Qualifying requirements for the use of particular instruments and methodologies – use of the IRB approach to credit risk (CRR Article 452)

Competent authority's approval to use the IRB Approach (CRR Article 452.a)

As at 31 December 2014, the Banco Comercial Portugues Group (the parent owner of Bank Millennium SA) has obtained the described below approvals of the competent authority pertaining to the use of the IRB Approach by the Group and Bank Millennium SA (“IRB Decisions”). Both approvals were issued by Banco de Portugal (the consolidating regulator of the Banco Comercial Portugues Group) in cooperation with the Polish Financial Supervision Commission.

The approval issued at the end of 2012 to use the Advanced IRB Approach for two credit portfolios of: retail exposures to individual clients secured by residential property (RRE) and qualifying revolving retail exposures (QRRE). The first IRB decision contained a “regulatory floor” according to which the minimum own funds requirements for the portfolios covered by the decisions had to be temporarily maintained at no less than 80% of the relevant capital requirements calculated using the Standardized Approach. The regulatory floor applied until the relevant authority determined that the conditions set forth by this decision have been fulfilled.

The approval issued at the end of 2014 entails:

a) reduction of the “regulatory floor” for RRE and QRRE portfolios from 80% to 70% of the relevant capital requirements calculated using the Standardized Approach. The regulatory floor shall be applied portfolio by portfolio, and should be adjusted up or downwards in case of any difference between expected losses and provisions so that the impact in the solvency ratios is exactly the same of considering only 70% of the capital requirements calculated under the standard method. The regulatory floor may be ultimately removed after the Group meets certain conditions by 31 December 2015.

b) commencement of use of the IRB Approach for the other retail exposures class is conditional upon meeting certain conditions by 30 June 2015.

c) commencement of use of the IRB Approach for corporates (including specialized lending) is conditional upon meeting certain conditions, while the new application to use the IRB Approach should not be submitted before 31 December 2016.

d) the permission to make changes to models applicable to RRE and QRRE portfolios is conditional upon meeting certain conditions, while the new application to use the IRB Approach to these portfolios should be submitted until 30 June 2015.

Structure of internal rating systems and relation between internal and external ratings (CRR Article 452.b.i)

The Group defines a rating system as all of the methods, processes, controls, data collection and IT systems that are used for the assessment of credit risk and for classification of exposures to a pool with a specified risk level, including the rules on the priority of rating models, if applicable, and the rules for overriding rating grades. Elements of the rating system include PD, LGD, CCF-EAD models (hereinafter: models) and methodologies for evaluating specialized lending.

Evaluation of the client's credit risk in respect to its probability of default (PD) is based on a uniform rating scale, referred to as the Master Scale.

The Master Scale (MS) has 15 risk grades, where ratings 1 to 3 are equivalent to a high credit quality, ratings 4-6: good credit quality, ratings 7-12 average and low credit quality and ratings 13-15 are procedural ratings used for impaired exposures.

All the clients with available lending, whether or not they actually use the approved credit limits and all other participants of credit transactions should have a previously awarded rating and should be assigned to an appropriate pool.

An adequate credit or rating policy should specify the model to be used for rating purposes or a homogenous pool for a given client segment.

Each PD model used must be calibrated to MS based on the observed or estimated probability of default.

The rating for governments, central banks, international organizations, multilateral development banks and Institutions may be assigned based on a rating awarded by recognized rating agencies, mapped to the Master Scale.

Should the above-mentioned entities have more than one classification awarded by recognised rating agencies (split rating) the rating corresponding to the second best risk shall be taken into account at all times.

The table showing relationships between internal and external risk grades is presented in chapter VIII of the Disclosures. The Bank recognizes the following external rating agencies for comparison purposes: Fitch, Moody’s, Standard & Poors.

A rating awarded through a behavioral model (behavioral rating) by default takes precedence over a rating awarded through an application model (application rating) if behavioral rating only is awarded.

Procedural ratings (13, 14 and 15 according to the Master Scale) are awarded to clients showing signs of deteriorating borrowing capacity and creditworthiness or with overdue debt.

