Acceleration in changing the prudential treatment for Software Assets: Covid-19 impact

Mon 20 Jul 2020

Over recent years, technology and software have become strategic assets for competitiveness and resilience in the banking sector. Institutions have no choice but to invest to develop and deliver innovative services whilst managing ever greater IT and cybersecurity risks.

The pandemic and announcement of lockdown measures posed a significant challenge for banks’ technology teams as hundreds of thousands of jobs were moved from office settings to employees’ homes. The way services were provided and distributed to customers had to adapt to the new circumstances and financial institutions had to rapidly increase their level of investment to beef up their IT capacity and build resilience into their infrastructure.

Firms have therefore made significant investments in technology and will have to continue to do so, which poses interesting questions in terms of the prudential treatment of software:

“We need banks to invest in software development to remain competitive and contribute to the digitalisation of the EU economy. Software investments remain penalised in Europe compared to the US where software is risk weighted as an ordinary asset, like premises and equipment.” Frederic Oudéa, President of the European Banking Federation

In terms of regulatory capital, software assets are currently treated as intangible assets that must be deducted from a bank’s Common Equity Tier 1. From a prudential perspective there are concerns regarding the uncertainty of the recoverable value of software. Especially in a situation of gone concern. Generally, software cannot be sold separately.

Covid-19 related measures and new prudential treatment

The European Parliament published on 26 June 2020 the final version of measures aimed at mitigating the economic impact of the Covid-19 pandemic in the European Union. One of the amendments brings forward the date for the new prudential treatment of software prescribed in the revised Capital Requirements Regulation, CRR2.

Article 36(1)(B) of CRR2 introduces an exemption from the deduction of intangible assets from CET 1 in case of “prudently valued software assets, the value of which is not negatively affected by resolution, insolvency or liquidation of the institution”.

The EBA was mandated to develop draft Regulatory Technical Standards (RTS) to specify how this provision will be applied. The RTS was published on 9 June 2020 with a reduced 1-month consultation period. This draft standard introduces a prudential treatment based on the amortisation of software assets.

Under this approach, the positive difference between the prudential and the accounting amortisation would be fully deducted from the CET 1 capital, while the residual portion of the carrying value of the software would be risk weighted at 100%.

The costs related to the research phase cannot be capitalised and will be expensed in the income statement, whilst the costs related to the development phase will be recognised as intangible asset. It is interesting to note that the boundaries between research and development costs are at the discretion of the institutions, so they could be tempted to inflate their development costs, which constitute the value of the intangible asset, in order to amortise more and benefit more from the prudential relief.

The intensity of the regulatory benefit will depend on the level of banks’ annual investment in software.

The proposed approach is expected to be easy to implement and applicable to all institutions in a standardised manner.

Timetable

From the EBA’s perspective, it seems difficult that the whole process including the adoption and publication of the RTS can be completed before the end of 2020. However, banks, for their part, would like to see this implemented as soon as possible.

It is also interesting to note that the UK has previously given some indication that this might be an area where the UK might diverge from the EU post Brexit. It will therefore be important for banks to remain aware of the publication of the RTS as technically it will apply from the date of publication, it would be applicable in the UK if this publication happened before the end of the Brexit Transition period at the end of the year.

Stay tuned….

Article prepared by Yannis Mindjou, Manager in FS Consulting, London

References:

1. https://eba.europa.eu/regulation-and-policy/own-funds/regulatory-technical-standards-prudential-treatment-software-assets

2. https://eba.europa.eu/calendar/public-hearing-consultation-cp-rts-prudential-treatment-software-assets