more than half of the exposure amount, the Ministry believes that the project as a starting point will not be considered as "with a view to resale for profit", i.e. that the loan exposure in such cases should be given a risk weight of 100 pct." Possible future changes In the new Basel standard, which according to the recommendation shall be implemented 1 January 20238 , the level of detail and risk sensitivity in the standard method for credit risk increases. The standard contains a separate category for financing of real estate projects. It is opened to differentiate the risk weight according to different characteristics of the exposure, such that loans where the project has a significant share of pre-sales, equity share and cash deposits from buyer/tenant9 , shall be able to receive a risk weight of 100 percent, provided that the lending meets specified general prudence criteria. For real estate development projects concerning commercial real estate, no lower risk weight than 150 percent is opened under the new Basel standard. 7 https://www.regjeringen.no/no/aktuelt/kapitalkrav-for-lan-til-eiendomsprosjekter-mv/id2850993/ 8 Implementation in EU is under consideration 9 And where this cash deposit is not refunded if the contract is terminated

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