Transitional arrangements for capital treatment of expected loss provisioning

Document Properties

  • Type of Publication: Letter
  • Date: April 9, 2020
  • To: Federally Regulated Deposit-Taking Institutions (DTIs)

OSFI’s letter to DTIs issued on March 27, 2020 introduced an adjustment to capital for Expected Credit Loss (ECL) provisioning. Further to that letter, this document describes the calculation of this adjustment and the related reporting on the Basel Capital Adequacy Reporting (BCAR) regulatory return.

I. Regulatory capital treatment

Exposures treated under the Standardized Approach (SA)

Each quarter, DTIs should compare Stage 1 and Stage 2 allowances allocated to the standardized approach at the end of that quarter with the baseline amount of Stage 1 and Stage 2 allowances. The baseline amount is the Stage 1 and Stage 2 allowances allocated to the standardized approach as at the quarter ending December 31, 2019 (for December year-end DTIs) or January 31, 2020 (for October year-end DTIs).

DTIs should multiply that increase in allowances by (100% less the DTI’s tax rate), and multiply the result by the scaling factor for the reporting period. The scaling factor is set at 70% in fiscal 2020, 50% in fiscal 2021 and 25% in fiscal 2022. The resulting amount should be added to CET1 capital. The allowances that may be included in Tier 2 capital under the standardized approach are the total eligible allowances (as per CAR Chapter 2, paragraph 40) less allowances included in CET1 capital from the standardized approach.

The transitional adjustment to CET1 capital will be made to Gross CET1 and therefore will affect deductions that use 10% of CET1 as a threshold, as well as large exposure limits, Tier 1 Capital (for both risk-based and leverage purposes), Total Capital, and Total Loss Absorbing Capacity (TLAC).

Exposures treated under the Internal Ratings Based (IRB) Approach

Each quarter, DTIs should compare Stage 1 and Stage 2 Allowances allocated to IRB portfolios at the end of that quarter with the baseline amount of Stage 1 and Stage 2 allowances. The baseline amount is Stage 1 and Stage 2 allowances allocated to IRB portfolios as at the quarter ending December 31, 2019 (for December year-end DTIs) or January 31, 2020 (for October year-end DTIs).

This increase should be multiplied by (100% less the DTI’s tax rate) and then multiplied by the scaling factor for the reporting period. The scaling factor is set at 70% in fiscal 2020, 50% in fiscal 2021 and 25% in fiscal 2022. DTIs should then take the lower of (i) this result and (ii) excess allowances eligible for inclusion in Tier 2 capital, and add this amount to CET1 capital. The allowances that may be included in Tier 2 capital are the total eligible allowances under the IRB approach (as per CAR Chapter 2, paragraph 41) less allowances included in CET1 capital.

As noted for standardized approach exposures, the transitional adjustment to CET1 capital will increase CET1 capital, with resulting impacts to calculations based off of CET1 capital. In addition, allowances subject to this transition should continue to be included in the allowance adjustment for the capital floor (CAR Chapter 1, paragraphs 67 and 69), as the floor adjustment for allowances in capital does not differentiate between CET1 and Tier 2 capital.

II. Basel Capital Adequacy Reporting (BCAR)

When filing the BCAR regulatory return, DTIs should report the above-noted arrangements as follows:

Exposures treated under the standardized approach (SA)

Step 1: Compare the Net Stage 1 and 2 allowances allocated to standardized portfolios on Schedule 4 - Allowance for Impairment: Capital Treatment in DPA 1995 with the same DPA reported in the baseline period (i.e. December 31, 2019 (for December year-end DTIs) or January 31, 2020 (for October year-end DTIs).

Step 2: If the result from step 1 is positive, adjust for taxes and scale the result based on the fiscal period as follows: [increase in allowances from step 1] * [1 - tax rate] * [Scaling factor]. If the result from step 1 is negative, there is no transition for the current period under the SA.

Step 3: Add the result from step 2 to CET1 capital by reporting it on Schedule 3 in the placeholder DPA 1586.

Step 4: Subtract the amount added to CET1 capital in step 3 from allowances eligible for inclusion in Tier 2 capital to determine SA allowances included in Tier 2 capital. As a result, DPA 1612 (Allowances included in Tier 2 capital under SA) will equal DPA 1998 from Schedule 4 (Allowances eligible for inclusion in Tier 2 capital) less any amount added to DPA 1586 in respect of standardized approach portfolios.

Exposures treated under the IRB approach

Step 1: Compare the Net Stage 1 and Stage 2 allowance allocated to IRB portfolios on Schedule 4 – Allowance for Impairment: Capital Treatment in DPA 2264 with the same DPA reported in the baseline period.

Step 2: If the result from step 1 is positive, adjust the increase for taxes and scale the result based on the fiscal period as follows:

  • the lower of:
    • [increase in allowances from step 1] * [1 - tax rate] * [Scaling factor]; and
    • the excess IRB allowances included in Tier 2 capital (DPA 1613)

Step 3: Add the result from step 2 to CET1 capital by including it on Schedule 3 in the placeholder DPA 1586 (adding it to allowances in CET1 for SA portfolios).

