6.3.2.3 Treatment of incomplete recovery processes

For the purposes of letter (a) of Article 181(1) of Regulation (EU) No 575/2013, in relation to the use of all defaults observed during the historical observation period within the data sources for LGD estimation, institutions should ensure that the relevant information from incomplete recovery processes is taken into account in a conservative manner. The LGD estimation should be based on the long-run average LGD.

Institutions should calculate the observed average LGD for each facility grade or pool and at the level of the portfolio covered by the LGD model taking into account realised LGDs on all defaults observed in the historical observation period related to closed recovery processes in accordance with paragraphs 155 to 157 without including any expected future recoveries. The observed average LGD should be weighted by the number of defaults included in the calculation.

Institutions should clearly specify in their internal policies the moment of closing the recovery processes. All recovery processes that have been closed should be treated as such for the purpose of the calculation of the observed average LGD.

Institutions should define the maximum period of the recovery process for a given type of exposures from the moment of default that reflects the expected period of time observed on the closed recovery processes during which the institution realises the vast majority of the recoveries, without taking into account the outlier observations with significantly longer recovery processes. The maximum period of the recovery processes should be specified in a way that ensures sufficient data for the estimation of the recoveries within this period for the incomplete recovery processes. The length of the maximum period of the recovery processes may be different for different types of exposures. The specification of the maximum period of the recovery process should be clearly documented and supported by evidence of the observed recovery patterns, and should be coherent with the nature of the transactions and the type of exposures. Specification of the maximum period of the recovery process for the purpose of the long-run average LGD should not prevent institutions from taking recovery actions where necessary, even with regard to exposures which remain in default for a period of time longer than the maximum period of the recovery process specified for this type of exposures.

For the purpose of the calculation of the observed average LGD, institutions should recognise without undue delay as closed recovery processes all exposures in default which fall into at least one of the following categories:

• (a) exposures for which the institution does not expect to take any further recovery actions;
• (b) exposures that remain in defaulted status for a period of time longer than the maximum period of the recovery process specified for this type of exposures;
• (c) exposures fully repaid or written-off;
• (d) exposures that have been reclassified to non-defaulted status.

With regard to the defaulted exposures falling under the categories in points (a) and (b), all recoveries and costs realised before or at the time of estimation should be considered for the purpose of the calculation of the observed average LGD, including any recoveries realised after the maximum period of the recovery processes.

Institutions should obtain the long-run average LGD by adjusting the observed average LGD taking into account the information related to processes that were not closed (‘incomplete recovery processes’) and where the time from the moment of default until the moment of estimation is shorter than the maximum period of the recovery process specified for this type of exposures. For these processes, institutions should comply with both of the following:

• (a) they should take into account all observed costs and recoveries;
• (b) they may estimate future costs and recoveries, both those stemming from the realisation of the existing collaterals and those to be realised without the use of collaterals within the maximum period of the recovery processes.

The estimation referred to in paragraph 158(b) should comply with the following principles:

• (a) for the purpose of estimation of the future costs and recoveries institutions should analyse the costs and recoveries realised on these exposures until the moment of estimation, in comparison with the average costs and recoveries realised during a similar period of time on similar exposures; for this purpose institutions should analyse the recovery patterns observed on both closed and incomplete recovery processes, taking into account only costs and recoveries realised up to the moment of estimation;
• (b) the assumptions underlying the expected future costs and recoveries as well as the adjustment to the observed average LGD should be:
• i. proven accurate through back-testing;
• ii. based on a reasonable economic rationale;
• iii. proportionate, taking into consideration that LGD estimates should be based on the long-run average LGD that reflects the average LGDs weighted by the number of defaults using all defaults observed during a historical observation period.
• (c) in estimating the future recoveries institutions should take into account the potential bias stemming from incomplete recovery processes being characterised by longer average recovery processes or lower average recoveries than closed recovery processes;
• (d) in estimating the future recoveries stemming from the realisation of the existing collaterals institutions should take into account the legal certainty of the claims on the collateral and realistic assumptions regarding the possibility of its realisation;
• (e) the adjustment of the observed average LGD may be estimated at the level of individual exposures, at the level of grade or pool or at the level of portfolio covered by the LGD model;
• (f) any uncertainty related to the estimation of the future recoveries on incomplete recovery processes should be reflected in an adequate MoC applied in accordance with section 4.4.