EBA’s software compromise draws fire on two fronts

UK regulator suggests it will neuter the proposed capital relief, which banks say doesn’t go far enough

European Banking Authority, Paris
European Banking Authority, Paris
Photo: EBA

As it races to complete a rulemaking on the capital treatment of technology assets, the European Banking Authority may settle for a compromise that is unlikely to satisfy banks, or even some regulators.

At the urging of European lawmakers, the EBA is expected to permit bank software to be treated as a risk-weighted asset (RWA) for capital purposes, rather than being fully deducted from capital. The catch is that the prudential value of software assets will need to be amortised over two years, after which point it will be fully deducted.

Banks argue the proposal – which will result in a capital benefit of fewer than 20 basis points in many cases – will do little to encourage technology investments or to level the playing field with global counterparts (see figure 1).

Photo of Adrian Docherty
Adrian Docherty, BNP Paribas

“It is easy to be conservative, but Europe has to promote investments and renewal,” says Adrian Docherty, head of financial institutions advisory at BNP Paribas.

“It is hard to argue with the fact that banks have to invest in their platforms. This is something that is sorely needed, and we should be encouraging people to do it well, rather than shoddily.”

And yet, the proposal is also facing scepticism from the UK’s Prudential Regulatory Authority for going too far. In a statement issued on June 30, the UK regulator said the EBA’s work “will inform the PRA’s supervisory approach, including an assessment of whether further action is necessary under pillar two”. In other words, any capital relief afforded by the EBA’s rulemaking could be offset by a supervisory capital add-on for UK banks.

The UK has, in theory, agreed to implement any European Union rules adopted before the Brexit transition period ends on December 31, 2020. The PRA’s statement reflects long-standing concerns among regulators about whether software assets will have any value in a resolution scenario.

“We were disappointed by the PRA’s apparently lukewarm approach to the European proposals,” says Simon Hills, director of prudential policy at lobby group UK Finance. “Banks in the UK plan to implement the provisions anyway for their year-end reporting, but may get a corresponding PRA capital deduction in the future, which does not help capital planning right now.”



Currently, software is considered an intangible asset under European accounting rules. This means it is deemed to have no value in bankruptcy, and must be fully deducted from capital under the Basel III regulatory standards. Other jurisdictions, including the US, Singapore and Switzerland, treat software as a fixed asset or a separate line item for accounting and capital purposes, typically with a 100% risk weight. This results in an 8% capital charge against software assets, versus a 100% deduction under the European rules.

European banks argue the disparity in capital treatment discourages technology investments. “If an American bank invests $100 in software, and a European bank invests $100 in software, why would that have a different representation in the prudential balance sheet?” says Docherty.

European lawmakers addressed the issue in 2019 in the second Capital Requirements Regulation (CRR II), which directed the EBA to devise a methodology for including software in RWAs. But the agency has taken a cautious line, maintaining that software would have limited value if a bank ran into trouble.

“This is due to the fact that software assets are usually tailor‐made and cannot be easily sold on the market as a standalone asset if needed,” said the EBA in draft advice provided to the European Commission, published on June 9.

The agency is now facing considerable pressure to soften its stance. On June 18, European lawmakers agreed to fast-track elements of CRR II in response to Covid-19. The ‘quick fix’ package makes any changes to the treatment of software assets effective immediately after the relevant regulatory technical standard (RTS) is adopted, rather than one year later, as originally planned.

The EBA has taken that as a signal to speed up the drafting of the RTS, and is now aiming to have it completed in 2020 if possible.

“Reading between the lines, the EBA is now under some pressure to come up with a view that has some prudent elements, but is applying a broad interpretation of what is a useful software asset, to give European banks a bit of additional [capital] headroom and also to level the playing field with regards to Swiss and US banks,” says Monsur Hussain, head of research on financial institutions at Fitch Ratings.

Going, gone

The EBA’s proposed compromise – detailed in a consultation published on June 9 – was based on a study of bank takeovers in resolution, which found that software assets were generally replaced by the acquiring bank in one to three years. The regulator took the midpoint of that range, and therefore suggested that the prudential value of software should be amortised over two years. During that period, the residual value of the software would be risk-weighted as an asset at 100%.

Docherty says the two-year window is insufficient to incentivise banks to make technology investments that are “potentially expensive, but long-lasting”.

An asset valuation expert agrees that the proposal is “not a game-changer”.

This amendment feels like you are saying to someone who is very hungry: ‘Here, have a candy’

Charlotte Lo, KPMG

A handful of banks expect to see capital benefits of more than 100bp if the EBA’s proposal is adopted. Sources say those firms may have recently made large investments in core banking or electronic trading operations, or launched new digital units.

For some banks, the capital benefits may not even be worth the trouble. Once software is recorded as an asset on the balance sheet, the bank’s auditors must conduct impairment assessments for financial reporting. The amortisation period for accounting tends to be much longer than the EBA’s proposed two years for capital purposes – anywhere from six to 14 years, depending on the nature of the software, according to respondents to the EBA consultation. Reconciling the accounting and prudential valuations would involve a great deal of extra work for only a modest payoff.

Charlotte Lo
Charlotte Lo, KPMG

“This amendment feels like you are saying to someone who is very hungry: ‘Here, have a candy.’ If it is only two years, the operational inconvenience would make them think there is not much to motivate them other than the desire to do things right [by the regulator],” says Charlotte Lo, a director in banking accounting advisory at KPMG.

The valuation expert points to another wrinkle. For banks that undertake large but occasional technology projects, the capital relief afforded by the EBA proposal is likely to be intermittent and volatile, making it difficult to manage from a capital planning perspective.

“If you need to launch a big technology project at the same time, you also need capital – that is not great, and a temporary relief of two years is not going to be much use, unless your bank is undertaking constant innovation,” he tells Risk.net.

While banks are generally in agreement that a two-year amortisation period is too short, there is no consensus on how long it should be.

Deutsche Bank suggested a three-year amortisation period in its response to the EBA’s consultation, while the Association for Financial Markets in Europe and Intesa Sanpaolo both pushed for four years, and the Spanish Confederation of Savings and Retail Banks urged six years.

BNP Paribas’s Docherty says the EBA’s decision to adopt a separate regulatory cap on the amortisation of software is a sensible response to the variation in accounting amortisation rates across Europe. But he suggests changing the underlying calculation method – using the average life of both gone-concern and going-concern software valuations across the sector, rather than just the gone-concern scenario. His research suggests an average useful life of around nine years, so a prudential amortisation schedule somewhere between this and the EBA’s two-year gone-concern proposal could make sense, he says.

That could be a tough pill for some regulators to swallow. If the UK’s PRA follows through on its idea of using pillar two supervisory charges to offset the capital relief afforded by the EBA, it could further skew the playing field, not only in comparison to the US, but even among European banks.

The issue could be resolved by the Basel Committee on Banking Supervision, which has a working group examining the prudential treatment of software assets. The current Basel III standards contain no specific guidelines beyond the general treatment of intangible assets. With bank software investments having tripled over the past decade, Docherty says it is all the more important for Basel to seek a global consensus.

“This is a classic example of an unlevel playing field,” he says. “The fact that we have a major operating asset that is treated differently in different jurisdictions really makes it a hot topic.”

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