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Please refer to the attached pdf letter

This is our covering letter note and response to Q1
Key messages:
On page 4 of the EBA consultation, the reason for the expansion of the scope to cover all exposures is set out:

The fact that the proposed scope of the draft guidelines was restricted to the large exposures regime has raised questions and comments among respondents to the public consultation.

We have reviewed most of the responses to the earlier consultation and note that only the comments of the German Banking Industry Committee (GBIC) was it suggested that the scope should be reviewed.

In all the other responses we have read, including our own BBA response, as well as the European Banking Federation (EBF), French Banking Federation, ESBG (European Savings and Retail Banking Group) and The Association for Financial Markets in Europe (AFME) etc. there is no suggestion to extend the scope.

In fact the overarching commentary on the earlier consultation was that the EBA was adding undue and unnecessary complexity to the concept. Responders did not support the broader application of economic dependency

For example the GBIC brought to the attention of the EBA the following:

In paragraph 27 of its large exposures framework the Basel Committee on Banking Supervision acknowledges that in cases of economic dependencies where a client is able to find alternative business partners or funding sources within an appropriate time period to overcome financial difficulties no combination of counterparties to form a group of connected clients would be necessary.

Our view is that gold plating of the Committee’s guidance at European level is unnecessary and this would only add to the complexity of the EBA framework

We are supportive of the response by the EBF and encourage the EBA to review its proposals.

In summary, we do not support the proposals to extend the scope as proposed. The attached response sets our comments in detail.

We would welcome an opportunity to discuss this matter with the EBA.

Response to Q1

Although there may appear to be benefits of the proposals, our view is that the practicalities of incorporating such changes into rating systems far outweigh the benefits of consistency in approach.

Our view is that identifying connected and control relationships economic dependencies and supply chain links between obligors is very challenging.

We are of the opinion that the revised scope and definition would go beyond what is set out in the Basel Accord and thus embraced within the EU regulation.

If implemented as set out it would result in the issues raised with respect to the first EBA consultation on the definition of connected clients still applying as well as being magnified since the scope of the guidelines would be wider.

1. A broader application of the economic dependency criteria would involve a significant operational effort by banks as the number of groups of connected clients may increase substantially. Clear instructions and definitions which are operationally manageable are needed.

2. In accordance with the purpose, when establishing a group of connected clients, only clients which are assessed to in fact constitute a single risk should form a group of connected clients. Thus, when assessing interconnectedness based on control relationship and/or economic dependency, actual substantiality and material impact on credit risk in the individual case is to be considered.

3. We do not support tying economic dependency to the existence of general financial difficulties irrespective of their duration and how serious their consequences are for the lending institution.

4. The EBA’s proposal to reduce the threshold to 2% of the eligible capital which triggers the investigation of potential economic connections would override the Basel framework jeopardising the level playing field. The 5% level is already a conservative threshold as long as large exposures are defined as those which overcome the 10% of bank’s eligible capital. We do not see the rationale for applying any other level than the 5% ensuring alignment with the Basel framework.

5. Moreover, such an important change, changing the threshold from 5% to 2%, should not be implemented via an EBA guideline but should rather be done through a revision of the level one regulation. The threshold is an essential element and should be interlinked with the European Commission potential revision of possible restrictions in the definition of eligible capital definitions.

6. Interconnectedness through control differs fundamentally from interconnectedness through economic dependency. Any obligation to link these in a prescriptive and mechanical manner may lead to unintended outcomes and far-reaching requirements for the formation of groups of connected clients. We are opposed to such an approach as currently proposed, as this would go beyond the requirements set in Article 4 (1) (39) b) of the CRR, however we recognise that where there is a clear risk of a default of an obligor through their economic connection leading to high and material likelihood of default of the counterparty it should be recognised and included in a large exposure assessment, based on analysis of the individual case by the relevant analyst

In addition to these concerns, the BBA would like to note that extending the scope of the definition of connected clients to retail clients raises legal, operational and system related issues. As well as whilst public information is available on large corporates, it is not the case for retail clients in order to connect these clients.

There are also concerns about maintaining the information up to date. In that vein, the BBA recommends the EBA to perform a cost/benefit analysis in order to assess the costly required IT changes.
As explained in the response to Q1, the application of the connected client framework to large corporates raise several concerns and has to be assessed on a case by case basis.