Procedural ratings by default take precedence over application ratings.

After the pre-conditions necessary to award any of the procedural ratings are no longer satisfied, ratings 13 and 14 expire immediately, while rating 15 either expires or is maintained for a “quarantine period”.

Use of internal estimates other than for calculating risk-weighted exposure amounts (CRR Article 452.b.ii)

The Group acts in accordance with the IRB principles for the application of "use test" criteria. This means that the risk parameters used to calculate capital requirements for credit risk are also the parameters that are used for other internal purposes, in particular in the risk management process. Internal rating or internal loss estimation models play a major role in the risk management process and in the decision process at different risk management levels, i.e. for the purposes of defining the Bank's credit risk strategy, for approving and monitoring credit risk and for allocating economic capital.

The Group has many years of experience in using internal rating models, since individual rating systems have been used to evaluate client risk since the 1990s. Ever since that time, the methodologies have been developed, improved and, to an increasing extent, incorporated in business processes, thus boosting risk management "culture" and awareness in the management process.

• Management information system

Internal estimates are used broadly in the management information system in the areas of risk and operating activity. The individual management levels (Supervisory Board, Management Board, specialized committees) receive detailed information about exposure to individual risks types and about the risk profile, including estimated risk parameters. This allows for effective risk management.

• Risk Appetite

Internal estimates have been used to determine the "risk appetite" of the Bank and the Bank Millennium Group. The risk appetite incorporates measures, buffers and quantitative limits which, along with qualitative guidelines on managing individual risk types, determine the Bank's propensity for risk. Risk parameters are also an important element of the risk strategy being pursued, which includes objectives and guidelines for managing different risk types.

• Concentration limits

In the area of credit concentration risk and risk of significant exposures, internal estimates have been used to develop exposure limits for individual segments of the credit portfolio. For this purpose, a risk level calculated using risk parameters is compared to the available financial resources, which may be used to secure the risk, including a buffer for a potential increase in risk.

• Decision-making powers

Credit decision-making powers are an important area where internal estimates are applied. The levels of limits for decision-making powers rely on the client's MS risk grade and the total exposure to its economic group (and the group of related entities in which the client is a member).

• Evaluation of borrowing capacity and creditworthiness

Internal estimates affect significantly the evaluation of the client's borrowing capacity and creditworthiness. The rating affects the borrowing capacity through the following activities: (a) verification of "cut-off point" criteria which determine the maximum acceptable rating for each segment/product; (b) calculation of the client's credit limit.

• Loan prices and pricing policy

Risk parameters are also used for pricing credit transactions, by reflecting the cost of risk and the cost of capital in the price.

• Economic capital

Credit and market risk parameters are used as one of the elements that allow the Bank to calculate economic capital corresponding to the risk. Economic capital in turn is used to evaluate the safety of operations, to allocate and reallocate capital to business lines, to evaluate risk-based efficiency and to determine concentration limits.

Description of the process for managing and recognizing credit risk mitigation (CRR Article 452.b.iii)

The main criterion considered in the Group when making a decision to provide financing on specific terms is the evaluation whether the client has capacity to service the financing on a timely basis without a need to realize the collateral. Collateral is accepted to reduce credit risk incurred by the Group if the client fails to make the payments in contractual amounts and on contractual dates. Accordingly, the requirements for accepted collateral should correspond to the credit risk incurred by the Group in connection with the specific client, while taking into account the specific features of each individual financing transaction. Additionally, in the case of loans to finance real property (in particular retail mortgage loans), establishing collateral on the property is a mandatory element of the credit product.

The Group's collateral policy defines the principles governing the types, kinds and legal forms of collateral, the rules for valuating collateral and the requirements to be satisfied when collateral is accepted, the rules of measuring and monitoring collateral.

