RTS and GL on estimation and identification of an economic downturn in IRB modelling

Status: Final draft adopted by the EBA and submitted to the European Commission

These draft RTS and GLs are part of the EBA’s broader work on the review of the IRB approach aimed at reducing the unjustified variability in the outcomes of internal models, while preserving the risk sensitivity of capital requirements.

EBA publishes final Guidelines on the estimation of LGD under an economic downturn

EBA publishes final Guidelines on the estimation of LGD under an economic downturn

06 March 2019

The European Banking Authority (EBA) published today its final Guidelines specifying how institutions should quantify the estimation of loss given default (LGD) appropriate for conditions of an economic downturn. In particular, the Guidelines focus on requirements for the quantification of the calibration target used for downturn LGD estimation. The Guidelines complete the EBA's broader work on the review of the IRB approach aiming at reducing the unjustified variability in the outcomes of internal models, while preserving the risk sensitivity of capital requirements.

Starting from the relevant downturn period(s) identified in accordance with the related Regulatory Technical Standard (RTS), the final Guidelines set out requirements for the appropriate quantification of the calibration target used for downturn LGD estimates and include three types of approaches:

  • Type-1 approaches can be applied when banks have sufficient loss data for the identified downturn period. In this case, institutions are allowed some modelling flexibility, but subject to a harmonised and prescriptive impact assessment;
  • Type-2 approaches can be applied when banks do not have sufficient loss data for the identified downturn period. In this case, institutions are given the choice between two approaches, the so-called haircut or extrapolation approaches This will harmonise the approaches used by banks.
  • Type-3 approaches can be applied in rare cases, where neither type-1 nor type-2 approaches can be used. In this case, banks have to apply a minimum margin of conservatism (MoC) requirement of 15 percentage points on LGD estimates.

Finally a reference value is put in place that acts as a non-binding challenger to the final downturn LGD estimation.

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 as of 1 January 2021, at the latest, 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.

These Guidelines are an amendment to the Guidelines on PD, LGD estimation and treatment of defaulted assets (EBA/GL/2017/16) published on 20 November 2017.

Press contacts:

Franca Rosa Congiu

E-mail: press@eba.europa.eu - Tel: +44 (0) 207 382 1772

EBA publishes final draft technical standards on the specification of an economic downturn

EBA publishes final draft technical standards on the specification of an economic downturn

16 November 2018

The European Banking Authority (EBA) published today its final draft Regulatory Technical Standards (RTS) specifying the nature, severity and duration of an economic downturn. These RTS complete the EBA's regulatory review of the internal ratings-based (IRB) Approach, with the objective of restoring market participants' trust in internal models by reducing the unjustified variability in resulting risk weighted exposure amounts. The EBA is currently finalising the related Guidelines on the estimation of loss given default (LGD) appropriate for conditions of an economic downturn.

The final draft RTS set out the notion of economic downturn to be taken into account when estimating the LGD and the conversion factors (CF). Given the specificities of the types of exposures covered by a rating system, the economic downturn should be identified separately for each rating system. However, as a rating system may cover exposures from different businesses, sectors and geographical areas, the notion of an economic downturn included in these RTS may comprise several disjunctive downturn periods (e.g. where a rating system covers two sectors which experienced downturn conditions in different periods of time).  

In addition, the final draft RTS specify the nature of an economic downturn via macroeconomic or credit-related factors (‘economic factors') that are explanatory variables or indicators for the business cycle of the considered type of exposure. The severity of an economic downturn is specified by the set of the most severe observations on the economic factors constituting the nature of an economic downturn, based on historical values of these factors over the last 20 years. The duration of an economic downturn is determined by the duration of the identified downturn periods and is generally specified as the 12-month period where the most severe values are observed. However, some flexibility is embedded in the draft policy to ensure that the severity and duration are appropriately specified.  

Legal basis, implementation and next steps

Under the advanced IRB Approach, institutions determine their own funds requirements for credit risk taking into account their own LGD and CF estimates. According to Article 181(1)(b) of the Capital Requirements Regulation (CRR), institutions shall estimate LGDs that are appropriate for an economic downturn and according to Article 182 (1)(b) institutions shall estimate conversion factors that are appropriate for an economic downturn.

Therefore, the EBA is mandated in Articles 181(3)(a) and 182(4)(a) to develop these draft RTS specifying the nature, severity and duration of an economic downturn to be taken into account when estimating the LGD and CF.

These draft RTS will apply from 1 January 2021. It should be noted that the Guidelines on the estimation of the probability of default (PD) and LGD, which will be complemented by the Guidelines on downturn LGD estimation, will apply as well from 1 January 2021. An earlier implementation of the Guidelines on downturn LGD estimation is, however, encouraged and 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.

Press contacts:

Franca Rosa Congiu

E-mail: press@eba.europa.eu - Tel: +44 (0) 207 382 1772