Uniform Letter – Derogation Policy under Art. 36bis of the Royal Decree of 23 September 1992

THE GOVERNOR your references your correspondent Prudential Policy & Financial Stability Secretariat TA National Bank of Belgium s.a. company number: tel.: + 32 2 221 38 12 boulevard de Berlaimont 14 0203.201.340 our references fax: + 32 2 221 31 04 1000 Brussels RPM Brussels TA/2014/11/L219.DeJ.DuM TA@nbb.be BELGIUM www.bnb.be Uniform Letter to concerned institutions Brussels, 18 November 2014

Madam, Sir,

As communicated during the consultation conducted by the National Bank of Belgium (NBB) in February 2014, it has decided to implement a new derogation policy regarding Article 36bis of the Royal Decree of 23 September 1992 pursuant to Article 38. You will find the practical arrangements for this new policy in the annex. This policy enters into force for accounting periods beginning on 1 January 2016 or after that date. Derogations granted before this date remain applicable until 31 December 2021.

A copy of this letter is sent to the auditor(s) of your institution.

We ask you to accept, Madam, Sir, the expression of our distinguished sentiments.

Luc Coene

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Annex A. Introduction

Pursuant to Article 36bis §1 and §2 of the Royal Decree of 23 September 1992, interest rate forward transactions are recorded off-balance sheet and gains and losses are recorded in the income statement.

However, for interest rate forward transactions used within the framework of interest rate risk hedging, profits and losses are recorded in the income statement symmetrically to the allocation of income or expenses of the hedged item, in accordance with Article 36bis §1 and §3. To be considered as hedging, these transactions must meet three conditions:

• the hedged item or the homogeneous group of items must expose the credit institution to interest rate variation risk;
• the hedging transaction must be qualified as such in the books from the outset;
• a close correlation must be observed between the value variations of the hedged item and those of the designated hedging transaction. In the case of options concluded as designated hedges, the correlation must be established between the variations of the hedged item and those of the underlying financial instrument.

Pursuant to Article 38 of the Royal Decree of 23 September 1992, the NBB is competent to grant derogations from articles of the Royal Decree, but only on an individual basis. The NBB has decided to maintain the previous policy of granting derogations under Article 36bis (particularly regarding the third condition mentioned above) under the conditions described below.

This derogation may be granted upon request by credit institutions, on an individual basis. To benefit from this derogation, the credit institution must satisfy three types of criteria: compliance with governance principles (point B), compliance with accounting principles (point C), and an obligation of transparency (point D).

The maintenance of the derogation will be subject to an ex officio review every three years. The beneficiary credit institution must, however, inform the NBB without delay in the event of a material change in its interest rate risk management, or of new securitization transactions not strictly covered by a previous derogation.

B. Governance Principles

Regarding governance, the credit institution must demonstrate that:

• the designated transactions have been approved by its management committee, as well as the limits and governance (including internal control and internal audit) relating to the management of these positions;
• these transactions and the associated risks are periodically evaluated (at least semi-annually) by its management committee taking into account the risk and volatility of the positions;
• the management committee must document the evaluation carried out according to paragraph 2 in its annual report as established pursuant to circular NBB_2011_09. This evaluation includes an analysis of the adequacy of hedging strategies, including an independent analysis of the correlation between the risks related to the items to be hedged and the hedges, so as to ensure that the strategies put in place effectively reduce the risks that are the subject of the hedge. This also includes the demonstration that transactions made as hedges are carried out within the framework of the policies and procedures described above.

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C. Accounting Principles

The accounting principles set out below do not modify in any way the accounting treatment – according to Belgian accounting standards – of instruments subject to hedging as well as that of interest rate forward transactions recognized as hedges.

The accounting principles set out below are based on the international accounting standard IAS 39 as currently applied in the European Union (references to IAS 39 standard are indicated in brackets).

