74. Capital Adequacy

Capital adequacy is a process which objective is to ensure that, for a given level of risk tolerance, the level of risk assumed by the Group associated with development of its business activity may be covered with capital held within given period of time.

The process of managing capital adequacy comprises in particular compliance with prevailing supervisory standards and risk tolerance level determined within the Group, the process of capital planning, inclusive of policy regarding capital acquiring sources.

The objective of capital adequacy management is to maintain own funds on a level that is adequate to the risk scale and profile of the Group’s activities continuously.

The process of managing the Group’s capital adequacy comprises:

• identifying and monitoring of all of significant risks,
• assessing internal capital to cover the individual risk types and total internal capital,
• monitoring, reporting, forecasting and limiting of capital adequacy,
• performing internal capital allocations to business segments, client segments and entities in the Group in connection with profitability analyses,
• using tools affecting the capital adequacy level (including: tools affecting the level of equity, the scale of equity item reductions and the level of the loan portfolio).

The fundamental regulations applicable in the capital adequacy assessment process as at 31 December 2015 are:

• the Regulation (EU) No. 575/2013 of the European Parliament and of the Council as of 26 June 2013 on prudential requirements for credit institutions and investment firms, amending the Regulation (EU) No. 648/2012, hereinafter called ‘CRR Regulation’. The CRR Regulation constitutes a part of so-called CRD IV/CRR package, which apart from the Regulation comprises CRD IV Directive - Directive 2013/36/EU of the European Parliament and of the Council as of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (Referred to as “CRD” IV),
• The Act of 29 August 1997, the Banking Law (Journal of Laws 2015, item 128, as amended) (Hereinafter referred to as the „Banking Act”),
• The Act of 5 August 2015, on macroprudential supervision of the financial system and crisis management in the financial system (Journal of Laws of 2015, Item 1513) (Hereinafter referred to as the „Act on macroprudential superivison”).

In accordance with the CRR Regulation, for the purpose of prudential consolidation the Group comprises: PKO Bank Polski SA Group, PKO Leasing SA, PKO BP BANKOWY PTE SA, PKO Towarzystwo Funduszy Inwestycyjnych SA, KREDOBANK SA Group, PKO Finance AB, Finansowa Kompania ‘Prywatne Inwestycje’ Sp. z o.o., PKO Finat sp. z.o.o and PKO Bank Hipoteczny SA.

Priority in case of conflict between the provisions of CRR regulations and the national legislation have the provisions or CRR regulation.

The level of capital adequacy of the Group in 2015 remained on a safe level, significantly above the supervisory limits.

74.1 Own funds for capital adequacy purposes

As at 31 December 2015 own fund of the Group for the purposes of capital adequacy were calculated in accordance with the provisions of the CRR Regulation and the Banking Act.

Own funds of the Group comprise Tier 1 basic capital and Tier 2 capital. No elements of additional Tier 1 capital are identified within the Group.

The Tier 1 basic capital (so-called Common Equity Tier 1 or CET1) comprise:

1. principal funds comprising: share capital, other reserves (reserve capital, reserves),
2. other comprehensive income (excluding gains and losses on cash flow hedges, whereas in respect of unrealised gains and losses on instruments classified to available for sale portfolio losses are recognized in full amount, and profits are recognized in the amount of 40% of their balance sheet value.
3. general banking risk fund,
4. retained earnings (undistributed profits from previous years),
5. net profit prior to approval and net profit for the current reporting period, calculated based on appropriate accounting standards, decreased by any expected charges and dividends, in amounts not exceeding amounts audited by certified auditor, whereas the term for inclusion of the above-mentioned net profit within Bank’s own funds is its approval by the General Shareholders’ Meeting, or prior to the approval by GSM, obtaining consent from the PFSA to its inclusion within own funds.

