6.1 General requirements specific to LGD estimation

Institutions that have obtained permission to use own estimates of LGD in accordance with Article 143(2) of Regulation (EU) No 575/2013 should assign an LGD estimate to each non-defaulted exposure and an estimate of LGD in-default and EL BE to each defaulted exposure within the range of application of the rating system subject to such permission in accordance with Articles 172 and 173 of Regulation (EU) No 575/2013. Institutions should estimate LGDs for all facility grades of the distinct facility rating scale or for all pools that are incorporated in the rating system. For the purpose of LGD estimation institutions should treat each defaulted facility as a distinct default observation, unless more than one independent defaults were recognised on a single facility which do not meet the conditions of paragraph

101. For the purpose of LGD estimation, with regard to defaults recognised on a single facility, where the time between the moment of the return of the exposure to non-defaulted status and the subsequent classification as default is shorter than nine months, institutions should treat such exposure as having been constantly defaulted from the first moment when the default occurred. Institutions may specify a period longer than nine months for the purpose of considering two subsequent defaults as a single default in the LGD estimation, if this is adequate to the specific type of exposures and reflects the economic meaning of the default experience.

Institutions should estimate their own LGDs based on their own loss and recovery experience, as it is reflected in historical data on defaulted exposures. Institutions may supplement their own historical data on defaulted exposures with external data. In particular, institutions should not derive their LGD estimates only from the market prices of financial instruments, including, but not limited to, marketable loans, bonds or credit default instruments, but they may use this information to supplement their own historical data.

Where in the case of retail exposures and purchased corporate receivables institutions derive LGD estimates from realised losses and appropriate estimates of PDs in accordance with Articles 161(2) and 181(2)(a) of Regulation (EU) No 575/2013 they should ensure that:

• (a) the process for estimating total losses meets the requirements of Article 179 of Regulation (EU) No 575/2013 and the outcome is consistent with the concept of LGD as set out in Article 181(1)(a) of this Regulation, as well as with the requirements specified in Chapter 6, in particular with the concept of economic loss as specified in section 6.3.1;
• (b) the process for estimating PD meets the requirements of Articles 179 and 180 of Regulation (EU) No 575/2013 as well as the requirements specified in Chapter 5.

An LGD model can contain several different methods, especially with respect to different types of collateral, which are combined to arrive at an LGD for a given facility.

Institutions should be able to demonstrate that the methods that they choose for the purpose of LGD estimation are appropriate to their activities and the type of exposures to which the estimates apply and they should be able to justify the theoretical assumptions underlying those methods. The methods used in the LGD estimation should in particular be consistent with the collection and recovery policies adopted by the institution and should take into account possible recovery scenarios as well as potential differences in the legal environment in relevant jurisdictions.

The methods used by the institution in the LGD estimation, the assumptions underlying these methods, the institution’s consideration of any downturn effect, the length of data series used, the MoC, the human judgement and, where applicable, the choice of risk drivers, should be adequate to the type of exposures to which they are applied.

6.1.2 Data requirements for LGD estimation

For the purpose of LGD estimation institutions should use an RDS covering all of the following items:

• (a) all defaults identified during the historical observation period specified in accordance with section 6.3.2.1;
• (b) all data necessary for calculating realised LGDs in accordance with section 6.3.1;
• (c) relevant factors that can be used to group the defaulted exposures in meaningful ways and relevant drivers of loss, including their values at the moment of default and at least within the year before default when available.

Institutions should include in the RDS information on the results of the recovery processes, including recoveries and costs, related to each individual defaulted exposure. To this end institutions should include:

• (a) information on the results of incomplete recovery processes until the reference date for the LGD estimation;
• (b) information on the results of recovery processes at portfolio level, where such aggregation of the information is justified, and in particular in the case of indirect costs and sale of a portfolio of credit obligations.
• (c) information on external or pooled data used in the estimation of LGDs.

