Response to consultation Paper on draft Guidelines on loan origination and monitoring.
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• The EBA guideline requirements for governance for credit granting and monitoring are comprehensive and adequate.
• As an area of industry gap to be noted relates to the fact that not all institutions develop comprehensive and regular staffing plans for their credit areas that cover resource level and skill set based on strategy and risk profile trends (as expected in the resources and skills subsection of Section 4).
• Entities should focus in credit granting monitoring and backtesting for complex individuals algorithms or multilevel decision making processes in SMEs and Corporates. Not all institutions can track and measure the effectiveness of their credit decision making processes vs. predefined policies.
Figure 2 – A&M Proposal for Credit Risk Management Roles along the three lines of defense
• Credit scoring and rating models have a long track record and IRB/IFRS9 requirements have forced models to pass multiple Internal and external validations thus promoting sound performance and granularity. The approval and use of IRB models should be promoted to ensure adequate performance of credit scoring and rating models (e.g., there are still some markets where the use of the standardised capital approach is high thus not promoting adequate risk capture).
• Draft guidelines related to collection of information and documentation from clients should apply principles of proportionality to balance adequate risk assessment and customer experience (e.g., strict and frequent data requirements might be cumbersome to clients)
• Level playing field in this area is key as non-banking competitors do not have the same requirements in terms of data collection and credit assessment.
• Monitoring of creditworthiness should be also integrated within conduct risk assessment identifying and limiting not properly granted loans.
• Data gathering and storage procedures must ensure data availability for performance and models monitoring. RDA principles must apply to credit assessment information.
• Credit rating and scoring models cover all the information requirements identified in section 5.2 for assessment of borrower’s creditworthiness of consumer loans.
• Sensitivity analyses at origination reflecting potential negative scenarios in the future that impact creditworthiness are very limited and there is a lot of room of improvement in this area
Lending to Professionals
• Credit rating and scoring models cover all the information requirements identified in section 5.2 for assessment of borrower’s creditworthiness of professional loans.
• Sensitivity analyses at origination reflecting potential negative scenarios in the future that impact creditworthiness are very limited and there is a lot of room of improvement in this area. Sensitivity analysis for idiosyncratic events are not usually included in credit assessment.
• KRIs and ratings must be aligned and frequently monitored (e.g., recent credit underwriting exercise evidenced some inconsistencies between KRIs and credit risk parameters driving ratings)
• The proper rating calculation must be monitored when expert judgement is applied. Rating challenge and 2nd review for random samples is a useful tool.
• A particular area of concern not covered in the guidelines is how institutions should use regulatory capital for pricing decisions. There are institutions that only consider economic capital in their pricing models, therefore originating transactions that do not meet cost of capital requirements particularly in cases where economic capital is substantially lower than regulatory capital.
• Loan prices are not always fully aligned with the risk profile of the loans originated due to market competition reasons that can drive mispricing risks. Adequate monitoring of new origination that does not fully cover all allocated costs can help banks understand and manage value creation. Due to heavy competition and margin pressure, there are today loan segments in Europe that do not meet the cost of capital. Supervisors should monitor these cases and control for mispricing loan segments.
• There are gaps in the area of profitability measurement for new business. In addition, implementation gaps in certain institutions exist when monitoring hurdle rates based on risk-adjusted profitability targets of new origination.
• We believe more detailed guidelines for pricing should have been given in the following areas
o Methodology
Costs analysis and quantification (funding, expected loss, cost of capital, operating cost…) and proper allocation by business / channels / products / customers / contracts.
Use of return on regulatory capital (including Basel IV considerations) vs. return on economic capital
Use of full costing vs. marginal costing assumptions
Use of lifetime projections vs. accounting based measures
Use of point in time vs. through the cycle expected loss measures
Definition of different type of hurdle rates (minimum vs. recommended level) and setting criteria
Definition of hurdle rates by business, portfolio, client and product
o Governance
Split of roles between business line, risk management and finance
Functioning and existence of pricing committees
Linkage between pricing hurdle rates and risk appetite / budget targets
• Mandatory rotation is not always necessarily the best solution for ensuring adequate valuation standards. Better and more detailed valuation rules and regulation of valuation companies can be an incentive for more effective valuation practices.