The list of collateral types accepted by the Group is long and includes financial security, mortgage, material collateral, guarantees, sureties and receivables. The accepted collateral types have been described in detail and the Group has also defined the terms relating to features of individual asset types on which they can be accepted as collateral. The Group has also defined a list of acceptable legal forms of collateral, taking into account the risk associated with the probability that the collateral might be lost, in particular upon bankruptcy of or enforced debt collection against the client.

The Group has defined the rules for measuring the value of assets accepted as collateral.

For financial collateral, its value is determined on the basis of current market valuation of the asset, less relevant haircuts, including price volatility haircuts.

Mortgage collateral is measured on the basis of valuations prepared by expert appraisers verified by the Group’s specialized units. As the value of collateral of retail loans is monitored during their service, the collateral amount is revaluated using the statistical method based on real property price indices.

For physical collateral, valuation depends on the type, unit value of the asset and age of the asset; the valuation is performed most frequently on the basis of the estimated market price determined by the Group’s specialized units.

In each case, the units performing the valuations/verifying the valuations are separate from sales units.

Depending on the type and kind of collateral items, the Bank monitors them in order to:

• ensure that the contractual terms of collateral are satisfied, which includes confirmation of legal certainty,
• update the value of collateral,
• verify that the collateral exists (local visits).

The Group additionally uses a range of supplementary collateral to facilitate enforcement or increase probability of achieving repayment from a given collateral type.

Control mechanisms for rating systems and rating systems review (CRR Article 452.b.iv)

The Group has implemented the principle of strict separation of commercial functions generating credit risk (which are performed in the Business Area) and client risk and exposure evaluation functions (which are performed by units in the Risk Area). In the area of retail exposures, the final risk grade (rating) is awarded automatically. In respect to corporate exposures, risk grades are awarded to clients and ratings monitored and changed when necessary during their term by the specialized Ratings Department.

Management of rating models, including the performance of control functions, is regulated in internal procedures pertaining to model development, model calibration and model monitoring. Responsibility for these actions has been assigned to designated model owners.

In order to ensure the appropriate control and review of the rating systems (adequate estimation of risk parameters and correct course of the rating and credit decision process), a validation and monitoring process has been introduced.

The monitoring process is performed by the unit responsible for model development.

The validation process is performed by a unit independent from the organizational units responsible for model development.

The following units handle the monitoring and validation process:

• The Risk Committee, which has general responsibility for risk control
• The Bank's Validation Committee which is responsible for confirming the results risk models validation and for continuing the implementation of the measures prescribed by the Model Validation Bureau. Validation results are then ratified by the Risk Committee.
• The Model Validation Bureau, which is responsible for qualitative and quantitative analyses, model validation independent from model development, development of model validation and monitoring methodologies, preparation of reports for the Validation Committee.
• Model Owners and Rating System Owners responsible for the development function which involves the following: new model development, recalibration of existing models, management of factors affecting the use of a model, implementation of Validation Committee recommendations on its own and in cooperation with the IT team.

Reports and recommendations from model monitoring are approved by the Head of the Risk Department. The results are presented to the Validation Committee and then approved by the Risk Committee..

Reports and recommendations of the Validation Team are approved by the Validation Committee.

The Chairman of the Validation Committee is obligated to submit to the Risk Committee and, if necessary, to other committees responsible for controlling credit risk, requests from the Validation Committee regarding all the credit risk models and rating systems and the implementation status of corrective action, if any.

The Bank stores the documentation of implemented models, rating systems, monitoring and validation reports and the methodologies used to prepare monitoring and validation reports; minutes on decisions made by the Validation Committee and the Risk Committee.

In addition, the Internal Audit Department shall review rating systems according to the annual Audit Plans approved by the Supervisory Board. These include the credit area, in particular issues of risk parameters estimation: PD, LGD, CCF and expected loss EL. Audit inspections include also an assessment of the model management processes, monitoring and validation. Inspections are carried out on the basis of uniform audit programs and methodologies approved by the Audit Committee of the Supervisory Board.

Description of the internal ratings process (CRR Article 452.c)

Central governments and central banks (CRR Article 452.c.i)

This exposure class is excluded permanently from the IRB approach.

