Illustrations

The scenarios included in this annex illustrate the application of the guidelines to groups of connected clients falling under the definition in Article 4(1)(39) of Regulation (EU) No 575/2013, from the perspective of the reporting institution.

Groups of connected clients based on control

Scenario C 1: Exceptional case (no single risk exists despite the existence of control)

The reporting institution has exposures to all entities shown below (A, B, C and D). Entity A has control over entities B, C and D. The subsidiaries B, C and D are special purpose entities/ special purpose vehicles (SPEs/SPVs).

To assess if there is no single risk, despite the existence of a control relationship, the reporting institution should assess at least all of the following elements in relation to each of the SPEs/SPVs (entities B, C and D in this scenario):

The absence of economic interdependence or any other factors that could be indicative of a material positive correlation between the credit quality of the parent undertaking A and the credit quality of the SPE/SPV (B, C or D). Among other factors, potential reliance on parent undertaking A for funding sources and some of the criteria preventing the deconsolidation of the SPE/SPV or the derecognition of securitised assets under the applicable accounting rules have to be assessed as potential signs of material positive correlation.

ii)

The specific nature of the SPE/SPV, especially its bankruptcy remoteness (based on Article 300(1) of Regulation (EU) No 575/2013) – in the sense that effective arrangements exist that ensure that the assets of the SPE/SPV will not be available to the creditors of parent undertaking A in the event of its insolvency – and if the debt securities issued by the SPE/SPV normally reference assets that are third parties’ liabilities.

iii)

The structural enhancement in a securitisation, and the delinkage of the obligations of the SPE/SPV from those of parent undertaking A, such as the existence of provisions, in the transactions documentation, ensuring servicing and operational continuity.

iv)

The compliance with the provisions under Article 248 of Regulation (EU) No 575/2013 regarding arm’s length conditions.

Having assessed all of these elements, the reporting institution could conclude that, for example, subsidiaries B and C do not constitute a single risk with parent undertaking A. As a result, the reporting institution needs to consider a group of connected clients composed only of clients A and D. The institution should document these assessments and their findings in a comprehensive way.

Alternative approach for exposures to central governments

To illustrate the possible scenarios, the following general scenario is used: the central government directly controls four legal persons (A, B, C and D). Entities A and B themselves have direct control over two subsidiaries each (A /A , B /B ). The reporting institution has exposures to the central 1 2 1 2 government and all of the entities shown.

Scenario CG 1: Alternative approach – partial use

The reporting institution could carve out only one group (‘central government/A/all controlled or dependent entities of A’) and keep the general treatment for the rest (‘central government/B, C and D/all controlled or dependent entities of B’): Scenario CG 2: Alternative approach – used for all directly dependent entities

Scenario CG 3: Alternative approach – applicable on ‘first/second level’, not below

In the scenarios CG1 and CG2, entities A, B, C and D constitute the ‘second level’, i.e. the level directly below the central government (‘first level’). Here, a carve-out from the overall group of connected clients is possible. However, entities A , A , B and B are only indirectly connected to the 1 2 1 2 central government. A carve-out on their level is not possible (e.g. both A1 and A2 need to be included in the group ‘central government/A’): Scenario CG 4: ‘Horizontal connections’ on the ‘second level’

In a variation on the general scenario above, entities A and B are economically dependent (payment difficulties for B would be contagious to A):

Assuming that the reporting institution uses the alternative approach only in part, as described in scenario CG 1 above, the following groups of connected clients need to be considered:

Central Central Government Government Economic

dependency

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Establishing interconnectedness based on economic dependency

Scenario E1: Main case

The reporting institution has exposures to all entities shown below (A, B, C and D). B, C and D rely economically on A. Hence the underlying risk factor for the institution is in all cases A. The institution has to form one comprehensive group of connected clients, not three individual ones. It is irrelevant that there is no dependency among B, C and D.

Scenario E 2: Variation on main case (no direct exposure to source of risk)

There is a grouping requirement even if the reporting institution does not have a direct exposure to A but is aware of the economic dependency of each client (B, C and D) on A. If possible payment difficulties for A are contagious to B, C and D, they will all experience payment difficulties if A gets into financial trouble. Therefore, they need to be treated as a single risk.