The RDS should contain at least the following information:

• (a) obligor-related, transaction-related and institution-related risk characteristics as well as external factors as referred to in paragraph 121 that are potential risk drivers at the relevant reference dates as specified in paragraph 122;
• (b) moment (date) of default;
• (c) all default triggers that have occurred, including both past due events and unlikeliness to pay events, even after the identification of default; in the case of exposures subject to distressed restructuring the amount by which the financial obligation has diminished calculated in accordance with the EBA Guidelines on the definition of default;
• (d) the outstanding amount of the exposure at the moment of default including principal, interest and fees;
• (e) the amounts and timing of the additional drawings after default;
• (f) the amounts and timing of write-offs;
• (g) the values of collaterals associated with the exposure and, where applicable, the type of valuation (such as market value or mortgage lending value as defined in points (74) and (76) of Article 4(1) of Regulation (EU) No 575/2013), date of valuation, a flag of whether the collateral has been sold and the sale price;
• (h) information on any dependence between the risk of the obligor and the risk of the collateral or collateral provider;
• (i) the types, amounts and maturities of unfunded credit protection including the specification and credit quality of the protection provider;
• (j) the amounts, timing and sources of recoveries;
• (k) the amounts, timing and sources of direct costs associated with recovery processes;
• (l) a clear identification of the type of termination of the recovery process;
• (m) where applicable, currency mismatches between two or more of the following elements: the currency unit used by the institution for financial statements, the underlying obligation, any funded or unfunded credit protection and any cash flows from the liquidation of the obligor’s assets;
• (n) amount of realised loss.

In accordance with Article 229(1) of Regulation (EU) No 575/2013 institutions may use various methods for the valuation of the collateral in the form of immovable property including in particular market value or mortgage lending value as defined in points (74) and (76) of Article 4(1) of that Regulation. Where institutions use various valuation approaches with regard to immovable properties that secure exposures included in the range of application of a certain rating system, they should collect and store in the RDS the information on the type of valuation and they should use this information consistently in the LGD estimation and in the application of LGD estimates.

Where institutions derive LGD estimates from realised losses and appropriate estimates of PDs in accordance with Articles 161(2) and 181(2)(a) of Regulation (EU) 575/2013 they should use a RDS that includes realised losses on all defaults identified during the historical observation period specified in accordance with section 6.3.2.1 and relevant drivers of loss.

Where aggregated information is collected and stored, institutions should develop an appropriate methodology for the allocation of recoveries and costs to individual defaulted exposures and should apply this methodology consistently across exposures and over time. In any case institutions should demonstrate that the process of allocation of recoveries and costs is effective and that it does not lead to biased LGD estimates.

Institutions should demonstrate that they collect and store in their databases all information required to calculate direct and indirect costs. All material indirect costs should be allocated to the corresponding exposures. This cost allocation process should be based on the same principles and techniques that institutions use in their own cost accounting systems. For the purpose of indirect cost allocation institutions may use methods based on exposure weighted averages, or statistical methods based on a representative sample within the population of defaulted obligors or facilities.

Institutions should take reasonable steps to recognise the sources of the cash flows and allocate them adequately to the specific collateral or unfunded credit protection that has been realised. Where the source of the cash flows cannot be identified, institutions should specify clear policies for the treatment and allocation of such recovery cash flows, which should not lead to a bias in LGD estimation.

6.1.3 Recoveries from collaterals

Institutions should recognise the recoveries as stemming from collaterals in all of the following situations:

• (a) the collateral is sold by the obligor and the obtained price has been used to cover parts or all of the outstanding amount of the defaulted credit obligation;
• (b) the collateral is repossessed or sold by the institution, the parent undertaking or any of its subsidiaries on behalf of the institution;
• (c) the collateral is sold in a public auction of the property by court order or in a similar procedure in accordance with the applicable legal framework;
• (d) the credit obligation is sold together with the collateral and the sale price for the credit obligation included the existing collateral;
• (e) in the case of leasing, the leasing object is sold by the institution;
• (f) the collateral is realised by any other method that is eligible under the legal framework of the relevant jurisdiction.