Institutions (CRR Article 452.c.ii)

This exposure class is excluded permanently from the IRB approach.

Corporates, including SMEs, specialised lending and purchased corporate receivables (CRR Article 452.c.iii)

Exposure classes subject to the plan of gradual implementation of the IRB approach. In accordance with the last IRB permission, the Group plans to file the IRB application for these portfolios on 31 December 2016 at the earliest.

Retail exposures (CRR Article 452.c.iv)

• PD models

The rating process in Bank Millennium is based on the following principles:

i. awarding risk grades to all credit exposures;
ii. All credit decisions should be preceded by awarding a risk grade to the client;
iii. In the retail segment, the rating process is based on PD scoring/rating models;
iv. The rating process is separated and independent from the credit decision process.

The presented rating principles apply to all categories of retail exposures: retail exposures to individuals secured by residential real estate, qualifying revolving retail exposures and other retail exposures.

The class of retail exposures to individuals secured by residential real estate include exposures which are mortgage loans or home equity loans granted to retail clients (small businesses and private individuals) and secured by mortgage.

The class of qualifying revolving retail exposures includes exposures to natural persons which are unsecured, renewable, with exposures not exceeding EUR 100,000 and which meet the requirement of low volatility of loss rates.

All the retail exposures that do not qualify to the above categories are treated as other retail exposures. They are covered by the IRB roll-out plan, and according to the last IRB permission, IRB Approval Pack regarding these exposures will be delivered until the 30^th June, 2015.

In the rating process, the powers are allocated as follows:

a) Data input
b) Verification of data
c) Awarding of the final risk grade (automated decision);

Model-based risk grades and procedural ratings are awarded automatically and are not subject to expert adjustments.

In the rating process, the Bank uses data from various available sources:

• internal sources (Bank’s IT systems),
• external sources (Biuro Informacji Kredytowej S.A.)
• data received from customers.

With respect to probability of default (PD) models for retail exposures, there is a rating system in place for microbusinesses and a rating system for private individuals. Both systems use behavioral scoring models and application scoring models designed for specific client and/or product groups. Procedural ratings are awarded to clients showing signs of deteriorating borrowing capacity and creditworthiness or with past due debt.

A procedural rating has the priority in use. If the client has no procedural rating then the behavioral rating should be used, provided that it has been awarded.

Behavioral rating is awarded for the first time after three months of the client's cooperation with the Bank and then monthly, provided that the client's accounts meet the requirements of the behavioral model.

If the client has no procedural rating and no behavioral rating then the application rating should be used.

• LGD models

Loss Given Default (LGD) models have been built for the following two portfolios:

a) unsecured portfolio for retail clients,
b) portfolio secured by residential real estate for retail clients.

Pursuant to CRR, as amended, banks must estimate LGD parameters using data on defaulted exposures from all the available sources, taking into account all information that is significant for the estimation of economic loss levels.

Accordingly, the Bank has estimated LGD parameters using a database that contains all the defaults resulting from quantitative and qualitative premises included in default definitions.

According to the LGD calculation methodology, the main factors in the calculation include: probability of cure or completion of the client recovery process, value of recoveries, costs and discount rate.

The Bank has taken the following approach to building LGD models:

• Estimate the probability of the path of cure from the default status, i.e. a probability tree;
• Estimate loss parameters for each path of cure from default.

Loss given default is estimated at a transaction level.

• Exposure at Default (EAD) models

An EAD model has been built for retail portfolio exposures. When estimating EAD, exposure at default was compared to the value of the limit and the book value of the exposure observed one year before the default event. Credit Conversion Factor (CCF) parameters have been calculated for product groups for which an off-balance sheet exposure could occur and where the Bank had a significant number of observations that enabled statistical conclusions to be drawn, i.e. for overdraft limits and for credit cards. In the case of guarantees, where the number of observations was too low to carry out statistical analyses, a conservative CCF value was used. At the same time, EAD model for RRE portfolio was not developed due to immaterial number of observations.