Step 4: As under the SA treatment, surplus allowances net of those included in CET1 capital in step 3 remain eligible for inclusion in Tier 2 capital. DPA 1613 (Allowances included in Tier 2 capital under IRB) will equal DPA 2500 from Schedule 4 (excess allowances under IRB eligible for inclusion in Tier 2 capital) less any amount added to DPA 1586 in respect of IRB portfolios. Overall, DPA 1613 + DPA 1612 + DPA 1586 will equal DPA 1998 + DPA 2500 from Schedule 4.

Changes to BCAR validation rules

Validation rules requiring the placeholder DPA 1586 to be zero, and tying DPAs 1612 and 1613 to Schedule 4 will be disabled. The floor calculation on Schedule 2A - Summary of Capital Floor Risk-weighted Assets is based on allowances amounts from Schedule 4, which are unaffected by this transition. Therefore, no validation rule change or adjustment to the calculation is required with respect to the capital floor.

III. Public disclosure requirements

Transparency surrounding these adjustments is important. In their Pillar 3 disclosures, DTIs are expected to separately make available each of the CET1, Tier 1, Total Capital, TLAC, and Leverage ratios had the transitional arrangement not been applied. Additional details on the specific disclosure requirements will be communicated in the coming weeks.

IV. Illustrative examples

Example 1

A DTI at the end of the baseline period (Q4 2019) had $75 million of stage 1 and 2 allowances allocated to its standardized portfolios and included as part of its Tier 2 capital. The Stage 1 and 2 allowances allocated to its standardized portfolios increases to $175 million as of Q1 2020.

The incremental $100 million is subject to this transition. Assuming a 25% tax rateFootnote 1, and after applying a 70% factor, $52.5 million would be included in CET1 capital. The balance of $47.5 million would be added to Tier 2 capital. This results in the total allowances included in Total capital in Q1 2020 of $175 million: 75 million in Tier 2 as of the baseline plus 52.5 million added to CET1 and 47.5 million added to Tier 2.

Example 2

A DTI at the end of the baseline period (Q4 2019) had $75 million of stage 1 and 2 allowances allocated to its standardized portfolios and included as part of its Tier 2 capital. The Stage 1 and 2 allowances allocated to its standardized portfolios decreases to $50 million as of Q1 2020.

Stage 1 and 2 allowances allocated to standardized portfolios in the reporting period have declined relative to the baseline period and as a result, no allowances will be included in CET1 capital in relation to the DTI’s standardized portfolios.

Example 3

A DTI using the IRB approach has $75 million of stage 1 and 2 allowances allocated to its IRB portfolios at the end of the baseline period (Q1 2020). The DTI reported an overall shortfall in allowances and resulting deduction from CET1 capital in the baseline period. The Stage 1 and 2 allowances allocated to its IRB portfolios increases to $175 million as of Q2 2020.

If the DTI remains in an allowance shortfall position then the incremental $100 million is not subject to the transition and no allowances will be included in CET1 capital in relation to the DTI’s IRB portfolios.

Example 4

A DTI using the IRB approach has $75 million of stage 1 and 2 allowances allocated to its IRB portfolios at the end of the baseline period (Q1 2020). The DTI reported an overall shortfall in allowances and resulting deduction from CET1 capital in the baseline period. The Stage 1 and 2 allowances allocated to its IRB portfolios increases to $175 million as of Q2 2020.

If the DTI is now in a surplus position of $150 million partially due to an increase in Stage 3 allowances, then the incremental $100 million increase in Stage 1 and 2 allowances allocated to IRB portfolios are subject to this transition. Assuming a 25% tax rate, and after applying a 70% factor the result is $52.5 million. The lower of $52.5 million and the DTI’s surplus position is $52.5 million, which would be included in CET1 capital. The balance of $97.5 million would be included in Tier 2 capital (resulting in the full $150 million excess allowances being included in Total Capital).

Example 5

A DTI using the IRB approach has $75 million of stage 1 and 2 allowances allocated to its IRB portfolios at the end of the baseline period (Q1 2020). The DTI reported an overall shortfall in allowances and resulting deduction from CET1 capital in the baseline period. The Stage 1 and 2 allowances allocated to its IRB portfolios increases to $175 million as of Q2 2020.

If the DTI is now in a surplus position of $50 million, partially due to an increase in IRB expected loss, then the $50 million of the $100 million increase in Stage 1 and Stage 2 allowances is subject to the transition. After adjusting the $100 million increase for tax and the 70% factor, the result is $52.5 million. The lower of $52.5 million and the DTI’s allowance surplus for the quarter is $50 million. The surplus allowances are allocated to CET1 capital and no allowances are included in Tier 2 capital under the IRB approach (resulting in the full $50 million excess allowances being included in Total Capital).

Footnotes

Footnote 1

These examples assume a 25% tax rate; however, DTIs should apply their own marginal tax rate when performing these calculations, which should be the same tax rate as is used for the creation of deferred tax assets that relate to expected credit losses.

Return to footnote 1