Capital Relief for Software Assets: European Commission Amends Own Fund Requirements
The Development: New Regulation (EU) 2020/2176 (the "Regulation") provides regulatory capital relief, allowing certain software assets to be considered when calculating Common Equity Tier 1 ("CET1") capital. It entered into force on December 23, 2020, and the new deduction method is applicable since December 31, 2020.
The Significance: In view of the increasing digitalization in the banking sector and to encourage IT investments, prudently valued software assets that will not be materially affected in resolution, insolvency or liquidation, will no longer be deducted from CET1.
Looking Ahead: The Regulation aims to provide relief for institutions hit by the COVID-19 pandemic and to accelerate investments in technology. Financial institutions may benefit from capital relief and should determine their qualifying software assets to update their capital planning.
Digitalization and Legislative Intent
Regulation (EU) 575/2013 on prudential requirements for credit institutions and investment firms ("CRR") was amended by Regulation (EU) 876/2019 ("CRR2"), including the capital treatment of software assets, which to date had to be deducted from regulatory capital when they were accounted for as intangible assets (article 36.1 (b)). The rationale had been that "software assets are usually tailor-made and cannot be easily sold on the market as standalone assets if needed (i.e. to absorb losses on an ongoing concern if losses arise)."
In connection with the revision of CRR, the EU legislator focused on supporting digitalization and encouraging IT investments in the banking sector. Now, certain prudently valued software assets should no longer be deducted from CET1. Accordingly, CRR2 amended article 36.1(b) of CRR to exclude from the deduction mechanism "prudently valued software assets the value of which is not negatively affected by resolution, insolvency or liquidation of the institution." A delegated regulation had to be adopted detailing the conditions of this new regime.
Coherent Supervisory Standards
As observed in the EBA's Final Report (EBA/RTS/2020/07), assessing the recoverable value of intangible assets is complex due to the multitude of different software applications in use by institutions. The economic value of these assets needs to be weighed against supervisory considerations and balanced accordingly. This called for a simplified approach to the prudential treatment of software assets, preventing operational obstacles for institutions and to facilitate coherent supervision by the authorities. Consequently, the Regulation amends Delegated Regulation (EU) No. 241/2014, which lays down technical standards regarding own funds, and establishes a new regime for the deductibility of software assets from CET 1 items.
Regulatory Technical Standards
The key provision in the Regulation setting out the new deduction method for software assets is Art. 13(a), which is added to Delegated Regulation (EU) 241/2014. According to this provision, prudently valued software assets may be exempt from CET1 deduction if their valuation is not negatively affected by resolution, insolvency or liquidation of the institution. Interestingly, no particular definition is provided for "prudently valued software assets," either in CRR2 or in this provision.
The new provision introduces a day-by-day regulatory amortization of software assets over a three year period. The amount to be deducted for each software asset is the difference between the accumulated amortization under prudential versus applicable accounting standards. The prudential amortization is calculated starting from the date on which the software asset is available for use and accordingly is then amortized under accounting standards. The remaining balance of the software asset carrying amount is risk-weighted at 100% (i.e. fully deducted). Investments in maintenance and upgrades of existing software assets are to be considered as other assets, provided that they are recognized as intangible assets under applicable accounting standards.
Early Entry into Force due to CRR Quick Fix
The CRR Quick Fix (Regulation (EU) 2020/873) accelerated the entry into force of this capital relief measure in light of the COVID-19 pandemic. Hence, the Regulation entered into force on December 23, 2020, and the new deduction method is applicable since December 31, 2020.
Three Key Takeaways
- The Regulation introduces a day-by-day regulatory amortization of software assets over three years. Especially for the Fintech sector subject to capital requirements under CRR, like payment service institutions or electronic money issuers notably with significant software assets, this can materially increase their regulatory capital base.
- The Regulation does not prevent institutions from fully deducting their software assets from CET1 items, nor does it hinder authorities to scrutinize software assets and exercise supervisory powers where there is a concern of undesired prudential benefits resulting from significant investments in software.
- The Regulation entered into force on December 23, 2020, and the new deduction method is applicable since December 31, 2020.
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