For the purpose of point (b) of paragraph 115 institutions should determine the value of repossession as the value by which the credit obligation of the obligor has been diminished as a result of the repossession of the collateral, and with which the repossessed collateral was recorded as an asset on the balance sheet of the institution. Where these values are different institutions should consider the lower of the two the value of repossession. The value of repossession should be considered a value of recovery at the date of repossession and should be included in the calculation of the economic loss and realised LGD in accordance with section 6.3.1.

Institutions should consider whether the value of repossession adequately reflects the value of the repossessed collateral, consistently with any established internal requirements for collateral management, legal certainty and risk management. Where the collateral repossessed meets the criteria for high quality liquid assets at Level 1, as defined in Article 10 of Commission Delegated Regulation (EU) 2015/61, institutions may take into account directly as a realised recovery the market value of the collateral at the time of the repossession. In all other cases institutions should apply an appropriate haircut to the value of repossession and include in the calculation of economic loss a recovery in the amount of the value of repossession after applying the appropriate haircut. Institutions should estimate this haircut taking into account all of the following conditions:

• (a) the haircut should reflect possible errors in the valuation of the collateral at the moment of repossession taking into account the type of the valuation available at the moment of repossession, the date it was performed and the liquidity of the market for this type of asset;
• (b) the haircut should be estimated with the assumption that the institution intends to sell the repossessed collateral to an independent third party and should reflect the potential price that could be achieved from such sale, the costs of the sale and the discounting effect for the period from the sale to the moment of repossession taking into account the liquidity of the market for this type of assets;
• (c) where there are observations available regarding the repossessions and subsequent sales of similar types of collaterals the estimation of the haircut should be based on these observations and should be regularly backtested; for this purpose institutions should take into account all of the following:
• (i) the difference between the value of repossession and the sale price, especially where there were no significant changes in market and economic conditions between the moment of the repossession and the moment of the sale;
• (ii) any income and costs related to this asset that were observed between the date of repossession and the moment of the sale;
• (iii) discounting effects;
• (iv) whether the institution repossessed the collateral with the intention of immediate sale or whether another strategy was adopted.
• (d) where historical observations regarding the repossessions and subsequent sales of similar types of collaterals are not available the estimation of the haircut should be based on a case-by-case assessment, including the analysis of the current market and economic conditions;
• (e) the fewer data an institution has on previous repossessions and the less liquid the market for the given type of assets is, the more uncertainty is attached to the resulting estimates, which should be adequately reflected in the MoC in accordance with section 4.4.3.

In any case the repossession of collateral should be recognised at the moment of repossession and should not prevent the institution from closing the recovery process in accordance with paragraph 155.

Any sale of credit obligations in accordance with point (d) of paragraph 115 should be included in the LGD estimation in a manner appropriate to the LGD estimation methodology taking into account all of the following conditions:

• (a) where institutions regularly sell credit obligations as part of their recovery processes, they should appropriately reflect the observations related to credit obligations subject to the sale in the model development process;
• (b) where institutions do not regularly sell credit obligations as part of their recovery processes and the allocation of the part of the price related to collaterals is too burdensome to make or too unreliable, they may decide not to take these observations into account in the process of model development;
• (c) institutions should not treat recoveries from the sales of the secured credit obligations as recoveries realised without the use of collaterals unless they can demonstrate that the recoveries related to these collaterals are immaterial;
• (d) in any case institutions should include all observations, including the sales of credit obligations, in the calculation of long-run average LGD.

In accordance with point (f) of paragraph 115 institutions may specify and recognise any other forms of realising collaterals adequate to the types of collaterals used by the institution that are eligible under the applicable legal framework. When recognising such other forms of realising collateral, institutions should take into account the fact that the collateral may take various forms and that various forms of collaterals may be related to the same asset. Where different forms of collateral refer to the same asset but the realisation of one of the collaterals does not decrease the value of the other, institutions should consider them separate collaterals in the process of LGD estimation. In particular, institutions should recognise separately the form of collateral which gives a right to repossess or sell the asset (such as a mortgage) and the form of collateral which gives a right to collect cash flows generated by the asset (such as a cession of rent or fees).