Response to cP on Guidelines on Credit Risk Mitigation for institutions applying the IRB approach with own estimates of LGDs

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Question 1: Do you agree with the proposed clarifications on eligibility requirements in accordance with Article 181(1)(f) of the CRR?

No

Question 2: Do you agree with the proposed clarifications on the assessment of legal certainty of movable physical collateral? How do you currently perform the assessment of legal effectiveness and enforceability for movable physical collateral?

No

Question 2: Do you agree with the proposed clarifications on the assessment of legal certainty of movable physical collateral? How do you currently perform the assessment of legal effectiveness and enforceability for movable physical collateral?

No

Question 4: Do you have specific concerns related to the recognition of collateral in the modelling of LGD? How do you currently recognise collateral in your LGD estimates?

No

Question 5: What approaches for the recognition of the unfunded credit protection do you currently use? What challenges would there be in applying approaches listed above for the recognition of unfunded credit protection?

According to the Finalization Package of Basel 3 (paragraphs 91, 96, 123, 254), the double-default option should not be considered anymore in 2022.
Hence, could EU institutions still consider it for a few years until the implementation of the Finalization Package ?

We understand that in a Substitution Approach:
• Where the guarantors is a SA guarantor, institutions will substitute SA RW,
• Where the guarantor is a F-IRB Guarantor, institutions can only substitute PD and use regulatory LGD of direct corporate exposure to the guarantor,
• Where the guarantor is a A-IRB guarantor, institutions will need to substitute PD and LGD of direct comparable exposure to guarantor.
Is this correct ?
Can you confirm that for the calculation of RWA, institutions reduce their exposure to the original obligor and create a new one on the guarantor/insurer ? Does this also apply to risk exposures, even if institutions need to keep track of the original exposure on the original obligor?

In the Modelling approach, institutions can only adjust LGD. This would be an incentive to use the substitution approach which will give greater benefits as PD which is a non-linear variable could only be adjusted in the Substitution Approach.

Is it correct that the recourse to the override Approach should remain an exception to be justified ?

Question 6: Do you have any specific concerns related to the issues excluded from the scope of the Guidelines?

According to GL 24, defaulted guarantors should be considered as ineligible providers of CRM, which is appropriate.
However, this GL does not consider the case of NPEs (Non Performing Exposures) partially or totally covered by a CRM issued by an eligible provider.
We consider that the CRR should include a reference to the Finalization Package of Basel 3 (d-424) and its paragraph 194 (a) (which is a copy-paste of paragraph 190 of Basel 3 / d-128) :
In addition to the legal certainty requirements in paragraphs 117 and 118 (or 125) above, in order for a guarantee to be recognised, the following conditions must be satisfied:
(a) On the qualifying default/non-payment of the counterparty, the bank may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee.
This would be a way to recognize clearly the way guarantees and credit-insurances covering long-term investment loans are drafted and executed.
As a consequence, this would open the door to a revision of the new article 47 (c) of the CRR which request banks to deduct from their Tier Equity up to 100% of the covered portion of an NPE, even if the guarantor (or credit-insurer, being an ECA, a multilateral insurer such as MIGA or a private insurer) is complying with its obligations of indemnification according to the original schedule of the loan.
If the article 47 (c ) remains unchanged, most institutions will not accept covers which do not include one compulsory lump sum payment in case of a default, which is not a market practice as of today and which is probably not in the interest of the stakeholders. If ECAs and other insurers do not accept such a request, some institutions will leave Export Finance activities and the Trade Finance gap regularly quoted in emerging markets might only widen.
A coordination with the EIOPA for private insurers on that topic might be appropriate, as well exchanges with the Ministries of Finance monitoring ECAs and with Multilateral Development Banks.

As regards the Legal Certainty, could you confirm that the Legal Opinion might be issued by an internal lawyer who was not involved in the transaction ? We notice that the guidelines mention that an independent legal opinion is required by collateral type and not for every transaction which is good. How can we manage the need for a legal opinion which is required where there are multiple jurisdictions particularly where legal systems differ?

Question 7: Do you agree with the proposed clarification regarding the parallel treatment of ineligible UFCP and ineligible FCP? How do you currently monitor the cash flows related to ineligible unfunded credit protection and how do you treat such cash flows with regard to the PD and LGD estimates?

NA

Question 8: Do you agree with the proposed rules for the application of the substitution approach? Do you see any operational limitations in excluding the guaranteed part of exposure to which substitution approach is applied from the scope of application of the LGD model for unguaranteed exposures?

NA

Question 9: Do you agree with the proposed rules for the application of the modelling approach?

According to GL 34, the cash-flows allocated to the guaranteed part of the exposure would only be those received from the guarantor; all other cash-flows would be allocated to the uncovered part.
This might be misleading for credit insurances and most guarantees as regards the value of these covers: in most cases, the original lender is sharing recoveries efforts with the guarantor/insurer and sometimes the lender recover funds that will then be shared with the guarantor as a consequence of subrogation clauses.
Option 1 which considers that all cash-flows coming from another source than the guarantor are allocated to the unguaranteed portion does not reflect the way most guarantees are drafted and the end-result might be over-payments of the unguaranteed portion and an under-estimation of the LGD.
Option 2 is neither fully satisfactory. In line with the principles of the subrogation which normally apply when a guarantor pays for a debtor, the pro-rata approach is the correct one. But the provided example shows a LGD of 76% on the unsecured exposure and a LGD of 34% on the secured exposure which means a default of the guarantor. With a pro-rata being only calculated on the remaining exposures of the institution after indemnification, strange results might appear with a negative exposure under the covered portion.
There might be a need for an Option 3 which would consider pro-rata allocations, based on the sum of remaining exposures of the institution and the guarantor with the obligor, the exposure of the guarantor being the paid and unrecovered indemnifications. Most probably, LGD on the uncovered portion would hence by in line with the payments made by the original obligor under this portion (cf attachment).

The point c) of GL 34 mentions that direct costs linked to the exercising of the cover have to be allocated to the covered portion while all other direct costs are allocated to the uncovered portion. This is not accurate, as usually the direct costs linked to the call of a guarantee are limited and the direct costs of recovery of the sums due by the original debtor are shared according the respective % of the covered and the uncovered portion..

Question 10: What challenges would you envisage for back-testing the substitution approach? Do you agree that the back-testing should be performed rather at Expected loss level? Do you have any approach currently in place for the back-testing of substitution approach?

The back testing on the expected loss level is probably the best solution.

Question 11: Do you agree with the proposed guidance for the estimation of the LGD of comparable direct exposure towards the guarantor? What concerns would you have about the calculation of the risk weight floor?

NA

Question 12: Do you consider portfolio guarantees as a form of eligible UFCP? Do they include cases where the guarantee contract sets a materiality threshold on portfolio losses below or above which no payment shall be made by the guarantor? Do they include cases where two or more thresholds (caps) either expressed in percentages or in currency units are set to limit the maximum obligation under the guarantee? How do you recognise the portfolio guarantees’ credit risk mitigation effects in adjusting risk parameters?

NA

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190524 EBA CRM.pdf (228.58 KB)

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ICC (International Chamber of Commerce) - Banking Commission

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