C.1 General Principles

A hedge of interest rate risk can only claim the derogation under Article 36bis if and only if all the following conditions are met:

(a) at the inception of the hedge, there is formal identification and documentation describing the hedging relationship as well as the entity’s risk management objective and hedging strategy. This documentation must include the identification of the hedging instrument, the nature of the risk being hedged, and how the entity will assess the effectiveness of the hedging instrument in compensating for exposure to changes in fair value or cash flows of the hedged item attributable to the hedged risk. [88 (a)]

(b) it is expected that the hedge will be highly effective (see C.2) in compensating for changes in fair value or cash flows attributable to the hedged risk, in accordance with the risk management strategy described at the inception for that particular hedging relationship. [88 (b)]

(c) the effectiveness of the hedge can be measured reliably, that is to say, the fair value or cash flows of the hedged item attributable to the risk and the fair value of the hedging instrument can be measured reliably. [88 (d)]

(d) the hedge is assessed continuously and determined to have been highly effective during all periods covered by the financial statements for which the hedge was designated. [88 (e)]

C.2 Additional Elements Regarding the Assessment of Effectiveness

A hedge is considered highly effective only if the following two conditions are met:

(a) at the beginning of the hedge and during subsequent periods, it is expected that the hedge will be highly effective in compensating for changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. This expectation can be demonstrated in various ways, including by comparing past variations in the fair value or cash flows of the hedged item attributable to the hedged risk and past variations in the fair value or cash flows of the hedging instrument. The entity may also choose a hedge ratio other than one-to-one to improve the effectiveness of the hedge;

(b) the actual results of the hedging transaction fall within a range between 80 and 125%. For example, if the actual results result in a loss, recorded on the hedging instrument, of 120 monetary units and a profit, realized on the cash instruments, of 100 monetary units, the compensation can be measured by the ratio 120/100, i.e., 120% or 100/120, i.e., 83%. In this example, assuming that the hedging transaction meets the condition stated in (a), the entity would conclude that the hedge has been highly effective. [AG 105]

Effectiveness is assessed quarterly.

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This approach does not impose a single method for assessing the effectiveness of a hedging transaction. The method adopted by an entity to assess the effectiveness of a hedge depends on its risk management strategy. For example, if the entity's risk management strategy consists of periodically adjusting the amount of the hedging instrument to reflect changes in the hedged position, the entity only needs to demonstrate that the hedge should be highly effective for the period until the next adjustment of the hedging instrument amount. In some cases, an entity adopts different methods for different types of hedges. An entity's documentation detailing its hedging strategy includes its procedures for assessing hedge effectiveness. These procedures indicate whether the assessment includes the entire profit or loss on a hedging instrument or if the time value of the instrument is excluded. [AG 107]

Sometimes, the hedging instrument only compensates for part of the hedged risk. For example, a hedging transaction is not fully effective if the hedging instrument and the hedged item are denominated in different foreign currencies that do not move in tandem. Similarly, a hedging transaction for interest rate risk using a derivative is not fully effective if part of the change in the fair value of the derivative is attributable to counterparty credit risk. [AG 109]

The hedge must therefore be linked to a specific identified and designated risk, and not simply to the entity's general business risks, and must also ultimately affect the entity's result. [AG 110]

If hedging instruments do not meet or no longer meet the hedge effectiveness criteria, interest rate forward transactions will be accounted for in accordance with Article 36bis §2.

C.3 Securitization

In the specific case of securitization transactions, the criteria retained to qualify derivatives as hedges instead of those set out in C.1 and C.2 are as follows:

(a) the institution must be able to justify that, overall, interest rate swap contracts effectively reduce interest rate risk;

(b) compliance with the principles set out in section 2 of chapter 1 of circular PPB-2006-17-CPB.

D. Obligation Regarding Information Included in Annex XXIV of Scheme B

The entity benefiting from a derogation is required to provide the following information as part of its annual accounts:

(a) a description of the financial instruments subject to hedging as well as the hedging instruments;

(b) the hedging method;

(c) the market value at the end of the period of the hedging instruments, compared to the book value of these derivatives;

(d) the amount of ineffectiveness at the closing date, and how it was treated accounting-wise;

(e) the method of calculating ineffectiveness.

E. Entry into Force

An entity must apply this policy for accounting periods beginning on 1 January 2016 or after that date. Derogations granted before this date remain applicable until 31 December 2021.