Publication alert: EBA - Final Report on draft RTS on PD and LGD under the internal default risk model
We communicate that the European Banking Authority (EBA) has published the Final report on Regulatory Technical Standards (RTS) on default probabilities (PDs) and losses given default (LGDs) for default risk model for institutions using the new IMA under the Fundamental Review of the Trading Book (FRTB).
1. Context
After the Basel Committee on Banking Supervision (BCBS) finalised and published standards on Minimum capital requirement for market risk in January 2019, previous minimum capital requirements for market risk in the global regulatory framework were replaced. As a key requirement, institutions using the Internal Model Approach (IMA) to compute own funds requirements for market risk are required to compute additional own funds requirement using an internal default risk model for their positions in traded debt and equity instruments included in IMA trading desks.
In this context, and after the publication of the consultation document in July 2020, the EBA has published the final report on Regulatory Technical Standards (RTS) on default probabilities (PDs) and losses given default (LGDs) for default risk model for institutions using the new IMA under the Fundamental Review of the Trading Book (FRTB) to clarify the requirements that an institution’s internal methodology or external sources are to be met for the estimation of PDs and LGDs under the default risk model (DRC).
2. Main points
Estimating PDs/ LGDs. As a novelty with respect to the consultation document, the requirements for estimating PDs and LGDs, are detailed in these RTS and shall be:
- For an institution’s internal methodology, estimating PD and LGDs shall fulfil several requirements when all of the following conditions are met (assessed quarterly): i) no external sources are available for estimating a PD for a specific issuer or an LGD for a specific position; ii) the use of an internal methodology that meets the IRB requirements is not feasible due to a lack of input data for that issuer or position or a disproportionality in relation to the materiality or holding period of the position; iii) the use of ‘fallback’ PD and LGD estimates is not excessive in relation to the overall scope of the internal DRC. These requirements are:
- Estimating PD. An institution’s internal methodology, or a part of it, shall assign to an issuer an estimate of PD which is equal to or higher than the maximum of the following values: i) the highest PD assigned to investment grade issuers of positions under the scope of the institution’s internal DRC and for which PDs are not estimated by means of the ‘fallback’ approach; ii) the equally weighted average of PDs assigned to issuers of positions under the scope of the institution’s internal DRC and for which default probabilities are not estimated by means of the “fallback’ approach, excluding defaulted issuers.
- Estimating LGD. An institution’s internal methodology, or a part of it, shall assign to an issuer an estimate of LGD which is equal to or higher than the maximum of the following values: i) 75% for subordinated debt positions; ii) 45% for senior unsecured debt positions; iii) 11.25% for covered bond positions; iv) 25% for any other positions.
For ‘fallback’ LGDs applied to positions for which own funds requirements decrease with increasing values of LGDs, the limits mentioned above should be understood as caps rather than floors.
- For external sources, estimating PD and LGDs requires that:
- are validated on a periodic basis for their use in the internal default risk model.
- are obtained from external sources by employing a methodology that is conceptually sound.
- Where more than one external source is used, a hierarchy of sources is established in order to ensure the overall consistency of PD and LGD estimates used in the internal default risk model
Documentation requirements for external sources. To comply with minimum qualitative standards, an inventory of the external data sources used by the institution when estimating PDs and LGDs shall be kept up to date, and include:
- a description of the methodologies used to estimate PDs and LGDs using external sources;
- the results of the validation performed;
- the hierarchy of the sources used;
- As a novelty with respect to the consultation paper, it includes documentation and underlying rationale where an institution has identified different terms, information or assumptions in accounting for expected credit losses and the PDs from external sources for the purpose of ensuring sound credit risk management.
3. Next steps
These RTS shall be adopted by the EC, and shall enter into force on the twentieth day following that of their publication in the Official Journal of the European Union.