The European Banking Authority (EBA) published today its final Guidelines on the estimation of risk parameters for non-defaulted exposures - namely of the probability of default (PD) and the loss given default (LGD), and on the treatment of defaulted exposures under the advanced IRB Approach, including estimation of parameters such as ELBE and LGD in-default. These Guidelines, which are part of the EBA's regulatory review of the IRB approach, aim to restore market participants' trust in internal models by reducing the unjustified variability in their outcomes, ensuring comparability of risk estimates while at the same time preserving risk sensitivity of capital requirements.
The Guidelines provide clarification on the estimation of risk parameters under the IRB Approach, with focus on PD and LGD parameters, as well as on selected aspects of the application of these risk parameters and on the regular reviews of estimates. The clarifications focus on the main concepts and definitions underlying the calibration of risk parameters, as these are the basis for the calculation of capital requirements and, therefore, have to be identified in an objective manner. The Guidelines allow for sufficient flexibility in model development to ensure appropriate risk differentiation and to preserve the risk sensitivity of models.
The specific clarifications included in the Guidelines cover, among other items, the discounting factor used to calculate realised LGD on historical observations. To ensure comparability of LGD estimates, the EBA decided to introduce a simplified concept of discounting factor where the discounting rate is specified as Euribor or an equivalent interbank rate for currencies other than euro plus a fixed add-on of 5%, which will have to be applied by institutions. While the proposed level of the add-on provides an adequate balance between the currently used discounting rates across the EU, the adequacy of the level of the add-on will be further analysed and, if necessary, reviewed before the application of these Guidelines. The EBA is also planning to publish a list of equivalent interest rates for exposures in currencies other than euro to be used in the LGD estimation.
The Guidelines are complemented by a Report on the results of the EBA qualitative survey carried out across the EU banks using the IRB Approach. The Report includes an overview of the current practices in IRB modelling and provides as a detailed impact assessment of the Guidelines. Changes are expected to apply to the majority of existing models in order to ensure compliance with these Guidelines. However, the materiality of these changes will have to be assessed and treated in accordance with the Commission Delegated Regulation (EU) No 529/2014 on the materiality of extensions and changes to rating systems.
Legal basis, implementation and next steps
The EBA has developed these Guidelines on its own initiative in accordance with Article 16 of its founding Regulation, which mandates the Authority to issue guidelines and recommendations addressed to competent authorities or financial institutions with a view to establishing consistent, efficient and effective supervisory practices within the ESFS, and to ensuring the common, uniform and consistent application of Union law.
The Guidelines will apply at the latest from 1 January 2021, but earlier implementation is encouraged. Institutions should engage with their competent authorities at an early stage in order to determine an adequate implementation plan, including the timeline for the supervisory assessment and approval of material model changes, where necessary.
The EBA is currently finalising its draft Regulatory Technical Standards (RTS) on the nature, severity and duration of economic downturn. Once these RTS are finalised, the Guidelines will be updated with additional clarifications on how to use the specified concept of the economic downturn in the estimation of downturn LGD.
Finally, these Guidelines include numerous references to the final draft RTS on the IRB assessment methodology and, therefore, these two documents should be read together. Once the RTS are adopted by the Commission, the Guidelines will be updated with references to the relevant Commission Delegated Regulation.