6.2 The effects of unfunded credit protection

Institutions may recognise the credit risk mitigation effects of unfunded credit protection using one of the following methods:

• (a) adjustment of PD or LGD estimates in accordance with Article 160(5), 161(3) and 164(2) of Regulation (EU) No 575/2013, on the basis of the criteria specified by institutions in accordance with Article 183(2) and (3) of Regulation (EU) No 575/2013 by using, in particular, one of the following approaches:
• (i) regardless of the approach applied to comparable direct exposures to the guarantor, adjustment of grades, pools or LGD estimates, including LGD in default and EL BE , by considering the unfunded credit protection in the estimation of risk parameters as further specified in these guidelines (i.e. the modelling approach);
• (ii) when comparable direct exposures to the guarantor are, or would be, treated under the IRB approach with or without own estimates of LGD and conversion factors, substitution of both the PD and LGD risk parameters of the underlying exposure with the corresponding PD and LGD of a comparable direct exposure to the guarantor as further specified in these guidelines (i.e. the substitution of risk parameters approach);
• (iii) regardless of the approach applied to comparable direct exposures to the guarantor, adjustment of grades, pools or LGD estimates, including LGD in default and EL BE , in the application of risk parameters by overriding the grade assignment process in accordance with Article 172(3) of Regulation (EU) No 575/2013 and Section 8.2 of the EBA GL on PD and LGD estimation (i.e. the override);
• (b) if the institution applies the Standardised approach for comparable direct exposures to the guarantor, and does not recognise the credit risk mitigation effects of the UFCP in the PD and LGD estimates in accordance with point (a), use of the risk weight applicable under the Standardised approach in accordance with Article 183(4) of Regulation (EU) No 575/2013 (i.e. the substitution of risk weight approach);
• (c) calculation of the risk-weighted exposure amount in accordance with Article 153(3), Article 154(2), Article 161(4) and Article 164(3), of Regulation (EU) No 575/2013 (i.e. the double default treatment).

Institutions should have clear policies for assessing the effects of unfunded credit protection on risk parameters. The policies should be consistent with their internal risk management practices and should reflect the requirements of Article 183(2) and 183(3) of Regulation (EU) No 575/2013, and the requirements specified in these guidelines. Institutions should include in these policies a clear specification which of the specific methods described in paragraph 31 is used for each rating system, and they should apply these policies consistently over time.

Unfunded credit protection that does not meet the eligibility requirements for guarantors and guarantees specified in Article 183(1) and (3) of Regulation (EU) No 575/2013 and in Section 5.2 of these guidelines should not be recognised using any of the methods specified in paragraph 31. For LGD estimation purposes, the cash flows received from exercising the ineligible unfunded credit protection should be treated as if they had been received without the use of unfunded credit protection. Regardless of this treatment, institutions should collect the information about the source of the cash flows related to ineligible unfunded credit protections and allocate them appropriately. Institutions should regularly monitor the levels of such cash flows as well as the extent to which the relevant types of unfunded credit protection are used. Where necessary, institutions should perform appropriate adjustments in order to avoid any bias in the PD and LGD estimates.

Where institutions adopt the modelling approach specified in paragraph 31(a)(i), they should consider and, if relevant, take into account in the LGD estimates in a conservative manner the following elements:

• (a) any currency mismatch between the underlying obligation and the unfunded credit protection;
• (b) the degree to which the guarantor’s ability to fulfil the contractual obligation under the unfunded credit protection agreement is correlated with the obligor’s ability to repay;
• (c) the defaulted status of the guarantor and its resulting reduced ability to fulfil the contractual obligation under the unfunded credit protection.

Where institutions adopt the modelling approach specified in paragraph 31(a)(i), the unfunded credit protection may be considered as a risk driver in the rating system. In particular, it may consist in:

• (a) adjusting only the LGD estimates according to historical experience related to the observed credit risk mitigation effects of the unfunded credit protection on realised LGDs, including realised recoveries and material costs associated with exercising the unfunded credit protection;
• (b) adjusting both the PD and the LGD estimates, where institutions can provide empirical evidence that the existence of the unfunded credit protection has an impact on the PD of the obligor and demonstrate that the simultaneous adjustment of both the PD and LGD estimates does not lead to double counting effects of the unfunded credit protection or to underestimation of expected loss.

The sole adjustment of the PD estimates should be deemed inappropriate in any circumstance.

Institutions may adopt the substitution of risk parameters approach specified in paragraph 31(a)(ii) only where the following conditions are met:

• (a) the unfunded credit protection is eligible according to the relevant criteria for unfunded credit protection set out in Part Three, Title II, Chapter 4 of Regulation (EU) No 575/2013;
• (b) the institution may reasonably expect that the direct costs of exercising the unfunded credit protection are negligible with respect to the amount covered by the unfunded credit protection;
• (c) the guarantor is in a non-defaulted status.

