Can the base for grandfathering and phase out limits be calculated in the currency that the instrument eligible for grandfathering is denominated in?
On the basis of the formula given in Article 486(4) of Regulation (EU) No 575/2013 (CRR), the institution calculates the base to which phased-out limits refer, the so-called 'base for grandfathering'. Over the next 10 years this base will be used to calculate the maximum amount of subordinated debt that can be classified as Tier 2 despite its non-compliance with criteria set out in Article 63. Due to the fact that the institution’s subordinated instruments are denominated in CHF in order to avoid the volatility of the maximum amount (resulting from fluctuations in foreign exchange rate CHF/PLN), the base shall be denominated in CHF. The reason for this is that the subordinated debt was issued to finance mortgage loans also granted in CHF. This 'natural hedge' reduces the volatility of the capital adequacy ratio. However, when the base for grandfathering is fixed in the bank's reporting currency (PLN), the benefit of this 'natural hedge' is eliminated. In such a case although the Tier 2 capital as well as capital charge are calculated in reporting currency, so that they co-move together with FX rate fluctuations, the absolute limit for grandfathering is fixed and does not change with FX rate movements.
The effects of the so called “natural hedge” should already be recognised in the income statement and therefore the fixing of the maximum amount as of 31 December 2012 should be done in the functional currency, which is normally the local currency, at the year-end middle exchange rate as required under accounting rules (see IAS 21).
Otherwise, the transitional rules would have to be split-up for each currency used, which would be overly complex and work against the flexibility originally provided for institutions by applying the maximum amount to classes of capital instead of single instruments.
Finally, using a stronger currency as a basis could lead to higher amounts to be recognised given the fact that the stronger currency could perform better in relation to functional currency.
Update 26.03.2021: This Q&A has been reviewed in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR) and continues to be relevant.