Response to consultation on Regulatory Technical Standards on the allocation of off-balance sheet items and UCC considerations
Question 1. Do you have any comment on the non-exhaustive list of examples provided?
The intention of the list is to provide examples of exposures that could be categorized under certain buckets. EFA welcomes the clarification and believes that the Bucket 1 allocation is clear and concise in its guidance. However, EFA believes that the Bucket 2 allocation lacks clarity. The examples mentioned in the consultation on page 9 and 10 are diverse, with the only commonality that a non-credit risk event would need to occur for a loss to materialize.
EFA understands that the purpose of the Credit Conversion Factor (CCF) is to reflect the likely extent to which an off-balance sheet item exposes the institution to the risk of credit losses in case of a default event. By necessity, the CCF includes an element of likelihood which is used to size the probability-weighted exposure at the time of default. This probability is conceptually distinct from the Probability of Default, which in the standardized method is captured in the Risk Weight of the exposure class.
EFA believes that there are substantial differences in the likelihood of occurrence and thereby associated risk of credit loss connected to the different examples provided in Bucket 2. The example of a guarantee connected to a pending takeover bid should be deemed as highly likely to happen, if there’s already a recognizable prize set. On the other hand, the example of a chargeback in case of merchant default requires not only the merchant defaulting but the customer recognizing the potential chargeback event and acting in order to obtain the chargeback. This requires a number of precursor events, all separate from the merchant’s default event, for the contingent risk to materialize. The aggregate likelihood of all these events occurring is something that should be considered considerably more unlikely than the takeover guarantee example above.
This material difference in the likelihood of the non-credit risk event occurring should be reflected in the CCF applied to said exposure. By only focusing on the fact that the exposure is a contingent item, the actual risk profile of the underlying product is not accurately considered. The nature and risk of the chargeback item should be considered more similar to a short term performance bond that historically has been treated as a medium/low risk item.
In its Q&A from April 2022, BaFin argues that chargebacks should be considered medium/low risk. They state that chargebacks cannot be considered neither high risk nor low risk, but should be considered medium/low risk, specifically mentioning that it is due to the low chargeback rates relating to total transaction volume.
The International Accounting Standards (IAS) specifically mentions in IAS 37.86. that the possibility of the settlement should be the basis to whether disclosure should be made of contingent liabilities. A remote possibility of settlement should lead to fewer or no disclosures. To adhere to the accounting standards, a remote probability of a settlement occurring should be reflected in the allocation to the buckets.
EFA agrees that it is not possible to have an overly detailed classification using the standardized approach. However, just categorizing an item as contingent does not accurately reflect the underlying risk of the item, especially when excluding attributes such as probability. Just focusing on the contingent nature and the non-credit risk event while still maintaining performance bonds in lower buckets because of trade finance elements does not make sense either from a risk perspective.
As there are multiple variables connected to the actual underlying risk of a contingent item, EFA believes that it isn’t an appropriate reflection of risk to categorize every item in the same bucket. We therefore ask the EBA to broaden the scope of assets analyzed in order to more accurately reflect the risk of the exposures. For the Bucket 2 suggested examples we ask EBA to expand the list and allocate the contingent items to different buckets, where low probability items are allocated to Bucket 4 and high probability items are allocated to Bucket 2.
Question 5. Do you have any comment on the allocation criteria proposed under Article 1?
EFA believes, as has been outlined in question 1, that the allocation criteria is too narrow, especially for Bucket 2. In order to more accurately reflect the risk of the exposure the likelihood of the non-credit risk event occurring should be taken into account. Based on this the items currently allocated to Bucket 2 should be allocated to different buckets.