Uniform Letter – Derogation Policy under Article 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 n.v. 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 under Article 36bis of the Royal Decree of 23 September 1992 pursuant to Article 38. You will find the practical details of this new policy in the annex. This policy enters into force for financial years beginning on 1 January 2016 or after this date. Derogations granted before this date remain applicable until 31 December 2021.

A copy of this letter is sent to the auditor(s), approved reviewer(s) of your institution.
We ask you to accept, Madam, Sir, the expression of our distinguished sentiments.

Luc Coene

THE GOVERNOR
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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 operations are accounted for off-balance sheet and gains and losses are recorded in the income statement.
However, for interest rate forward operations 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 operations must meet three conditions:

• the hedged item or the homogeneous set of hedged items must expose the credit institution to interest rate fluctuation risk;
• the hedging operation 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 operation. In the case of options concluded as designated hedging, 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 at the request of credit institutions, on an individual basis. To benefit from this derogation, the credit institution must satisfy three types of criteria: respect for governance principles (point B), respect for 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 new securitization operations not strictly covered by a previous derogation.

B. Governance Principles
Regarding governance, the credit institution must demonstrate that:

• the designated operations 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 operations 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 assessment carried out according to paragraph 2 in its annual report as established pursuant to circular NBB_2011_09. This assessment includes an analysis of the adequacy of hedging strategies, including an independent analysis of the correlation between 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 hedging. This also includes the demonstration that transactions made as hedging are carried out within the framework of the policies and procedures described above.

THE GOVERNOR
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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 operations recognized as hedging.
The accounting principles set out below are based on 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
An interest rate risk hedging can claim the derogation under Article 36bis only if and only if all the following conditions are met:
(a) at the inception of the hedging, there is formalized identification and documentation describing the hedging relationship as well as the entity’s objective in terms of risk management and hedging strategy. This documentation must include the identification of the hedging instrument, the nature of the risk hedged, and how the entity will assess the effectiveness of the hedging instrument to compensate 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 hedging 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 this particular hedging relationship. [88 (b)] (c) the effectiveness of the hedging can be measured reliably, that is to say, that 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 hedging is evaluated continuously and determined to have been highly effective during all periods covered by the financial statements for which the hedging was designated. [88 (e)] C.2 Additional elements regarding the assessment of effectiveness A hedging is considered highly effective only if the following two conditions are met:
(a) at the inception of the hedging and during subsequent periods, it is expected that the hedging will be highly effective to compensate for changes in fair value or cash flows attributable to the hedged risk during the period for which the hedging is designated. This expectation can be demonstrated in various ways, including by comparing past variations of the fair value or cash flows of the hedged item attributable to the hedged risk and past variations of the fair value or cash flows of the hedging instrument. The entity may also choose a different hedging ratio than unity to improve the effectiveness of the hedging; (b) the actual results of the hedging operation fall within a range between 80 and 125%. For example, if the actual results translate into 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 operation meets the condition stated in (a), the entity would conclude that the hedging was highly effective. [AG 105] Effectiveness is assessed quarterly.

THE GOVERNOR
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This approach does not impose a single method for assessing the effectiveness of a hedging operation.
The method adopted by an entity to assess the effectiveness of a hedging 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 variations in the hedged position, the entity must demonstrate that the hedging should be highly effective only for the period until the next adjustment of the hedging instrument amount. In some cases, an entity adopts different methods for different types of hedging. The entity’s documentation detailing its hedging strategy includes its procedures for assessing hedging 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 compensates only part of the hedged risk. For example, a hedging operation is not fully effective if the hedging instrument and the hedged item are denominated in different foreign currencies that do not evolve in concert. Similarly, a hedging operation of an interest rate risk using a derivative is not fully effective if part of the variation in the fair value of the derivative is attributable to the counterparty credit risk. [AG 109] The hedging 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 hedging effectiveness criteria, interest rate forward operations will be accounted for under Article 36bis §2. C.3 Securitization In the specific case of securitization operations, the criteria selected to qualify derivatives as hedging 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. Information obligation 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 calculation method of the ineffectiveness. E. Entry into force An entity must apply this policy for financial years beginning on 1 January 2016 or after this date. Derogations granted before this date remain applicable until 31 December 2021.