Reference date = 50 months (red line)

In accordance with Article 181(1)(h) of the CRR, the EL BE estimation methods should take into account all currently available and relevant information and, in particular, consider current economic circumstances and exposure status. Taking this into consideration, the GL clarify that the EL BE should not include any MoC, as this would not be in line with the best estimate concept. Adding conservativeness does not increase the accuracy of the estimates, but rather covers for the risk that the estimates might be too optimistic.

For the purposes of considering current economic circumstances, the GL clarify that institutions should take into account economic factors, including macroeconomic and credit factors, that are relevant for the type of exposures under consideration. In this context, institutions should obtain their EL BE estimates through an adjustment to the long-run average LGD for defaulted exposures, where necessary, consistently with the estimation of LGD in-default, such that a meaningful application of the risk weight formula is ensured. The difference between LGD in-default and EL BE determines the level of unexpected loss, which is used for computing the risk weight. Therefore, the GL aim to ensure consistency of the estimation approaches used for the two risk parameters.

To avoid excessive use of adjustments and hence increased subjectivity of resulting estimates, it is specified in the GL that the adjustment should be applied only where necessary. The adjustment may be necessary where the observed sensitivity of realised LGDs to economic conditions is not reflected in the EL BE estimates, either through direct use of macroeconomic factors in the model or through risk drivers which are sensitive to economic conditions. In all other cases, it is considered that the EL BE estimates based on the long-run average LGD for defaulted exposures sufficiently reflect current economic conditions, and that no further adjustments to address this issue should be made. Where the adjustment is applied, it should be adequately documented, including its rationale and calculation.

The calculation of the IRB excess/shortfall in accordance with Article 159 of the CRR is based on a comparison between expected losses and credit risk adjustments. In this context, using accounting provisions as EL BE estimates is a frequent practice observed within European institutions. However, this approach is considered inappropriate, as it does not ensure compliance with the CRR requirements. To ensure consistency between the EL BE and LGD in-default estimates, the GL restrict the use of provisions as EL BE to two specific circumstances. The first refers to those cases where a model used to determine accounting provisions respects all the requirements for own LGD estimates set out in the CRR and in these GL, or where the provisions can be adjusted to meet those requirements, in particular those related to the concept of economic loss. The second possibility refers to those cases where provisions are individually assessed, so there is no model behind them. In these circumstances, the information of the individual assessment could be used as a potential reason for an override of the EL BE model outcomes where institutions are able to prove that this improves the accuracy of the estimation for a given exposure. For this purpose, individually assessed provisions should be adjusted to be consistent with the requirements on economic loss set in these GL.

Specific requirements for LGD in-default estimation

According to Article 54(1) of the RTS on IRB assessment methodology, institutions may estimate LGD in-default either directly or as a sum of EL BE and an add-on that captures the unexpected loss that might occur during the recovery period. Irrespective of the approach, it is expected that the method for the estimation of LGD for exposures in default should consider a possible adverse change in economic conditions during the expected length of the recovery process, in accordance with Article 54(2)(a) of the RTS on IRB assessment methodology. It is clarified in the GL that, to reflect the adverse change in economic conditions, institutions should reflect in their LGD in-default estimates at least downturn conditions. This is in line with Article 181(1)(b) of the CRR, as LGD in-default is in fact part of an LGD model. However, estimates of LGD in-default reflecting downturn conditions do not preclude the inclusion of additional sources of uncertainty that are not related to economic conditions during the recovery process. For the purpose of considering additional unexpected losses mentioned in Article 181(1)(h) of the CRR, institutions may therefore need to increase the LGD in-default over the downturn level. Finally, like the LGD for non-defaulted exposures, the LGD in-default should also include adequate MoC. In this context, irrespective of which of the approaches is used for LGD in-default estimation, institutions should always be able to document:

•  the breakdown of the LGD in-default into its components: the EL BE and the add-on; and
•  the breakdown of the add-on into its components: the downturn adjustment, MoC, and, where relevant, any component covering for additional unexpected losses during the recovery period.

Figure 7 presents in graphical form two possible approaches to estimating LGD in-default, which, however, should lead to the same results:

•  directly, increasing the long-run average LGD adjusted for downturn conditions (LGD downturn in Figure 7, or long-run average LGD + C) by the MoC and additional potential unexpected losses (B in Figure 7); or
•  as the sum of the EL BE and the add-on, where the add-on is given by summing up the downturn conditions component (A in Figure 7) to the MoC and the additional potential unexpected losses, if any (B in Figure 7).

LRA LGD – long-run average LGD As the relation between EL BE and LGD in-default is crucial for the adequate determination of risk weights, potential overrides have to be considered and applied consistently as well. It is therefore specified in the GL that to the extent that the reason for overriding the EL BE also applies to the LGD in-default an override of the LGD in-default should be triggered.