4.4 Treatment of deficiencies and margin of conservatism

Institutions should identify all deficiencies related to the estimation of risk parameters that lead to a bias in the quantification of those parameters or to an increased uncertainty that is not fully captured by the general estimation error, and classify each deficiency into one of the following categories:

• (a) Category A: Identified data and methodological deficiencies;
• (b) Category B: Relevant changes to underwriting standards, risk appetite, collection and recovery policies and any other source of additional uncertainty.

For the purposes of identifying and classifying all deficiencies referred to in paragraph 36 institutions should take into account all relevant deficiencies in methods, processes, controls, data or IT systems that have been identified by the credit risk control unit, validation function, internal audit function or any other internal or external review and should analyse at least all of the following potential sources of additional uncertainty in risk quantification:

• (a) under category A:
• (i) missing or materially changed default triggers in historical observations, including changed criteria for recognition of materially past due credit obligations;
• (ii) missing or inaccurate date of default;
• (iii) missing, inaccurate or outdated rating assignment used for assessing historical grades or pools for the purpose of calculation of default rates or average realised LGDs per grade or pool;
• (iv) missing or inaccurate information on the source of cash flows;
• (v) missing, inaccurate or outdated data on risk drivers and rating criteria;
• (vi) missing or inaccurate information used for the estimation of future recoveries as referred to in paragraph 159;
• (vii) missing or inaccurate data for the calculation of economic loss;
• (viii) limited representativeness of the historical observations due to the use of external data;
• (ix) potential bias stemming from the choice of the approach to calculating the average of observed one year default rates in accordance with paragraph 80;
• (x) necessity of adjusting the average of observed one-year default rates in accordance with paragraph 86;
• (xi) missing information for the purpose of estimating loss rates or for the purpose of reflecting economic downturn in LGD estimates;
• (b) under category B:
• (i) changes to underwriting standards, collection or recovery policies, risk appetite or other relevant internal processes;
• (ii) unjustified deviations in the ranges of values of the key risk characteristics of the application portfolio compared with those of the dataset used for risk quantification;
• (iii) changes to market or legal environment;
• (iv) forward-looking expectations regarding potential changes in the structure of the portfolio or the level of risk, especially based on actions or decisions that have already been taken but which are not reflected in the observed data.

4.4.2 Appropriate adjustment

In order to overcome biases in risk parameter estimates stemming from the identified deficiencies referred to in paragraphs 36 and 37, institutions should apply adequate methodologies to correct the identified deficiencies to the extent possible. The impact of these methodologies on the risk parameter (‘appropriate adjustment’), which should result in a more accurate estimate of the risk parameter (‘best estimate’), represents either an increase or a decrease in the value of the risk parameter. Institutions should ensure and provide evidence that the application of an appropriate adjustment results in a best estimate.

Institutions should document the methods used to apply appropriate adjustments to rectify the identified deficiencies, where relevant, as well as their justification.

Institutions should regularly monitor the adequacy of appropriate adjustments. The adoption of an appropriate adjustment by institutions should not replace the need to address the identified deficiencies.

4.4.3 Margin of conservatism

In relation to the requirement that institutions should add a margin of conservatism (‘MoC’) that is related to the expected range of estimation errors as required by Articles 179(1)(f) and 180(1)(e) of Regulation (EU) No 575/2013, institutions should implement a framework for quantification, documentation and monitoring of estimation errors.

The final MoC on a risk parameter estimate should reflect the uncertainty of the estimation in all of the following categories:

Category A: MoC related to data and methodological deficiencies identified under category A as referred to in paragraph 36(a);

Category B: MoC related to relevant changes to underwriting standards, risk appetite, collection and recovery policies and any other source of additional uncertainty identified under category B as referred to in paragraph 36(b);

Category C: the general estimation error.

In order to quantify MoC institutions should do all of the following:

• (a) quantify MoC for the identified deficiencies referred to in paragraphs 36 and 37, to the extent not covered by the general estimation error, at least for each of the categories A and B at the level of the calibration segment ensuring that:
• (i) where appropriate adjustments in the sense of paragraph 38 are used, the MoC accounts for any increase in the uncertainty or additional estimation error associated with these adjustments;
• (ii) the MoC at category level related to the appropriate adjustments is proportionate to the uncertainty around these adjustments;
• (iii) the MoC is applied to address the uncertainty of the risk parameter estimate stemming from any deficiencies among those referred to in paragraphs 36 and 37 that have not been corrected via appropriate adjustments as referred to in point (i);
• (b) quantify the general estimation error of category C referred to in paragraph 42 associated with the underlying estimation method at least for every calibration segment; the MoC for the general estimation error should reflect the dispersion of the distribution of the statistical estimator.

For the purpose of paragraph 43(a) and for each of the categories A and B, institutions may group all or selected deficiencies, where justified, for the purpose of quantifying MoC.

Institutions should quantify the final MoC as the sum of:

• (a) the MoC under category A as referred to in paragraph 43(a);
• (b) the MoC under category B as referred to in paragraph 43(a);
• (c) the MoC for the general estimation error (category C) as referred to in paragraph 43(b).

Institutions should add the final MoC to the best estimate of the risk parameter.

Institutions should ensure that the impact of the final MoC does not result in lowering the risk parameter estimates and in particular that:

• (a) the MoC stemming from the general estimation error is greater than zero;
• (b) the MoC stemming from each of the categories A and B is proportionate to the increased uncertainty in the best estimate of risk parameters caused by the identified deficiencies listed in each category. In any case, the MoC under each of the categories A and B should be greater than or equal to zero.

Institutions should consider the overall impact of the identified deficiencies and the resulting final MoC on the soundness of the model and ensure that the estimates of the risk parameters and the resulting own funds requirements are not distorted by the necessity for excessive adjustments.

For each rating system, the MoC applied should be documented in the relevant model documentation and methodology manuals. The documentation should contain at least the following:

• (a) a complete list of all identified deficiencies, including errors and uncertainties, and the potentially affected model components or risk parameters;
• (b) the category under which these deficiencies are classified, as referred to in paragraph 42;
• (c) a description of the methods for quantification of the MoC related to identified deficiencies as referred to in paragraph 43(a) and in particular the methodologies used to quantify the MoC per category.

Institutions should regularly monitor the levels of the MoC. The adoption of a MoC by institutions should not replace the need to address the causes of errors or uncertainties, or to correct the models to ensure their full compliance with the requirements of Regulation (EU) No 575/2013. Following an assessment of the deficiencies or the sources of uncertainty, institutions should develop a plan to rectify the data and methodological deficiencies as well as any other potential source of additional uncertainty and reduce the estimation errors within a reasonable timeframe, taking into consideration the materiality of the estimation error and the materiality of the rating system.

When reviewing the levels of the MoC institutions should ensure all of the following:

• (a) that the MoC stemming from categories A and B referred to in paragraphs 36 and 37 is included in internal reporting separately for each category and may be reduced over time and eventually eliminated once the deficiencies are rectified in all parts of the rating system that were affected;
• (b) that the MoC stemming from the general estimation error referred to in paragraph 43(b) is included in internal reporting in a separate category (’C’);
• (c) that the level of the MoC is assessed as part of the regular reviews referred to in Chapter 9 and in particular that the level of MoC related to the general estimation error remains appropriate after the inclusion of the most recent data relevant for the risk parameter estimation.

Institutions should ensure that necessary changes in the MoC are implemented in a timely manner.