XVII.6.5 Equities (CRR Article 452.c.v)

In equity exposures, the Millennium Group classifies shares and equity instruments held by any of the Bank's units. On the consolidated basis, however, the shares representing investments in subsidiaries are excluded, since those are classified as intragroup transactions. However due to the fact that the total value of the Group's equity portfolio is insignificant, it has been decided that these exposures should be excluded from the IRB approach permanently and the capital requirement for these exposures should be calculated based on the standardized approach.

Exposure values by exposure classes, including the value of outstanding loans (balance sheet), unused commitments (off-balance sheet), average risk weights, average risk-weighted exposure amounts (CRR Article 452.d.e)

Amounts of exposures by exposure classes, including the amount of outstanding loans (balance sheet), unused commitments (off-balance sheet) as at 31 December 2014 (in PLN thous.)

Amount of exposure, risk-weighted exposure and the average risk weight by exposure class as at 31 December 2014 (in PLN thous.)

Amount of retail exposures in respective rating classes grouped by classes to allow for a meaningful differentiation of credit risk (CRR Article 452.f)

Amount of exposure, risk-weighted exposure and the average risk weight by exposure class as at 31 December 2014 (in PLN thous.)

Actual specific credit risk adjustments for each exposure class (CRR Article 452.g)

Amount of specific credit risk adjustments for each exposure class as at 31 December 2014 (in PLN thous.)

The Group has not observed significant differences in value adjustments in 2014 compared to previous experiences.

Description of the factors that impacted on the loss experience, in conjunction with the actual results in a longer term. (CRR Article 452.h.i.j.)

Comparison of actual and modeled PD

The tables below present the calculation of actual default rates and estimated default rates for portfolios covered by the permission to use the IRB approach.

Actual and estimated default rates for the QRRE portfolio (in %)

Actual and estimated default rates for the portfolio of loans secured by residential property (in %)

The actual default rates have fallen in recent years and are now lower than estimated. The observed decrease in actual default rates in recent years is consistent with the observed market trends and may be explained by the following:

• Stable macroeconomic situation,
• Change of the Bank’s credit policy introduced in 2010 in response to the global financial crisis.

The actual default rates were also lower than the average probability of default (PD) because of the following:

• Higher level of default rates in previous years, which were taken into account when estimating the long-term PD
• The fact that the long-term PD estimation also included a conservative buffer for estimation errors, which boosts the estimated PD levels.

Comparison of actual and modeled CCF

The analysis of actual CCF has been conducted for QRRE portfolio cases defaulted during the calendar year 2014 (reporting period) and 2013 (comparative period) which, at the end of the preceding year (31 December 2013 and 31 December 2012, respectively) were not defaulted and had a positive off-balance sheet exposure. The analysis involved a comparison of the average actual conversion factors with average modeled levels (average weighed by the amount of off-balance sheet exposure was applied in both cases). The modeled factors include a number of conservative haircuts and should be higher than the actual figures. The results are presented in the table below.

Comparison of actual and modeled CCF (in %)

In both the reporting period and the comparative period, actual CCF levels did not exceed the modeled levels. Since the Bank has not recorded higher than expected credit conversion factors, this credit risk element does not lead to the occurrence of higher than expected losses.

Comparison of actual and modeled LGD

The analysis of actual LGD was carried out for cases from RRE and QRRE portfolios. Calculation of actual LGD figures requires a longer time horizon, because recoveries may occur only after the exposure achieves the default status. Accordingly, the calculation of actual LGDs was based on the cases, which defaulted by December 2012. The average LGD calculated on the basis of these cases (average weighed by the exposure size) was compared with the average LGD level obtained from the model used (average weighed by the exposure size was applied in both cases). The modeled values include a number of conservative haircuts and should be higher than the actual losses. The results are presented in the table below.

Comparison of actual and modeled LGD (in %)

For both analyzed portfolio, modeled loss amounts were much higher than actual figures. We can therefore state that there were no unexpected losses associated with LGD levels and the model used has proven to be sufficiently conservative.

• CRR Article 452.j.