• For some random samples a second valuation (valuation challenge) can identify inadequate valuation practices. For those cases, penalties to valuation companies, mandatory rotation and/or adjustments to historical valuations should be applied.
• Banks should implement collateral valuation practices to promote sound internal risk
• Entities have implemented Watchlist processes but room for improvement in anticipatory modelling and sensitivity analysis (e.g., reliance on certain borrower triggers instead of conducting comprehensive and granular peer analysis)
• Results of watchlist are effective to identify and classify clients but should become better monitoring, anticipation and customer recovery management tools.
• Sensitivity analysis and stress testing is not commonly used in portfolios monitoring. In the case of relevant exposures is even less common to use macro or idiosyncratic impact analysis in the credit monitoring.
5. What are the respondents’ views on the requirements for governance for credit granting and monitoring (Section 4)?
• Credit governance standards are well established at most institutions• The EBA guideline requirements for governance for credit granting and monitoring are comprehensive and adequate.
• As an area of industry gap to be noted relates to the fact that not all institutions develop comprehensive and regular staffing plans for their credit areas that cover resource level and skill set based on strategy and risk profile trends (as expected in the resources and skills subsection of Section 4).
• Entities should focus in credit granting monitoring and backtesting for complex individuals algorithms or multilevel decision making processes in SMEs and Corporates. Not all institutions can track and measure the effectiveness of their credit decision making processes vs. predefined policies.
6. What are the respondent’s views on how the guidelines capture the role of the risk management function in credit granting process?
• Most institutions have adopted a three lines of defense model consistently with the EBA guidelines. We believe the guidelines should be more explicit about the roles and responsibilities related to credit risk management for the three lines of defense. In addition, there are some banks that have recently separated their Chief Credit Officer (outside the line of business) from their Chief Risk Officer, effectively building a 4 line of defense model instead of a model based on three lines of defense. See figure 2 for an illustrative model with roles and responsibilities along the three lines of defense for credit risk management. Roles and responsibilities should be defined along the risk management cycle including business planning, execution and performance monitoring / evaluation phases. In our proposed model, we defend that although there might be business aligned credit functions within the second line of defense, these should report through the CRO function.Figure 2 – A&M Proposal for Credit Risk Management Roles along the three lines of defense
7. What are the respondents’ views on the requirements for collection of information and documentation for the purposes of creditworthiness assessment (Section 5.1)?
• Credit rating and scoring models cover all the information requirements identified in section 5.1 for lending to consumers and lending to professionals.• Credit scoring and rating models have a long track record and IRB/IFRS9 requirements have forced models to pass multiple Internal and external validations thus promoting sound performance and granularity. The approval and use of IRB models should be promoted to ensure adequate performance of credit scoring and rating models (e.g., there are still some markets where the use of the standardised capital approach is high thus not promoting adequate risk capture).
• Draft guidelines related to collection of information and documentation from clients should apply principles of proportionality to balance adequate risk assessment and customer experience (e.g., strict and frequent data requirements might be cumbersome to clients)
• Level playing field in this area is key as non-banking competitors do not have the same requirements in terms of data collection and credit assessment.
• Monitoring of creditworthiness should be also integrated within conduct risk assessment identifying and limiting not properly granted loans.
• Data gathering and storage procedures must ensure data availability for performance and models monitoring. RDA principles must apply to credit assessment information.
8. What are the respondents’ views on the requirements for assessment of borrower’s creditworthiness (Section 5.2)?
Lending to Consumers• Credit rating and scoring models cover all the information requirements identified in section 5.2 for assessment of borrower’s creditworthiness of consumer loans.
• Sensitivity analyses at origination reflecting potential negative scenarios in the future that impact creditworthiness are very limited and there is a lot of room of improvement in this area
Lending to Professionals
• Credit rating and scoring models cover all the information requirements identified in section 5.2 for assessment of borrower’s creditworthiness of professional loans.
