Chapter 7: Estimation of risk parameters for defaulted exposures

General requirements specific to EL BE and LGD in-default

Estimation methodologies for EL BE and LGD in-default

The treatment of defaulted assets was identified as one of the major drivers of variability of the own funds requirements across institutions. Clarification has already been provided in the RTS on IRB assessment methodology, in particular in Article 54(2)(c), that direct estimation of LGD in-default should be consistent with the LGD for non-defaulted exposures, to avoid potential cliff effects. Following this approach, it has been further clarified in the GL that, for the purpose of estimating EL BE and LGD in-default, institutions should use the same estimation methods used for estimating LGD for non-defaulted exposures, as they are in fact part of the LGD model. Thus, Chapter 7 generally refers to the requirements on LGD estimation set out in Chapter 6, as well as general estimation requirements set out in Chapter 4, and the requirements on the application of risk parameters specified in Chapter 8. Chapter 7 provides guidance only on those specific aspects where different treatment for defaulted exposures in terms of loss rate estimation is justified.

Reference dates

The difference between the LGD in-default and the EL BE is used for computing the risk weight in accordance with Article 153(1)(ii) of the CRR, which is then applied to the current outstanding exposure value to obtain the risk-weighted exposure amount. Moreover, the EL BE is compared with credit risk adjustments for the purpose of calculating IRB shortfall / excess, where credit risk adjustments are again computed with respect to the current value of exposures. Thus, for the purpose of computing realised LGDs for defaulted exposures, institutions should use reference points in time that will be relevant for the current outstanding obligations of defaulted exposures. The concept of current outstanding exposure is clearly defined in Article 166(1) of the CRR and should be used also for defaulted exposures in the application of the EL BE and LGD in-default. However, given data limitations, the continuous concept of current exposure amount may not be suitable for estimation purposes. The GL therefore suggest that institutions should set discrete relevant reference dates at which the realised LGDs should be computed. This way, it should be feasible to estimate the parameters for defaulted exposures that are appropriate for their current status. To ensure adequacy of the estimates, institutions should set the reference dates according to the recovery patterns observed on a specific type of exposures. Such reference dates may either be event based, e.g. linked with the realisation of collateral, or reflect certain time periods during which exposures have been in default.

For the purpose of application of the estimated LGD in-default and EL BE to a given defaulted exposure in the current portfolio, institutions should first evaluate which reference date is relevant for the exposure under consideration. In accordance with Article 158(5) of the CRR, the amount of expected loss to be assigned to the defaulted exposure under consideration should be calculated as the product of the EL BE relevant at the selected reference date, in percentage terms, and the current exposure value.

Data requirements for EL BE and LGD in-default

As for non-defaulted exposures, EL BE and LGD in-default estimates should be based on the institutions’ own experience. The scope of data necessary for proper EL BE and LGD in-default estimation includes not only those required for LGD for non-defaulted exposures, but also all relevant information obtained during the recovery process and, in particular, at each reference date used in the estimation. This implies that, for the purpose of the treatment of defaulted exposures, institutions should additionally store data including relevant risk drivers, which may become relevant after default, and outstanding exposure amounts and values of collaterals at each reference date.

Model development in the estimation of EL BE and LGD in-default

This section specifies which types of potential risk drivers should be taken into account in estimating EL BE and LGD in-default on top of those used for non-defaulted exposures. Article 54(2) of RTS on IRB assessment methodology prescribes that the LGD in-default and EL BE estimation methods take into account the information on the time in default and recoveries realised so far. In this respect, the GL clarify that the information on recoveries realised so far and on time in default may be taken into account either directly, as risk drivers, or indirectly, in setting the reference dates for estimation purposes. Moreover, to ensure that the information after default is taken into account in a timely manner, it is clarified that the relevance of risk drivers should be re-evaluated for the relevant periods after default, until the date of termination of the recovery process. This implies, for example, that new risk drivers might become relevant after the date of default. Calibration of EL BE and LGD in-default

Calculation of realised LGD and long-run average LGD for defaulted exposures

One major difference between the calculation of realised LGDs for the purpose of estimation of risk parameters for defaulted and non-defaulted exposures is that the former should be performed at each relevant reference date, rather than at the date of default, as described above. Other than this, to calculate realised LGDs for defaulted exposures institutions should follow the same requirements as those set out in Chapter 6. This implies that institutions should calculate for each defaulted exposure in the RDS the realised LGDs according to each reference date that is relevant for estimation purposes.

Another important aspect clarified in this section concerns the treatment of incomplete recovery processes for the purposes of calculation of long-run average LGD for defaulted exposures. The approach to the long-run average LGD is aligned with that prescribed in Section 6.4, with the exception that incomplete recovery processes should be used only for those reference dates for which observations of recoveries and costs are available at least until the next reference date. The rationale for this exception is to avoid a circular reference in the estimates and to ensure that each observation included in the calculation brings additional information. In fact, incomplete recovery processes on which EL BE and LGD in-default are estimated should not take part in the estimation itself and will be therefore excluded, if only those incomplete recovery processes for which later reference dates are relevant are taken into account.

The application of the same requirements for the treatment of incomplete recovery processes, as specified in Section 6.4, also means that no further recoveries should be estimated beyond the maximum length of the recovery processes specified for the specific type of exposures. However, relevant exposure-specific information may be taken into account in the process of application of the risk parameters, and may provide the basis for an override of the model output where justified.

Similarly in the case of partial write-offs performed on a defaulted exposure, while the estimation of the risk parameters should be based on a full outstanding credit obligation, the information on the partial write-off on a specific exposure may provide the basis for an override of the output of the model. Such an override would have the purpose of achieving consistency between the estimation and the application of the risk parameters, taking into account the fact that the risk weight and the expected loss amount will be calculated on the basis of the accounting value of the exposure, determined in accordance with Article 166 of the CRR.

Example on the treatment of incomplete recovery processes

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2. Ceanglais aitheanta

3. Caighdeáin ghaolmhara

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