Tier 1 basic capital is reduced by the following items:

1. losses for the current financial year,
2. intangible assets stated at carrying amount less any associated deferred income tax liability, (the deducted amount includes goodwill taken into account in measurement of the Bank’s significant investments),
3. additional value adjustments of assets measured at fair value (AVA),
4. additional value adjustments of derivative instruments reflect their own credit risk of the Bank (DVA)
5. deferred income tax assets based on future profitability and not arising from temporary differences,
6. deferred income tax assets based on future profitability and arising from temporary differences which exceed 10% of Tier 1 basic funds (without considering deductions due to equity exposures and deferred income tax assets),
7. the Group’s significant direct and indirect equity exposures to entities of financial sector in case the Group did not invest significantly in those entities, expressed as shares or other Tier 1 or 2 basic funds instruments of these entities, if total amount exceeds 10% of Tier 1 basic funds of the Group (without considering deductions due to equity exposures and deferred income tax assets)
8. The Group’s significant direct and indirect equity exposures to entities of financial sector in case the Group did invest significantly in those entities, expressed as shares or other Tier 1 or 2 basic funds instruments of these entities, if total amount exceeds 10% of Tier 1 basic funds of the Group (without considering deductions due to equity exposures and deferred income tax assets)
9. the amount by which the sum of:
   a) deferred tax assets based on future profitability and arising from temporary differences, up to 10% of Tier 1 basic funds (without considering deductions due to equity exposures and deferred income tax assets), and
   b) the Groups direct and indirect equity exposures to entities of financial sector in case the Group did not invest significantly in those entities, expressed as shares or other Tier 1 basic funds instruments of these entities up to 10% of Tier 1 basic funds (without considering deductions due to equity exposures and deferred income tax assets)
   exceeds the equivalent of 17,65% of Tier 1 basic funds (with considering deductions from points mentioned in positions 1-5-and the full value of the items referred in point 9 a-b, without the application of the threshold. The amount below the threshold in subject does not reduce own funds and is included within risk weighted assets.

Tier 2 basic capital comprise subordinated liabilities, which meet the CRR Regulation requirements and in case of which the Bank obtained consent from the PFSA to their inclusion within own funds.

Tier 2 capital is reduced by the Group’s equity exposures to financial institutions, lending institutions, domestic banks, foreign banks and insurance companies in the form of Tier 2 funds instruments of these entities wherein, in accordance with Article 472 of CRR, the residual value of the item is deducted half from Tier 1 capital and half from Tier 2 capital.

If the value of deduction would decrease in Tier 2 capital below 0, the value of excess of these deductions above the value of the

Tier 2 capital is subtracted from the Tier 1 basic capital.

As at 31 December 2015 in the Group’s own funds calculated for the purposes of capital adequacy the Bank’s net profit for the 2014 in the amount of PLN 3 079 471 thousand and the retained earnings from previous years in the amount of PLN 132 793 thousand. Profit was included in Tier 1 basic funds of the Group, whereas the amount of PLN 1 962 264 thousand increased other reserves of the Bank (spare and reserve capital) and the amount of PLN 1 250 000 thousand remained undivided.

Information on the structure of the Group’s own funds included in prudential consolidation, set out for purposes of capital adequacy as at 31 December 2015 and as at 31 December 2014, according to the CRR Regulation, is presented in the table below:

74.2 Requirements as regard own funds (Pillar I)

In accordance with the CRR Regulation being in force since 1 January 2014, the Group calculates requirements in respect of own funds for the following risk types::

• in respect of credit risk – using the standardised method,
• in respect of operational risk for the Bank– in accordance with the Base Indicator Approach (BIA) in the activities of the branch of the Bank in the Federal Republic of Germany and in accordance with the Advanced Measurement Approach (AMA) in respect of other activities of the Bank, and for the entities of the Group included in precautionary consolidation – under BIA approach
• in respect of market risk - using basic methods.

The Group calculates requirements for own funds on account of credit risk using the following formula:

• in case of statement of financial position items – a product of a carrying amount (considering value of adjustments for specific credit risk), a risk weight of the exposure calculated according to the standardised method of credit risk requirement as regards own funds and 8% (considering recognised collaterals),
• in case of off-balance sheet liabilities granted – a product of value of liability (considering value of adjustments for specific credit risk), a risk weight of the product, a risk weight of off-balance sheet exposure calculated according to the standardised method of credit risk requirement for own funds and 8% (considering recognised collaterals),
• in case of off-balance sheet transactions (derivative instruments) – a product of risk weight of the off-balance sheet transaction calculated according to the standardised method of credit risk requirement for own funds, equivalent in the statement of financial position of off-balance sheet transaction and 8% (the value of the equivalent in the statement of financial position is calculated in accordance with the mark-to-market method).