• Sensitivity analyses at origination reflecting potential negative scenarios in the future that impact creditworthiness are very limited and there is a lot of room of improvement in this area. Sensitivity analysis for idiosyncratic events are not usually included in credit assessment.
• KRIs and ratings must be aligned and frequently monitored (e.g., recent credit underwriting exercise evidenced some inconsistencies between KRIs and credit risk parameters driving ratings)
• The proper rating calculation must be monitored when expert judgement is applied. Rating challenge and 2nd review for random samples is a useful tool.
9. What are the respondents’ views on the scope of the asset classes and products covered in loan origination procedures (Section 5)?
• Scope of assets classes and products covered in Section 5 is comprehensive and adequate. Detailed annexes included in guidelines provide sufficient detail in metrics and information to be considered for assessing creditworthiness.10. What are the respondents’ views on the requirements for loan pricing (Section 6)?
• The level of sophistication and granularity of pricing methods differs across banks. Areas that might generate gaps include cost of capital (regulatory vs. economic), cost allocation of operating expenses, inclusion of MREL/TLAC requirements in cost of funding and IFRS9 considerations in cost of credit.• A particular area of concern not covered in the guidelines is how institutions should use regulatory capital for pricing decisions. There are institutions that only consider economic capital in their pricing models, therefore originating transactions that do not meet cost of capital requirements particularly in cases where economic capital is substantially lower than regulatory capital.
• Loan prices are not always fully aligned with the risk profile of the loans originated due to market competition reasons that can drive mispricing risks. Adequate monitoring of new origination that does not fully cover all allocated costs can help banks understand and manage value creation. Due to heavy competition and margin pressure, there are today loan segments in Europe that do not meet the cost of capital. Supervisors should monitor these cases and control for mispricing loan segments.
• There are gaps in the area of profitability measurement for new business. In addition, implementation gaps in certain institutions exist when monitoring hurdle rates based on risk-adjusted profitability targets of new origination.
• We believe more detailed guidelines for pricing should have been given in the following areas
o Methodology
Costs analysis and quantification (funding, expected loss, cost of capital, operating cost…) and proper allocation by business / channels / products / customers / contracts.
Use of return on regulatory capital (including Basel IV considerations) vs. return on economic capital
Use of full costing vs. marginal costing assumptions
Use of lifetime projections vs. accounting based measures
Use of point in time vs. through the cycle expected loss measures
Definition of different type of hurdle rates (minimum vs. recommended level) and setting criteria
Definition of hurdle rates by business, portfolio, client and product
o Governance
Split of roles between business line, risk management and finance
Functioning and existence of pricing committees
Linkage between pricing hurdle rates and risk appetite / budget targets
11. What are the respondents’ views on the requirements for valuation of immovable and movable property collateral (Section 7)?
• Banks must define and implement better processes and procedures for collateral valuation. This must include review pricing procedures and incentives for valuers.• Mandatory rotation is not always necessarily the best solution for ensuring adequate valuation standards. Better and more detailed valuation rules and regulation of valuation companies can be an incentive for more effective valuation practices.
• For some random samples a second valuation (valuation challenge) can identify inadequate valuation practices. For those cases, penalties to valuation companies, mandatory rotation and/or adjustments to historical valuations should be applied.
• Banks should implement collateral valuation practices to promote sound internal risk
12. What are the respondents’ views on the proposed requirements on monitoring framework (Section 8)?
• Entities have proper behaviour models but sometimes are not really used for monitoring processes. In some cases, credit monitoring only starts just after some days loans become past due.• Entities have implemented Watchlist processes but room for improvement in anticipatory modelling and sensitivity analysis (e.g., reliance on certain borrower triggers instead of conducting comprehensive and granular peer analysis)
• Results of watchlist are effective to identify and classify clients but should become better monitoring, anticipation and customer recovery management tools.
• Sensitivity analysis and stress testing is not commonly used in portfolios monitoring. In the case of relevant exposures is even less common to use macro or idiosyncratic impact analysis in the credit monitoring.
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