Applying the same framework to retail clients is even less appropriate. Although its application to retail clients is required by the CRR, the concept of connected clients such as defined by the draft EBA guidelines makes sense for entities but less for physical persons and we believe that the extension of the EBA guidance to include physical persons is incorrect and unwarranted.

In addition to the fact that information for retail clients would not be readily available, it must also be noted that it will be difficult to maintain the information up-to-date.

The application of the connected client framework to the proposed extended scope would impact the retail classification and increase the risk-weighted assets of banks.

Retail exposures, in particular SME exposures would more easily breach the EUR 1 million threshold to be classified into the retail category. For example, an exposure to a small supplier below EUR 1 million could no longer be classified in the retail category if this supplier is considered to be connected to a large corporate. In this case, the 75% risk weight for retail exposures could not be applied anymore and the exposure would be assigned with a higher risk weight for Pillar 1 purposes.

It is noteworthy that the 75% risk weighted associated to retail exposures is justified by the diversification effect on a portfolio level. Indeed, on a portfolio level, it is very unlikely that all the retail exposures get into difficulties simultaneously, which justifies the application of a lower risk weight than the ones that applies for corporates.

Furthermore, the connected client framework would then be disconnected from banks’ practices with regard to retail exposure management.

• Retail exposures are typically managed on a portfolio level in each entity, not individually.
• Aggregation of required retail information in all subsidiaries will not be feasible.

It is also worth mentioning that the quantification of the impact of the application of the framework is not possible either under IRB or STA due to the difficulties of getting the data on retail clients.

This leads onto significant challenges for processes to calculate the revised risk weights as well as implications for Pillar 3 reporting that have not been explained by the EBA.

Finally, the proposal would create some overlapping of connected clients. In the following example, C is economically dependent from A and B (with no connection between A and B). According to the Guidelines, 2 groups of “connected clients” should be formed (A+C and B+C)

(refer to letter for illustration)

The possibility that counterparties could be mapped in more than one group of connected clients would lead to an unjustified multiple counting of banks’ exposures. Besides the operational complexity of the proposed assessment which would require an additional and burdensome investigation of economic relations, this double counting seems unduly penalising. Some specification should be introduced in the guidelines to avoid the double counting of exposures.
This issue will raise significant concerns with regard to the categorisation of retail and corporate exposures. Indeed, if the proposal is applied as such, the very same client could be included in a group of connected clients that should be deemed as non-retail and at the same time in a group that should considered as retail. In this case, it is not clear how capital requirements must be calculated.
We draw the EBA’s attention to the Basel Committee’s guidance on this subject.

4. Risk rating system operations

(i) Coverage of ratings

422. For corporate, sovereign, and bank exposures, each borrower and all recognised guarantors must be assigned a rating and each exposure must be associated with a facility rating as part of the loan approval process. Similarly, for retail, each exposure must be assigned to a pool as part of the loan approval process.

423. Each separate legal entity to which the bank is exposed must be separately rated. A bank must have policies acceptable to its supervisor regarding the treatment of individual entities in a connected group including circumstances under which the same rating may or may not be assigned to some or all related entities.

So, no, we don’t believe that there would be no impact of the EBA proposals. If the EBA considers otherwise, we would like to review the impact assessment.

On the contrary, the impacts are likely to be significant since the rating systems would now have to take into account several issues that remain out of the control of the entity but that will depend on its judgement and its capacities to identify the relationships between exposures.

All in all, the new framework would add complexity and heterogeneity in its application.

The rating systems will need to be developed and adapted to include all the information required to implement the new framework. We think that the additional complexity that this creates is not commensurate with any more preciseness of risk sensitivity.

More specifically, the inclusion of economic connections based on “repayment difficulties” in the policies for the treatment of groups, as required by Article 172(1)(d) of the CRR, would have a material impact on the credit risk modelling.

The proper inclusion of the information on economic connections among clients for rating assignment is conditioned to the capacity of including a congruous improvement of the risk differentiation performance. The “repayment difficulties” concept has a weaker and less clear relation with the default events, thus the extension of the economic link mapping by applying such approach would limit the discriminatory power contribution stemming from the information on the existence of an economic link.
As far as the application of the rating systems is concerned, the “group effect” considered in the counterparty rating assessment would be extended to a larger number of entities - included in the group perimeter due to a modified definition of economic connection - embedding the potential shortcomings concerning the risk differentiation power of the group link information.

