6.2 Model development in LGD estimation

Institutions should identify and analyse potential risk drivers that are relevant to their specific circumstances and to the specific characteristics of the type of exposures covered by the rating system. Potential risk drivers analysed by institutions should include in particular the following:

• (a) transaction-related risk characteristics, including type of product, type of collateral, geographical location of the collateral, unfunded credit protection, seniority, Loan-to-Value ratio (Lt V), exposure size, seasoning, and recovery procedures;
• (b) obligor-related risk characteristics, including, where applicable, size, capital structure, geographical region, industrial sector, and line of business;
• (c) institution-related factors, including internal organisation and internal governance, relevant events such as mergers, and existence of specific entities within the group dedicated to recoveries;
• (d) external factors, including interest rates, legal framework and other factors influencing the expected length of the recovery process.

Institutions should analyse the risk drivers not only at the moment of default but also at least within a year before default. Institutions should use a reference date for a risk driver that is representative of the realisations of the risk driver within a year before default. When choosing the appropriate reference date for a risk driver institutions should take into account its volatility over time. Institutions should apply these practices also with regard to the reference date of the valuation of collateral; the value of the collateral at the reference date should not reflect the impact of the decrease in credit quality of the exposure shortly before default.

Institutions should specify or calculate the risk drivers in the application of LGD estimates in the same way as they are specified or calculated in the estimation of LGD.

6.2.2 Eligibility of collaterals

In accordance with Articles 170 and 181(1)(f) of Regulation (EU) No 575/2013 institutions may take into account in their LGD estimations the existence of any types of collaterals for which they have established internal requirements in terms of collateral management, legal certainty and risk management that are generally consistent with those set out in Section 3 of Chapter 4 of Title II in Part Three of that Regulation. In the case of the types of collateral that are not specified in Chapter 4 of Title II in Part Three of that Regulation institutions may use those types of collaterals in their LGD estimations where their policies and procedures relating to internal requirements for valuation and legal certainty of these collaterals are appropriate to the respective type of collateral.

To the extent that LGD estimates take into account the existence of unfunded credit protection institutions should specify the criteria and methodology for recognising and including in their LGD estimates the protection in the form of guarantees and credit derivatives that meet the criteria specified in Article 60 of the RTS on IRB assessment methodology.

Institutions should take into account as a risk driver or segmentation criterion information on all main types of collaterals that are used within the scope of application of the LGD model. Institutions should clearly define in their internal policies the main and other types of collaterals used for the type of exposures covered by the rating system and should ensure that, to the extent that LGD estimates take into account the existence of collateral, the policies regarding the management of these types of collateral comply with the requirement of Article 181(1)(f) of Regulation (EU) No 575/2013. Institutions should specify the main types of collaterals in such a way that the cash flows from the remaining types of collaterals will not significantly bias the estimation of recoveries that are realised without the use of collaterals.

Collaterals which do not meet the requirement of Article 181(1)(f) of Regulation (EU) No 575/2013 cannot be included as a risk driver in the LGD estimation and the cash flows received from those collaterals should be treated as if they had been received without the use of collaterals. Regardless of this treatment in the LGD estimation, institutions should collect the information about the source of the cash flows related to those collaterals and allocate them as related to those collaterals. Institutions should regularly monitor the levels of such cash flows as well as the extent to which the relevant types of collaterals are used. Where necessary, institutions should perform appropriate adjustments in order to avoid any bias in the LGD estimates. 6.2.3 Inclusion of collaterals in the LGD estimation

For the purpose of LGD estimation institutions may group the types of collaterals that are homogeneous in terms of recovery patterns taking into account both the average time of collection process and the recovery rates on these types of collaterals.

The approach developed by institutions to include the effect of collaterals in the LGD estimation should meet all of the following conditions:

• (a) institutions should avoid the bias that may stem from including the cash flows related to realisation of collateral in the estimation of recoveries that are realised without the use of collaterals and vice versa;
• (b) where institutions estimate separate recovery rates for specific types of collaterals, they should avoid a bias that may stem from including in the estimation sample the observations where the exposure was secured by only a part of the value of the collateral. For this purpose institutions should take reasonable steps to obtain the data on the total value of the collateral and total sale price of the collateral and include this information in the estimation where it is available;
• (c) where institutions estimate separate recovery rates for specific types of collaterals they should recognise and include in this estimation direct costs related to the collection on each of these specific types of collaterals separately as well;
• (d) where institutions estimate separate recovery rates for specific types of collaterals they should include in this estimation all recoveries realised from a specific type of collateral including those realised on exposures where the realisation of the collateral has been completed but the overall recovery process has not yet been closed;
• (e) where the same collateral covers several exposures, institutions should specify an adequate allocation methodology in order to avoid double counting of collaterals; the allocation methodology should be consistent between the LGD estimation and the application of LGD estimates and with the methodology used for accounting purposes;
• (f) the estimates should not be based solely on the estimated market value of the collateral but they should also take into account the realised recoveries from past liquidations and the potential inability of an institution to gain control and liquidate the collateral. For this purpose, institutions should take into account in the estimation those historical observations where the collateral could not be realised or where the recovery process was longer than expected, due to inability or difficulty to gain control or liquidate the collateral. Where institutions estimate the recovery rates related to specific types of collaterals, they should take into account the time between the moment of default and the time when the cash flows related to the collection on these types of collaterals have been received and should include in the estimation those observations where the collateral has not been realised as a result of inability to gain control;
• (g) the estimates should take into account the potential decreases in collateral value from the point of LGD estimation to the eventual recovery, in particular those resulting from changes in the market conditions, the state and age of the collateral and, where relevant, currency fluctuations. Where institutions have experienced decreases in values of collaterals and these are already reflected in observed recoveries, no further adjustments to the LGD estimates based on these observations should be made. Where potential decreases in values of collaterals are not reflected in historical observations or where institutions predict further, potentially more severe decreases in the future, they should be included in the quantification of LGD estimates by means of an appropriate adjustment based on forward-looking expectations. However, the LGD estimates should not be adjusted to take into account any potential increases in collateral value;
• (h) the estimates should take into account in a conservative manner the degree of dependence between the risk of the obligor and the risk of the diminishing value of the collateral as well as the cost of liquidating the collateral.

6.2.4 Homogeneity of facility grades or pools

In order to fulfil the requirement of Article 38 of the RTS on IRB assessment methodology, institutions should assess the homogeneity of exposures assigned to the same grades or pools based on the data in the RDS and they should ensure, in particular, that grades are defined in such a manner that individual grades are sufficiently homogeneous with respect to loss characteristics.