ComplianceFinanceApril 29, 2020

Prudential consolidation: A perfect storm?

The EU’s Capital Requirements Directive V (CRD V) introduces new rules for prudential consolidation that did not feature in previous versions of the regulation. As a result, affected firms will need to reassess the way they construct the financial figures their supervisors use to ensure financial stability.

CRD V aims to introduce greater transparency by getting a more granular, consolidated view of diversified financial institutions. The term ‘prudential’ refers to the more conservative stance CRD V requires from banks as they construct financial statements for supervisors, from which the figures used also form the inputs for calculation of their Basel and CRD V capital requirements.

At its core, prudential consolidation follows very similar principles to the financial consolidation provisions contained in IFRS 3, 10 and 11. In CRD V, the EU makes specific references to IFRS but applies so-called ‘prudential adjustments’ to ensure a more cautious approach.

As a result of this approach regulated entities may find themselves required to provide a different kind of account than under IFRS of the assets and liabilities of the firms within their purview. This would grow the level of complexity as more consolidation circles and methods need to be managed and processed under both IFRS and CRR. In addition the entity scope for IFRS and CRR might distinctly differ. Furthermore, financial institutions may face a higher number of sub-consolidations that they need to take into consideration when meeting their CRD V obligations.

Local authorities will have a say in the matter, particularly when it comes to deciding on which consolidation method to apply. In this case, additional reporting and disclosures might also be required on a sub-consolidation level.

In sum, prudential consolidation might multiply the number of disclosures and reporting requirements that institutions need to comply with. This is without taking into account the national variations.

Implications of CRD V for affected firms

With CRD V implementation under way, the implications for your finance, risk, data and regulatory activities are wideranging. CRD V adds various levels of consolidation, with sub-consolidations by country, region and other dimensions. The greater number of sub-consolidation levels that apply to your organization, the more important it is to address consolidation appropriately. Since there is a multiplication factor that can add to complexity substantially, it is essential that banks identify how many ‘CRD V units’ they have and calculate the amount of prudential consolidations they need to perform.

To begin with, CRD V (and coming CRR3 and CRD VI) will have a significant effect on your liquidity, solvency, credit and market risk calculations. This will also extend to the capital your firm needs to put aside to meet the more stringent requirements.

Outlined below are essential changes that are taking place:

a) All Basel components have changed: credit risk (standardized and IRB), market risk, CVA risk, operational risk, large exposures, leverage ratio, liquidity LCR and NSFR, IRRBB, and capital.

b) Proportionality has been introduced, providing different methods for various levels of complexity. This applies to market risk, CVA, CCR, reporting, liquidity and NSFR.

c) The output floor has established a ‘backstop’ to minimal capital requirements when using internal models.

d) The FRTB has led to a redefinition of the boundary between the trading and non-trading books affecting both sides’ sizes.

e) Pillar 3 disclosures are now more standardized and aligned with regulatory reporting requirements.

CRD V’s consolidated prudential provisions require that financial institutions build on a consolidated view of their financial situation to create a consistent picture of:

  • Consolidated liquidity (e.g. NSFR)
  • Consolidated capital.

In addition, auditors and regulators will closely monitor how you organize yourself, your data and the processes to deliver these figures, not to mention your data reconciliations with other regulatory reports, such as FINREP. This indeed has all the signs of a perfect storm.

So, what steps should firms be taking not only to weather the coming storm, but to emerge on the other side stronger than before?

Finance and risk reconciliation

Although financial statements and regulatory reports serve different functions and differ in audiences, there is a need to reconcile them in order to minimize unintended effects on risk and risk management (See Basel Committee on Bank Supervision, WP 28, The interplay of accounting and regulation and its impact on bank behavior: Literature review, January 2015).

CRD V’s prudential adjustments for regulatory capital aim to build a bridge between the two. An example of this can be seen in the diagram below.

CRD V prudential adjustments for regulatory capital

Both private and listed companies must publish their financial statements based on agreed financial reporting rules and principles. But the supporting principles and concepts that underpin accounting standards are not always consistent with those underpinning banking regulations. The figures produced for public financial reporting are the starting point for the calculation of a bank’s capital requirement, but it is the regulators who consider whether these figures need to be adjusted for prudential principles. Entities already need to actively report differences between financial consolidation and prudential consolidation with a brief outline of the reasons for those differences (See Capital Requirements Regulation [CRR], Art. 436).

The objective of prudential adjustments is to maintain the desired characteristics of regulatory capital for those institutions that follow accounting standards, such as IFRS, that aim to promote a fair and comprehensive description of the company’s economic reality with no conservative or counter-cyclical biases. Specifically, these characteristics include measures of magnitude, quality and stability. In short, prudential adjustments should provide a more prudent measure of an institution’s ability to withstand unexpected losses on a going concern basis than one derived from pure accounting standards.

A practical example of this integration of finance and risk is CRR Article 111, which specifies that the exposure value of an asset item shall be its accounting value remaining after specific risk adjustments. At its core, the financial figures are the starting point and reconciliation benchmark for the different risk calculation processes; in addition, several adjustments are made to get to the final exposure value.

The case of prudential consolidation

One of the prudential adjustments applied under CRD V is the concept of prudential consolidation, founded on the IFRS standards. As a rule of thumb, when preparing the consolidated figures under prudential consolidation, normally the method to go for is ‘full’ consolidation. But under certain circumstances, however, CRR Article 18 does allow alternative methods to be used other than full consolidation.

