Asset Quality Review - Europa

1 Asset Quality Review Phase 2 Manual June 2018 Contents Introduction 2 1 Processes, policies and accounting Review 13 2 Loan tape creation and data integrity validation 36 3 Sampling 70 4 Credit file Review 102 5 Collateral and real estate valuation 145 6 Projection of findings of credit file Review 160 7 Collective provision analysis 176 8 Fair value exposures Review 214 9 Determination of AQR-adjusted CET1% and definition of remedial actions for the bank following the CA 270 10 QA and progress tracking 278 AQR Manual 1 Introduction This manual provides the parties involved with the information necessary to execute Phase 2 of the Asset Quality Review (AQR).

2 This introduction aims to explain the high-level methodology for Phase 2 of the AQR and the approach for communicating the methodology to all involved parties. Phase 2 of the AQR begins in full following completion of the portfolio selection (Phase 1). This manual provides the detailed methodology for the exercise. Successful execution of the AQR Phase 2 requires consistent application of the centrally defined methodology. As a significant number of third-party providers may provide support in the execution of the AQR, the methodology must be clearly passed down to all practitioners involved. The Central Project Management Office (CPMO) the author of the methodology may provide additional technical support and clarification throughout the exercise.

3 Context around Phase 2 of the AQR AQR as part of the comprehensive assessment The European Central Bank (ECB) and the national competent authorities (NCAs) responsible for conducting banking supervision carry out comprehensive assessments ( CAs) of banks, in line with the provisions of the Regulation on the single supervisory mechanism (SSM Regulation). A CA consists of an AQR and a stress test. Following completion of Phase 1 of the AQR (portfolio selection), Phase 2 execution of the AQR begins. This document is the manual to be followed in executing Phase 2 of the AQR: the Phase 2 manual . The final results of the comprehensive assessment are determined on the basis of a join-up of the AQR and the stress test, in which the results of both are combined (while duly avoiding any double-counting impact).

4 AQR as a prudential exercise The AQR is conducted with reference to harmonised definitions. This means that the AQR methodology complies fully with the relevant accounting principles ( for IFRS banks IFRS 9, IAS 37, IFRS 13). Nevertheless, the AQR is a prudential exercise, focused on providing the necessary clarity on the situation of banks that are, or will be, subject to the ECB s direct supervision. Therefore, for the purposes of the AQR and to ensure consistency of findings across banks, further guidance is provided on particular topics around how to apply the principles in the accounting rules. The AQR should not be seen as an attempt to introduce greater prescription into the accounting rules outside of the existing mechanisms; as such AQR Manual 2 methodological choices reflected in this manual should not be interpreted as attempts to prescribe accounting practices.

5 Link to international vs national accounting standards The manual has been written with a focus on IFRS principles, although some banks subject to the AQR may apply national generally accepted accounting principles (GAAP). For these banks, bank teams will be required to align as closely with the manual as is appropriate given national GAAP rules. The ECB and the relevant NCA(s) will cooperate closely in preparing the AQR to develop the specific approach. Link to other ECB publications The ECB/SSM occasionally publishes guidelines, policy stances, methodologies, and other similar documents on aspects covered by the AQR methodology.

6 As those reflect official ECB/SSM views, they should be seen as complementary guidance to be taken into account in applying the methodology described in this manual. Where necessary, specific instructions on the implementation of such additional guidance will be provided to all parties involved in the AQR in the form of methodological notes/circulars. Key outputs from Phase 2 of the AQR There will be two primary outputs from Phase 2 of the AQR: Key issues to include in a letter (or other form of supervisory communication) to the relevant bank: Following completion of the AQR, the Joint Supervisory Teams (JSTs) (comprising ECB and NCA supervisors) will write a letter to each bank outlining any areas where it is found to be outside of accounting principles or of supervisory requirements and the required remedial actions the bank would be expected to take (including adjustments to the carrying values of assets).

7 In some cases, these issues would be expected to lead to adjustments to available capital and hence be reflected in Pillar 1 capital requirements at the next reporting date. Inputs into the stress test/overall CA results: The AQR generates a series of parameters that will act as inputs into the stress test process and, ultimately, the overall CA results. The key inputs into the stress test will be: any adjustments to data segmentation highlighted by data integrity validation (DIV); an AQR-adjusted Common Equity Tier 1% (CET1%) parameter (to allow the impact of the AQR to be applied to stress test projections of CET1%); probability of default (PD) and loss given impairment (LGI)/loss given loss (LGL) parameters for use in the stress test.

8 AQR Manual 3 Summary of Phase 2 methodology workblocks The high-level process for Phase 2 of the AQR contains ten different workblocks, as illustrated in the figure below: Figure 1 Illustration of Phase 2 workblocks The Review is led centrally by the CPMO, supported by the NCAs of the banks concerned. It is carried out at bank level by a team consisting of third-party audit firms and/or other Asset appraisal specialists (depending on the capabilities of the auditor) termed the bank team . In cases where a JST, comprising ECB and NCA staff, has already been established for a bank subject to the AQR by the time the exercise is carried out, the JST may take on what is referred to throughout this manual as the role of the NCA.

9 Each element of the Review is summarised below and described in detail in the subsequent chapters of the manual: 1. Processes, policies and accounting Review : B ank processes, policies and accounting practices have a key impact on the carrying values of assets in banks balance sheets and so must be reviewed. The Review represents a bare minimum Review of the key topics that influence accounting balance sheet valuations. Key topics to be covered include: application of fair value hierarchy; accounting classifications (amortised cost, f air value through profit & loss, fair value through other comprehensive income); high-level credit valuation adjustment (CVA) approach; provisioning approach; impairment staging criteria; treatment of non-performing exposures (NPEs) and forbearance; etc.

10 This will Tape Creation and DIV3. file review7. Collective Provision Analysis 9. Determination of AQR-adjusted CET1 and definition of remedial actions for banks following the AQR10. Quality assurance and progress tracking6. Projection of findings of credit file review5. Collateral and Real Estate Valuation1. Processes, policies and accounting Review (PP&A)I. General processes, policies and accounting reviewII. Conduct risk reviewIII. CVA challenger model analysis8. Fair value exposures reviewI. Revaluation of Non-Derivative AssetsII. Trading Book Core Processes ReviewIII. Derivative Pricing Model ReviewIV.