Complying with the Capital Adequacy Requirements

Only a few weeks ago, the Cyprus Securities and Exchange Commission (CySEC) published its findings from the numerous inspections performed by the commission, effectively advising firms on ensuring compliance with the regulatory capital requirements.

It is worth mentioning that the capital adequacy (COREP) forms, follow the capital requirements directive (CRD IV) and regulation (CRR), and have been into force since 2013. This means that the regulation is in place for more than 6 years, long enough for the appropriate practices to be developed and to be followed. Nevertheless, it seems that many firms, still to this today, are completing and therefore submitting their Capital Adequacy forms incorrectly – reporting misleading figures on capital adequacy ratio and own funds.

We take this opportunity to analyze within this commentary, the desk-based inspections by CySEC and provide compliance tips for the accurate submission of the capital adequacy forms.

Errors identified related to own funds
It is reported that the own funds, including the Tier 1 and Tier 2 Capital, are calculated incorrectly under the Capital Adequacy Form 06.1 and spreadsheet CA1. In many cases, the result of this practice is the calculation of a higher amount of own funds.

A. Findings related to Tier 1 Capital

Firms report in a wrong way the ‘accumulated profit and loss’, the ‘retained earnings’  and the ‘other reserves’ figures from their balance sheet.
Compliance Tip 1: The ‘accumulated profit and loss’ should be equivalent to the ‘previous years retained earnings’, while the ‘profit and loss of the current year’ are part of the ‘eligible profit and loss’. Further, ‘other reserves’ are only the ‘non-refundable contributions from their shareholder’.

It is reported that firms treat incorrectly the ‘interim profits and losses’ figure and do not follow the single rulebook issued by the European Banking Authority (EBA).
Compliance Tip 2: According to EBA and the Capital Requirement Regulation (CRR), firms must incorporate in their Tier 1 Capital, the interim or final losses as soon as they are incurred. On the other hand, firms must be granted permission by their National Competent Authority (in this case CySEC) in order to include the interim profits in their Tier 1 Capital.  Firms must follow the below steps to obtain such permission;
– Profits need to be verified by the external auditors as part of the interim audit verification report,
– All expected charges and/or dividends ought to be deducted from the profits,
– An adequate level of assurance must be provided by the external auditor in regards to the evaluation of the calculated profits,
– Provision of the Total Tier 1 Capital before and after the interim profits.  

Firms are not deducting the Investors Compensation Fund (ICF) contribution from Tier 1 Capital.
Compliance Tip 3: As of the 10th of October 2016, firms must deduct the ICF contribution from the Tier 1 Capital, as ‘additional deductions of CET1 Capital’, and they should no longer consider the ICF as a risk-weighted amount of the ‘public sector entities credit exposure’.

B. Findings related to Tier 2 Capital

A wrong-way treatment on the Tier 2 Capital has been observed by the regulator and specifically the process followed in regards to the capital instruments and subordinated loans eligible as Tier 2 Capital. The identified errors resulted in the calculation of a higher amount of own funds.

Compliance Tip 4: Firms can include the instruments and subordinated loans as Tier 2 Capital when the instruments or loans;
– are raised and fully paid-up in cash,
– are not granted by the institution, its subsidiaries or any form of ownership,
– are not subject to a guarantee or any arrangement that enhances the seniority of a claim,
–  have an original maturity of at least five years.

Compliance Tip 5: Firms must follow the amortization principle in order to calculate the instruments qualifying as Tier 2 Capital during their final five years of maturity by;
– taking the nominal amount on the first day of the final five year period,
– divide by the number of calendar days of the equivalent period, and
– multiply by the remaining number of calendar days until maturity.

Compliance Tip 6: Firms are allowed to proceed with redemption or repayment of the instruments or subordinated loans qualify as Tier 2 Capital, prior to the maturity day of the five years only when a change in the regulatory classification of the instruments result to the exclusion from own funds or the reclassification is of lower quality which was not foreseeable at the time of issuance. Otherwise, early redemption or repayment may be allowed only with CySEC’s permission and when certain conditions are met.

Compliance Tip 7: Firms must have available the relevant loan agreements and to keep sufficient evidence.

Identified errors related to the calculation of Operational Risk Exposure

Firms with initial capital requirements of 730,000 EUR – dealing on own account license – calculate the operational risk exposure by using a methodology which applies to firms with a lower authorisation, resulting to a miscalculation of the operational risk.
Compliance Tip 8: Firms dealing on own account shall calculate their operational risk exposure using the Basic Indicator Approach and by considering a 15% of the average relevant indicator over the last three years, counting from the end of the financial year. It is worth mentioning that the firm shall use business estimates if the firm has been in operation for less than three years and use actual figures as soon as they are available.

To conclude, CySEC draws special attention for consistency between the forms linked to each other and specifically between;
– the capital adequacy (COREP) forms,
– the quarterly (QST) statistics,
– the annual risk-based supervision framework (RBSF) form, and
– the management accounts.

It is evident that the intention of CySEC is to ensure compliance on the regulatory reporting practices and issue a strong and final warning, before proceeding with fines. Our main question is whether firms that have not yet been inspected, understand they are not in compliance and at risk?

Feel free to ask any question or clarification at info@salvusfunds.com and read our previous article if you are interested in the upcoming new capital requirements directive (CRD V) and regulation (CRR II).

The information provided in this article is for general information purposes only. You should always seek professional advice suitable to your needs.