Thus, the potential impact might be twofold:
1. appropriateness of rating assignment on the single obligor and of the applicable pricing
2. extension of the rating assignment perimeter embedding the group link function to broad set of obligors.

The proposal also affects the implementation of the EBA Guidelines on the definition of default.

As specified in Paragraph 61, connected clients approach should be considered in the identification of default. At the same time, the identification of default drives the definition of the target variables for developing and calibrating the models.

In addition, the policies for the identification of default contagion effect should be in line with the assignment of obligors to obligor grades . Were the “repayment difficulties” criterion applied, in case of default of one member of the group, the need for assessing the potential “unlikeliness to pay” might be extended to a much broader perimeter of clients, with potential consequences on the accuracy of the analysis.

Also for the purposes of Article 172(1)(d) of the CRR and EBA Guidelines on the definition of default, it is therefore deemed important to keep the concept of “single risk” definition more anchored to the current approach based on “substantial, existence threatening repayment difficulties”.

The rating systems will need to be developed and adapted to include all the information required to implement the new framework.

Banks would probably keep individual ratings for internal risk assessment, which would increase the gap between with the standardised approach.

In summary the EBA proposals have a number a number of additional consequences to other EBA guidance and RTS that we do not think that have been considered by the EBA. So we encourage the EBA to review its proposals.
Similarly as the consequences of the application of the framework to the classification of retail exposures explained in Q2, the application of the guidelines to the current practices regarding the use of the SME supporting factor could imply an increase of the risk weighted assets of banks.

Indeed, SME exposures would more easily breach the EUR 1,5 million threshold below which the SME supporting factor can be applied. For example, an exposure to a small supplier below EUR 1,5 million would not benefit anymore from the SME supporting factor and thus from the associated reduction in the required risk weighted assets if this supplier is considered to be connected to other SMEs or corporates. In this case, the exposure would be assigned with a higher risk weight for Pillar 1 purposes.

Moreover, it would imply significant changes in banks’ internal models, at least those used for large corporate as this category would consequently cover a wider population, with new features. Those model changes being material, they would have to be addressed through the new ECB model validation process. It is also to be noted that, as the population covered by the modified models is to be less homogenous, the precision of the models would be of lesser quality.

It is noteworthy that the introduction of the SME supporting factor into the European Legislation is considered as an important element to promote financing to SMEs which are a key driver of economic growth and job creation.

All in all, the application of the guidelines to the current practices regarding the use of the
SME supporting factor could jeopardize the effectiveness of the SME supporting factor.

Finally, it is also worth mentioning that the application of the framework to the practices regarding the use of the SME supporting factor would also raise operational issues as explained in Q1 and Q2.
The application of the proposed connected client framework to reporting requirements would raises significant operational issues since the liquidity databases currently storing the data on counterparties are not designed in a way that would easily allow integrating the proposed definition of connected clients. In this sense, the application of the proposed framework to reporting requirements would entail significant efforts in time and costs.

The following implications of the adoption of the new framework in current practices are worth to be mentioned:

• LCR & NSFR: change in the type of some counterparties if they are included in a group of connected clients.
• ALMM Template 67: Concentration of funding by counterparty. The concentration ratios may increase if some counterparties are included in a group of connected clients.
• ALMM Template 71: Concentration of counterbalancing capacity by issuer. The concentration ratios may increase if some counterparties are included in a group of connected clients.

As explained before, it is also worth mentioning that the quantification of the impact of the application of the framework is not possible since it required data is not collected and available in the current context.

In addition, it is to say that the EBA draft guidelines on the definition of connected clients were initially aimed at the large exposure regime only. Consequently they were limited to clients to which a bank has granted a loan. If the scope of the guidelines is expanded to clients that only have deposits, it would mean that institutions would have to gather additional information that would not be available under the EBA draft guidelines. It is also less likely that costumers with deposits only would be willingly to provide such information. In this sense, the guidelines should not be extended to areas of liquidity.

Furthermore it should be noticed that some clients belong to several group of connected clients. For the large exposure regime this may be feasible. In case of the area of liquidity such multi-assignments are problematic. In case of ALMM this would lead to an overestimation of concentration risk on the refinancing site (C67.00).

In general the BBA oppose the idea of expanding the scope of connected clients to the liability side of the balance sheet. Such classifications do not exist at the moment in banks IT systems and building them up from the scratch will be a huge challenge. Costs-benefits analysis is needed, since benefits remain unclear while costs would be significant.