Changing prudential treatment for software in the EU and the UK – Towards a level playing field in banking

Background

Technology and software have become strategic assets for competitiveness in the banking sector and resilience in the context of the Covid-19 pandemic. Institutions have no choice but to invest in the development of their infrastructure and adoption of innovative technologies whilst managing increased IT and cybersecurity risks.

However, investments in software are a potential source of competitive disadvantage for European financial institutions in comparison to non-regulated technological firms and international competitors due to the difference in prudential treatment.

From a regulatory capital perspective in the EU, software assets have historically been treated as intangible assets and had to be fully deducted from a bank’s Common Equity Tier 1 (CET1) capital unless the bank had a clear value in case of resolution, insolvency or liquidation. This treatment is reflective of the uncertainty of the recoverable value of software assets which generally decreases over time and is limited in a gone concern scenario.

On the other hand, in the US for instance, banks do not account for software as an intangible asset and as a result do not deduct it from their CET1 capital.

New prudential treatment

On 14 October 2020, the European Banking Authority (EBA) published its final draft Regulatory Technical Standards (RTS) on the prudential treatment of software assets under Capital Requirements Regulation (CRR) – EBA/RTS/2020/07.

The Authority proposes a prudential amortisation approach, i.e. a more gradual deduction of software assets. This proposition is deemed to strike the right balance between the need of prudence in the treatment of software assets as intangibles, and their relevance from a business and an economic perspective.

The key aspects of this approach are as follows:

To design and draft its RTS, the EBA has studied:

• the international developments and differences in the accounting and regulatory treatments of investments in software
• practices of software valuation in case of transactions
• observed recoverable values of software in the event of liquidation, resolution and other insolvency procedure
• generally observed length of migration / implementation period

Supervisory scrutiny

The EBA has identified areas where close scrutiny by regulators and external auditors may be warranted, as a change in the treatment will likely influence the accounting treatment and other related aspects as follows:

• Capitalisation of costs related to internally generated software: As boundaries between research and development costs are open to interpretation, revisions to the prudential treatment could provide institutions with incentives to inflate the amount of capitalised software by exploiting the lack of clarity in the accounting standards.
• Accounting amortisation period: Institutions may extend the accounting amortisation period to align with the 3-year prudential amortisation period even if the effective useful life of a software is shorter than 3 years.
• Software acquired in business combinations: Institutions may be prone to trying to allocate more (fair) value to the software acquired in business combinations to further benefit from either the recognition of a lower amount of goodwill (deducted from CET1) or the recognition of a higher amount of bargain purchase gain (included in CET1).

Application

Following the publication in the EU official Journal on 22 December 2020, this requirement in Article 36(1)(b) of the amended Capital Requirements Regulation (CRR II) became effective on 23 December 2020. In accordance with the European Union (Withdrawal Agreement) Act 2020, and as confirmed in the PRA’s communication on 30 December 2020, this requirement now applies to all PRA-regulated firms.

In the meantime, the PRA has looked for evidence for realisable or recoverable value of software assets in liquidation or in stress and found no credible evidence that software assets can absorb losses effectively in stress. The PRA is therefore concerned that exempting software assets from the CET1 capital deduction requirements could undermine the safety and soundness of UK.

Therefore, The PRA intends to consult in due course to maintain the earlier position whereby all software assets continue to be fully deducted from CET1 capital.

List of CRR articles impacted by this RTS

• Article 1 - amended
• Article 13a – new article added
• Article 36(1)(b) – amended
• Article 36(4) – new paragraph added

References

• October 2020 Draft RTS
• June 2020 Consultation Paper