Where institutions adopt the substitution of risk parameters approach or the substitution of risk weight approach specified in paragraph 31(a)(ii) and 31(b) respectively, they should:

• (a) collect and store information on the characteristics and performance of the obligor and the exposure and use this information in the estimation of PD of the obligor in accordance with the EBA GL on PD and LGD estimation;
• (b) for internal risk management purposes, consider separately direct exposures to guarantors and exposures secured by unfunded credit protection provided by such entities;
• (c) define a separate scope of application of the LGD models and calculate separately the risk weight for the type of guaranteed exposures or parts of exposures whose PD and LGD risk parameters are substituted or that are assigned the risk weight of the guarantor. For the guaranteed exposures or parts of exposures included in the scope of application of the substitution of risk parameters approach or the substitution of risk weight approach, institutions are not required to estimate the LGDs other than the LGDs of the comparable direct exposures to the guarantors if they adopt the substitution of risk parameters approach.

For the purposes of paragraph 37, if a given unfunded credit protection does not fully cover the original exposure, institutions should be able to assign to the part of the exposure that is not covered by the given unfunded credit protection the PD and LGD estimates applicable to the original exposure without recognising the effect of the given unfunded credit protection. Moreover, for the purposes of calculating the realised LGD applicable to the part of the exposure not covered by the unfunded credit protection, institutions should allocate cash flows and costs in the following way:

• (a) Cash flows received from the guarantor should be allocated to the guaranteed part of the exposure, while cash flows that come from any other source should be allocated to the part of the exposure not covered by the unfunded credit protection. In the case of exposures that also benefit from funded credit protection, the cash flows associated with the funded credit protection should be allocated to the part of the exposure that is covered by this funded credit protection, in accordance with the guidance provided in paragraph 46.
• (b) Indirect costs should be allocated to the different parts of the exposure in accordance with the guidance provided in paragraph 113 of the EBA GL on PD and LGD estimation.
• (c) Direct costs that are directly linked to the exercising of the unfunded credit protection should be allocated to the guaranteed part of the exposures, while any other direct cost should be allocated to the part of the exposure not covered by the unfunded credit protection. In the case of exposures that also benefit from funded credit protection, the direct costs associated with realisation of the funded credit protection should be allocated to the guaranteed part of the exposure in accordance with the guidance provided in paragraph 46.

Where institutions adopt the substitution of risk parameters approach and the obligor has defaulted, the following applies:

• (a) The risk weight of the guaranteed part of the exposure should be that of the comparable direct exposure to the non-defaulted guarantor.
• (b) The expected loss of the guaranteed part of the exposure should be that of the comparable direct exposure to the non-defaulted guarantor.
• (c) Where the guarantor remains in a non-defaulted status, the guaranteed part of the exposure should be considered defaulted for the purposes of the calculation of the IRB shortfall or excess in accordance with Article 159 of Regulation (EU) No 575/2013 and Section 8.4 of the EBA GL on PD and LGD estimation.

Where institutions apply the substitution of risk parameters approach, the other quantitative validation tools required by Article 185(c) of Regulation (EU) No 575/2013 should include a comparison of the expected loss of comparable direct exposures to the guarantor with the observed loss rates of the underlying exposures or parts of exposures to defaulted obligors that were considered guaranteed before the moment of default.

Where institutions adjust the risk parameters in individual cases by considering the unfunded credit protection using overrides in accordance with paragraph 31(a)(iii), institutions should be able to justify that the nature and characteristics of the unfunded credit protection do not allow the use of methods described in paragraph 31(a)(i), 31(a)(ii) or 31(b) to reflect the credit risk mitigation effects of the unfunded credit protection.

Where institutions adopt one of the approaches described in paragraph 31(a) and the resulting estimates produce a lower risk weight than the risk weight that would apply to an otherwise identical exposure in respect of which the institution has no unfunded credit protection, the final risk weight cannot be lower than the risk weight of a comparable direct exposure to the guarantor in accordance with Article 161(3) and 164(2) of Regulation (EU) No 575/2013, i.e. the risk weight floor applies.

For the purposes of applying the substitution of risk parameters approach and calculating the risk weight floor, where institutions have not received the permission of the competent authority to use own LGD estimates in accordance with Article 143(2) of Regulation (EU) No 575/2013 for comparable direct exposures to the guarantor, institutions should use LGD values specified according to Article 161(1) of that Regulation to derive the LGD of a comparable direct exposure to the guarantor.