Not applicable. The Group does not have companies conducting credit activity abroad.

Use of credit risk mitigation techniques (CRR Article 453)

• CRR Article 453.a

The Group does not make use of on- and off-balance sheet netting.

• CRR Article 453.b

Policies and processes for collateral valuation and management

In the collateral management area, the Group applies the approach, in which collateral is used to ensure that the Group receives the repayment of principal, interest, commissions and fees if the client fails to make the payments in contractual amounts and on contractual dates. However the main source for the repayment of receivables is always the borrower's income and/or the funded project. Accordingly, collateral should correspond to the credit risk incurred by the Bank, while taking into account the specific features of each individual credit transaction.

Legal collateral is applicable until all the amounts due to the Group under the collateralized credit transaction are repaid. The validity date or maturity date of collateral should not be earlier than the date of total repayment of the secured credit transaction.

Real estate collateral (revaluation)

In respect to the valuation of loan collateral in the largest credit portfolio, i.e. residential retail loans, the loan application review process must include in each case a valuation of the real estate securing the loan performed by an expert appraiser.

The Group monitors collateral in order to:

• update the base value of the collateral,
• ensure that the contractual terms of collateral are satisfied,
• verify that the collateral exists (local visits).

The base value of mortgage collateral may be updated using one of the following forms:

• assessment of the value of the real estate, understood as the Group's estimation of the current value of the real estate collateralizing the credit transaction, based on the methodologies used by the Bank or on an analysis of the real estate market analysis on the date of the assessment.
• valuation by an expert appraiser.

Update of the base value of financial collateral

In the case of financial collateral classified as "participation units in mutual funds sold by Bank Group entities and managed by Millennium TFI" and "WSE-listed shares", their base value is updated daily.

Update of the base value of material collateral

The base value of material collateral is updated by assessing the value of material collateral. The value of material collateral is assessed once a year.

Assessment of material collateral value involves the application of depreciation ratios determined by the age and type of the material collateral, to its initial value. The application of depreciation begins in the year following the year of production. An assumed period of use is assumed for every collateral item, after which a zero value of collateral is assumed.

• CRR Article 453.c

The table below presents the types, kinds and legal forms of collateral accepted by the Bank. The collateral acceptance process is regulated by special procedures. Other collateral types may be accepted if they meet certain specified requirements.

Types and kinds of collateral used by the Group

• CRR Article 453.d

The Group does not use any guarantees and credit derivatives as risk protection instruments in the capital requirement calculation process.

• CRR Article 453.e

The Group notices concentration related to credit risk mitigation with respect to collaterals for loans in the form of a mortgage. Loans secured by real estate accounted for ca. 60% of the total loan portfolio at the end of 2014, including PLN loans 21% of the portfolio (ca. PLN 9.3 billion), and loans denominated in CHF 39% (ca. PLN 17.7 billion). The main risk factor associated with this protection are:

1) an increase in the exchange rate of CHF / PLN,

2) a decrease in the value of mortgage.

Both of these factors contribute to increase of average LTV ratio (the ratio of loan to value of collateral) and the resulting increase in the value of loans, where the value of the LTV is greater than 100% and a deterioration of capital adequacy. The first risk factor increases the DTI ratio (the ratio of debt-to-income for a customer) and it leads also to deterioration of liquidity.

The Group identifies, measures, monitors and controls continuously above risk factors. Conservative liquidity strategy is used, which provides for the maintenance of liquid assets buffer for unexpected changes in exchange rates. Capital plan provides for the maintenance of capital adequacy at a satisfactory level in the coming years. Both plans - Liquidity and Capital –account for stress tests assuming a significant appreciation of the exchange rate of CHF / PLN. The level of non-performing loans is regularly monitored and in case of potential problems with debt repayment customer is contacted in order to apply the right solution, suitable to his financial capability. The quality of loans secured by real estate remains at a high level.

• CRR Article 453.f, 453.g – not applicable

• CRR Article 454 – not applicable

• CRR Article 455 – not applicable