Asset encumbrance risk management policy for Luxembourg banks

1. Introduction

The Commission de Surveillance du Secteur Financier (the “CSSF”) Circular 12/552 (“Circular 12/552”) is applicable to all credit institutions, investment firms and, to a certain extent, professionals performing lending operations, and it sets out provisions on central administration, governance and risk management.

The implementation of the ESRB Recommendations and the desire to simplify the general outsourcing regime in the financial sector led to the need to modify Circular 12/552 in November 2014.

A consolidated version in English of Circular 12/552, including the modification which entered into force on 31 December 2014, is available on the website of the CSSF.

2. ESRB Recommendations

The background for this new regulatory “burden” is the recommendations of the European Systemic Risk Board (the “ESRB”) (ESRB/2012/2) which were first published on 20 December 2012 (the “Recommendations”), with various implementation deadlines up to December 2013.

In Luxembourg, the authority in charge of implementing the Recommendations is the CSSF, which promptly implemented the Recommendations in Circular 12/552.

Scope of the modifications of Circular 12/552

The scope of the requirement to implement a risk management policy for asset encumbrance is only applicable to credit institutions, including branches of Luxembourg credit institutions opened in another member state and non-EEA branches opened in Luxembourg. Thus, investment firms do not have to implement such a risk management policy.

The easing of the outsourcing conditions encompasses both credit institutions and investment firms which make recourse to Luxembourg-based service providers.

3. Credit institutions have to adopt risk management policy for asset encumbrance in 2015

Luxembourg credit institutions are required to adopt a risk management policy for asset encumbrance as of 31 December 2014, in accordance with the brand-new chapter 6 of part III of Circular 12/552.

According to the ESRB Recommendations, an “encumbered asset” is an asset that is, explicitly or implicitly, pledged or subject to an arrangement to secure, collateralize or credit-enhance any transaction. The encumbered assets are used by the banks in order to procure financing for themselves. In case of a bank failure, the collateralized assets are not available to general creditors, thus the need to include the encumbered assets in the risk management policy of a credit institution.

The responsibility for adopting and approving the risk management policy for asset encumbrance lies with the board of directors of the credit institutions.

The policy should contain the following information:

• the approach to asset encumbrance;
• procedures for identification, monitoring and management of risks associated with collateral management and asset encumbrance; and
• a description of controls for identification, monitoring and management of risks associated with collateral management and asset encumbrance.

In terms of monitoring framework, the authorized management and the board of directors shall receive information at least once a year regarding certain quantitative reporting, such as: (i) the level, evolution and types of asset encumbrance and related sources of encumbrance (i.e. secured funding or other transactions); (ii) the amount, evolution and credit quality of eligible assets which are unencumbered; (iii) the amount, evolution and types of additional encumbrance resulting from a stress scenario (contingent encumbrance).

Apart from the risk management policy for the encumbered assets, the credit institution has to modify its business continuity plan in order to address the scenario of a contingent encumbrance resulting from stress events such as devaluation of pledged assets, downgrading of a credit institution’s credit rating and an increase in margin requirements.

4. Easing the outsourcing conditions in the financial sector

Without prejudice to the outsourcing conditions applicable to credit institutions and investment firms pursuant to section 7.4.1 of Circular 12/552, the CSSF has decided to simplify the requirements in terms of outsourcing an activity to a Luxembourg credit institution or a support professional of the financial sector, commonly known as PSF (i.e. client communication agents, administrative agents of the financial sector, primary IT system operators in the financial sector and secondary IT systems and communication network operators in the financial sector).

All outsourcing to a Luxembourg credit institution or a support PSF performed after 31 December 2014 can be processed by a simple notification to the CSSF and prior authorization is no longer needed.