As in scenario E 1, it does not matter that there is no dependency among B, C and D. A causes the grouping requirement, although it is not a client itself and thus is not part of the group of connected clients. Scenario E 3: Overlapping groups of connected clients

If an entity is economically dependent on two (or more) other entities (note that the payment difficulties of one of the other entities (A or B) might be sufficient to result in C being in difficulty),

it has to be included in the groups of connected clients of both (all such) entities:

The argument that the exposure to C will be double-counted is not valid because the exposure to C is considered a single risk in two separate groups.

The large exposure limit applies separately (i.e. the limit applies once to exposures to group A/C and once to exposures to group B/C).

As there is no dependency between A and B, no comprehensive group (A + B + C) needs to be formed. Scenario E 4: Chain of dependency

In the case of a ’chain of dependency’, all entities that are economically dependent (even if the dependency is only one way) need to be treated as one single risk. It would not be appropriate to form three individual groups (A + B, B + C, C + D).

Scenario E 5: Reporting institution as source of funding (no grouping requirement)

In the following scenario, the reporting institution is the sole provider of funds for three customers. It is not an ‘external funding source’ that connects the three clients and it is a funding source that can normally be replaced. Scenario E 6: Reporting institution as source of funding (grouping requirement)

In the following scenario, the reporting institution is the liquidity provider of three SPVs or conduits (similar structures):

In such a case, the reporting institution itself can constitute the source of risk (the underlying risk factor) as recognised in recital 54 to Regulation (EU) No 575/2013:⁽¹⁹⁾

In the scenario above, it does not make a difference whether the liquidity lines are directly to the SPV or to underlying assets within the SPV; what matters is the fact that liquidity lines are likely to be drawn on simultaneously. Diversification and quality of the assets are also not considerations in this scenario, nor is the reliance on investors in the same sector (e.g. investors in the ABCP market), as the single risk is created by the use of similar structures and the reliance on commitments from one source (i.e. the reporting institution as the originator and sponsor of the SPVs).

Relation between interconnectedness through control and interconnectedness through economic dependency

Scenario C/E 1: Combined occurrence of control and economic dependency (one-way dependency)

In the following scenario, the reporting institution has exposures to all entities shown in the diagram below. A controls A and A , B controls B . Furthermore, B is economically dependent on A (one-1 2 1 1 2 way dependency):

Grouping requirement: In this scenario, the reporting institution should come to the conclusion that B1 is in any case to be included in the group of connected clients of A (the group thus consisting of A, A , A and B ) as well as of B (the group thus consisting of B and B ): 1 2 1 1

In case of financial problems for A, A2 and ultimately B1 will also experience financial difficulties on account of their legal (A2) and economic (B1) dependency respectively. The forming of three different groups (A + A + A , A + B , B + B ) would not be sufficient to capture the risk stemming from A, 1 2 2 1 1 because B1, although dependent on A2 and thus on A itself, would be carved out of the single risk of group A. Scenario C/E 2: Combined occurrence of control and economic dependency (two-way dependency)

In this scenario, the economic dependency of A2 and B1 is not only one way but mutual:

Grouping requirement: A2 would need to be included additionally in group B, and B1 would need to be included additionally in group A: Scenario C/E 3: Downstream contagion

In a variation on scenario C/E 1 above, B1 also controls two entities (B2 and B3). In this case, the financial difficulties of A will pass through A2 and B1 down to the two subsidiaries of B1 (‘downstream contagion’).

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Grouping requirement:

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23 23 Scenario C/E 4: Upstream contagion

The control relationship between B and B1 does not automatically lead to including B in the group of connected clients of A, as financial problems for A are not likely to result in financial difficulties for B. However, the controlling entity B needs to be included in the group of A if B1 forms such an important part of group B that B is economically dependent on B1. In this case, the financial difficulties of A will proceed not only downwards but also upwards to B, causing payment difficulties for B (i.e. all entities now form a single risk).

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Grouping requirement:

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Control and management procedures for identifying connected clients

Scenario Mm 1: Limits to the identification of a chain of contagion

Further developing the scenario above (C/E 4), the reporting institution has exposures only to entity A and entity B3. In such a case, it is recognised that it might not be possible for the reporting institution to become aware of the chain of contagion and the group of connected clients might not be correctly formed.

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