For the purposes of applying the substitution of risk parameters approach and calculating the risk weight floor, the value of unfunded credit protection should be the following:

• (a) The value of the unfunded credit protection should be specified in accordance with Article 233 and Article 239(3) of Regulation (EU) No 575/2013. Any potential maturity mismatch should be considered in the adjusted value of the unfunded credit protection in accordance with Article 239(3) of that Regulation, whereas the maturity of comparable direct exposures to the guarantor should be the same as the maturity of the exposure to the obligor.
• (b) If the unfunded credit protection covers the value of the exposure remaining after pursuing the obligor, and, if relevant, any other forms of credit risk mitigation, institutions should estimate the value of the protection based on past experience in a conservative manner.
• (c) The value of the unfunded credit protection meeting the requirements of the second subparagraph of Article 215(1)(a) or Article 215(2) of Regulation (EU) No 575/2013 may be the maximum amount that the protection provider has undertaken to pay in the event of default or non-payment of the borrower or on the occurrence of other specified credit events.

Institutions should calculate the risk weight floor in the following manner:

• (a) Where the exposure benefits from multiple unfunded credit protection, each providing protection to different parts of the exposure, institutions should calculate the risk weight floor as the exposure-weighted average of the risk weights of comparable direct exposures to each of the guarantors.
• (b) Where the exposure benefits from multiple unfunded credit protection, and where two or more of these are providing protection to the same part of the exposure, institutions should calculate the risk weight floor for this part of the exposure as the lowest of the risk weights of each comparable direct exposure to the guarantor. In the calculation of each risk weight, the LGD of a comparable direct exposure to each of the guarantors may consider the effect of the other existing unfunded credit protection.
• (c) Where any part of the exposure is not covered by any unfunded credit protection, institutions should assign to this part of the exposure the risk weight applicable to such exposure to the obligor without any unfunded credit protection; in this case they should calculate the risk weight floor as the exposure-weighted average of the risk weight applicable to the part of the exposure covered by the unfunded credit protection and the risk weight applicable to the remaining part of the exposure.
• (d) For the purposes of calculating the exposure-weighted average risk weight in accordance with points ((a) and ((c), each risk weight should be calculated separately and weighted by the relevant share of the exposure value.

For the purposes of paragraph 45 and in order to recognise the effects of multiple credit risk mitigation techniques in accordance with the approaches specified in paragraph 31, all of the following conditions should be met:

• (a) Institutions should have clear policies for the allocation, sequence and recognition of funded and unfunded credit protection that are consistent with the internal recovery and collection process.
• (b) Institutions should not recognise the effects of the same credit risk mitigation twice; for example, in allocating the funded credit protection between the part of the exposure covered by the unfunded credit protection and the part of the exposure that is not covered by the unfunded credit protection, double recognition of the funded credit protection should not be allowed.
• (c) Institutions should apply the approaches consistently; therefore:
• (i) Splitting the part of the exposure covered by a given unfunded credit protection into two parts and applying to one part the substitution of risk parameters approach or substitution of risk weight approach and to the other part the modelling approach should not be allowed.
• (ii) In cases of multiple unfunded credit protections that are, at least partially, covering the same part of the exposure, institutions should establish appropriate criteria to choose which unfunded credit protection to use for the purposes of substituting the risk parameters. Such criteria should be described in the internal policies specified by institutions for adjusting PD and LGD estimates in accordance with paragraph 38. Without prejudice to sub-point (i), institutions are allowed to split the part of the exposure covered by a given unfunded credit protection into two parts and apply to one part the substitution of risk parameters approach while recognising the effects of the remaining part of the given unfunded credit protection in the application of the substitution of risk parameters approach to the other existing unfunded credit protections; in particular, the risk mitigation effect of the remaining part of the given unfunded credit protection may be considered in the LGD of comparable direct exposures to the other existing guarantors in accordance with paragraph 47.

For the purposes of recognising the credit risk mitigation effects of multiple credit protections that, as a result of the allocation performed by the institution in accordance with paragraph 46, cover the same part of an exposure, institutions may use one of the approaches specified in paragraph 31(a). In particular, for the purposes of applying the substitution of risk parameters approach and calculating the risk weight floor, institutions should use the following methods

mitigation effects of the additional credit protection:

• (a) Where comparable direct exposures to the guarantor are in the scope of a rating system for which the institution has not received prior permission to use own estimates of LGD in accordance with Article 143(2) of Regulation (EU) No 575/2013, the institution should use the LGD values provided in Article 161(1) of that Regulation,

requirements in Part Three, Title II, Chapter 4 of that Regulation.

• (b) Where comparable direct exposures to the guarantor are in the scope of a rating system for which the institution has received prior permission to use own estimates of LGD in accordance with Article 143(2) of Regulation (EU) No 575/2013, the institution should use the LGD of a comparable direct exposures to the guarantor that includes the effect of additional unfunded or funded credit protection. If institutions are not able to recognise this additional credit protection in the estimation of the LGD of comparable direct exposures to the guarantor, then:

to the LGD of unsecured exposures to the obligor, they should use the LGD estimates of the exposure to the obligor reflecting the effect of the additional credit protection; or