In total, CRR proposes at least four different consolidation methodologies: full method, equity method, proportional method, and aggregate method. The two latter methods – proportional and aggregate consolidation – are not being considered under IFRS standards (IFRS 10 and 11), but might be used in certain circumstances under CRD V prudential consolidation. A lot of responsibility is propagated to the competent authorities, which have the mandate to permit and determine whether and how (i.e. method) consolidation is to be carried out (See Regulation 2019/876 prudential consolidation, Art. 6).

IFRS and step-in risk  

Under CRD V, companies that would not necessarily be considered part of a consolidated group under IFRS standards may still be covered by prudential consolidation, and vice versa. IFRS standards are more concerned with the concept of ‘control’ and are not really looking into whether the firm in question is part of a consolidated group in the context that liquidity or solvency problems would occur. In some countries, financial institutions combine lending and insurance activities. But this is not the case for prudential consolidation, where the scope is centered around credit institutions, investment firms, financial institutions or an ancillary service undertaking, excluding insurance companies, for example.

Another example, this time expanding the prudential scope, is step-in risk (See Basel Committee on Bank Supervision, Guidelines, Identification and Management of Step-In Risk, October 2017). This is the risk incurred when a bank decides to provide financial support to an unconsolidated entity that is facing stress, in the absence of, or in excess of, any contractual obligations to provide such support. One reason for accepting step-in risk might be to avoid the reputational risk that a bank might encounter if it does not provide support to a related entity facing stress.

Regulatory timeline summary

Where an entity is considered to have step-in risk from a group point of view, that entity would be regarded as part of the prudential consolidation group. This notion does not exist in an IFRS context, where the investor is assumed to have significant influence if the entity holds 20% or more of the voting power of the investee. Under CRR, the term ‘significant influence’ is much broader as it lists several qualitative features, such as the sharing of managerial personnel as well as the existence of share warrants, share call options or debt securities that are convertible into ordinary shares (See EU regulation 575/2013 – Art. 18(6)(a)).

Another ambiguity is the definition of ‘control’ under IFRS 10, where it is defined as a situation where the investor is exposed, or has rights, to variable returns from its involvement. In the case of step-in risk, this implies that an entity might not be seeking control, but intervenes anyway for the sake of its reputation, for example, where there are solvency or liquidity issues.

As part of the CRD V regulation, the EBA will submit draft regulatory technical standards to the Commission by 31 December 2020, to specify conditions under which consolidation applies to some of the more exotic cases. To date, the regulations have given rise to some market uncertainty, and financial institutions may be impacted further by the reassessment of prudential consolidation requirements. In practice, this could mean that you will need to support multiple, but different, group hierarchies and several consolidation exercises. It also means applying

different consolidation exercises to comply with both prudential consolidation and IFRS requirements. Any consolidation solution would be required to cope with a multitude of these consolidation types.

Clouds on the horizon?  

It is unlikely that a well-aligned system, data and consolidation process will be impacted by these regulatory changes. However, in a recent Wolters Kluwer survey poll, more than 40% of respondents indicated that the revised prudential consolidation rules are a highly important factor in their Basel process. As mentioned above, the revision of prudential consolidation rules will likely mean that you will need to deal with additional consolidation hierarchies by extending or reducing the number of entities and additional consolidation methods, which are different from those stipulated in IFRS standards. In addition, you will likely need to run the same calculation process on multiple consolidation (sub)group levels, further stretching the complexity of the whole operation.

In case you are dealing with a scattered process and data landscape this indeed might be the perfect storm. This is a good reason for you to address the current challenges you face with regards to your finance, risk and regulatory needs. Beyond the CRD V and Basel challenges, it might represent an ideal moment to think more strategically about data and processes, and determine how more integration can be achieved.

How we can help

Wolters Kluwer’s FRR solution framework for finance, risk and regulatory reporting can help streamline your back office and regulatory processes, in turn centralizing and instilling a sense of ownership of your data. When it comes to CRD V, we do not focus simply on risk but help you think more broadly by proposing holistic solutions that centralize and unify data and processes, thereby removing unnecessary reconciliation checks between finance, risk and regulatory verticals.

Regulatory calculators and COREP reporting are important, but so is the financial data that goes into your calculators and reports. Having the correct data serves as a great sounding board for any additional risk processes. By providing you with a solution that addresses your financial and prudential consolidation in a dynamic and integrated manner, we sustain the whole back office and regulatory stream for both finance and risk from start to finish.

Conclusion

Yes, CRD V is the perfect storm. But how you weather the storm will depend on your choices: will you be able to leverage your regulatory obligations into something with strategic business value?

In many ways, CRD V presents you with the opportunity to adapt your banking back office for the next decade. It provides better alignment between finance and risk data, more automated processes, and faster time to regulatory submissions in the context of CRD V for both prudential and financial consolidation.

Wolters Kluwer’s FRR solution framework connects critical processes in finance, risk and regulatory compliance. You get greater value from your back office, speed up your reporting processes and, in turn, free up valuable time for more strategic initiatives. Because the consolidated accounting

figures are the cornerstone for your risk calculations, it is of absolute necessity to have those aligned, processed, automated, and properly reconciled.

We can help you to prepare and capture these opportunities and give advice, so you can emerge stronger from the regulatory storm and face any future change more easily.

What is certain is that more complex regulation clouds will keep heading our way. CRD V is an opportunity to leverage and generate strategic change and finally overcome the bandaid approach we as an industry have applied for so long. This is the only way to weather any future regulatory storm conditions. I wish you smooth sailing.


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