The total requirement in respect of Group’s own funds comprises the sum of the own funds capital requirements in respect of:

1. credit risk, including counterparty credit risk and the risk in relation to exposures to a central counterparty (CCP)
2. market risk, including currency risk and commodity price
3. risk of credit valuation adjustment (CVA),
4. settlement and delivery risk
5. operational risk,

The following table presents the requirements for the Group’s own funds for particular types of risk. Data as of 31 December 2015 and 31 December 2014 have been calculated in accordance with CRR Regulation as mentioned above.

The decrease in own funds capital requirement in respect of credit risk in 2015 compared by PLN 224 million was mainly due to the measures taken by the Bank that reduced risk-weighted assets (AWR). The most important reason for performing optimization was to improve the quality, of data mainly through the inclusion in the category of retail exposures to SMEs meeting customer segmentation criteria and to perform a review of off-balance sheet exposures, including verification of assigned risk weights of the product.

The decrease in own funds requirement in respect of operational risk for the Group of the amount of PLN 759 million (as at 31 December 2014) to approx. PLN 663 million (as at 31 December 2015) is mainly due to the completion of the merger process of the Bank with Nordea Bank Polska SA.

74.3 Capital requirements for insurance companies

The PKO Bank Polski SA Group comprises an insurance company, PKO Życie, which, as an entity covered with separate supervision of PFSA Office, including capital requirements compliance assessment, is excluded from the prudential consolidation.

In accordance with the Act as of 22 May 2003 on Insurance Activity (with subsequent amendments) an insurance company is obliged to possess own funds in the amount not lower than the required solvency margin and not lower than the guarantee fund. The guarantee fund is equal to the value higher of:

1. one third of the solvency margin
2. the minimum amount of the guarantee fund

The principles on calculation of the required solvency margin and the minimum amount of the guarantee fund is determined by the Regulation of the Minister of Finance as of 28 November 2003 on calculation of the required solvency margin and the minimum amount of the guarantee fund for insurance classes and groups (with subsequent amendments).

74.4 Internal capital (Pillar II)

The Group calculates internal capital in accordance with:

• the CRR Regulation, and the CRD IV Directive,
• the Banking Act,
• the Resolution No. 258/2011 of the PFSA of 4 October 2011 on detailed principles for functioning of risk management system and internal control system and detailed terms of estimating internal capital by banks and reviewing the process of estimating and maintaining internal capital and the principles for determining the variable salary components policy for key management personnel.
• The Act on Macro-prudential supervision

Internal capital is the amount of capital estimated by the Group that is necessary to cover all of the identified significant risks characteristic of the Group’s activities and the effect of changes in the business environment, taking account of the anticipated risk level.

The internal capital in the PKO Bank Polski SA Group is calculated to cover each of the significant risk types:

• credit risk (including default risks and concentration risk),
• currency risk,
• interest rate risk,
• liquidity risk,
• operational risk,
• business risk (including strategy risk).

Materialisation of macroeconomic changes risk, model risk, compliance risk and loss of reputation risk is reflected in the estimates of internal capital for covering the types of risk: credit, interest rate, currency, operational and business.

The Bank regularly monitors the significance of the individual risk types relating to the Bank's activities and other Group entities.

The internal capital for covering the individual risk types is determined using the methods specified in the internal regulations. In the event of performing internal capital estimates based on statistical models, the annual forecast horizon is adopted and a 99.9% confidence level. The total internal capital of each entity of the Group is the sum of internal capital amount necessary to cover all of the significant risks for the entity. The total internal capital of the Group is the sum of internal capital amount of the Bank and all Group entities. The correlation coefficient for different types of risk and different Group entities used in the internal capital calculation is equal to 1.

In 2015, the relation of the Group’s own funds to its internal capital remained on a level exceeding both the threshold set by the law and the Group’s internal limits.

74.5 Disclosures (Pilar III)

The Group annually announces information, in particular, on the risk management and the capital adequacy, in accordance with:

• The CRR Regulation,
• implementing acts to CRR Regulation,
• The Banking Act,
• The Act on Macro-prudentrial supervision,
• Recommendation M relating to operational risk management in banks, issued by the Polish Financial Supervision Authority.

Details of the scope of information disclosed, the method of its verification and publication are presented in PKO Bank Polski SA Capital Adequacy Information Policies and other information to be published, which are available on the Bank’s website (www.pkobp.pl).