Effectively Preparing for the EBA’s New Definition of ... · RTS on IRB assessment methodology...

Effectively Preparing for the EBA’s New

Definition of Default by 2020

Dr Petr Zemcik, Senior Director, Economics & Business Analytics

Maria Valle Del Olmo, Associate Director-Senior Economist, Economics & Business Analytics July 2019

New Definition of Default 2

1. The Big Picture

2. EBA documents on the Definition of Default (DoD)

3. Regulatory Technical Standards (RTS) on the materiality threshold

for credit obligations past due

4. Guidelines (GL) on the application of the DoD under Article 178

5. Is my institution ready? Checklist

Agenda


Petr Zemcik is a Senior Director at the Moody’s Analytics London office who manages of a team of risk modelers in London

and Prague offices. He frequently serves as an engagement lead and a head modeler for projects across several lines of

business in Europe, Africa, and the Middle East to design and validate PD/LGD/EAD credit risk models for IFRS 9, A-IRB,

and stress testing. He previously worked at CERGE-EI, a joint workplace of the Center for Economic Research and Graduate

Education of Charles University in Prague and the Economics Institute of the Academy of Sciences of the Czech Republic,

and at Southern Illinois University in Carbondale. He has published numerous articles on econometric methodology and on

real estate bubbles in peer-reviewed professional journals such as Journal of Real Estate Economics and Finance, Journal of

Housing Economics, and Journal of Multivariate Analysis. Petr holds a Ph.D. and MA in Economics from the University of

Pittsburgh and MSc in Econometrics and Operations Research from the University of Economics in Prague.

Maria Valle Del Olmo is an Associate Director at the Moody’s Analytics London office. Her responsibilities include leading

client projects regarding capital and impairment forecasting and stress testing, particularly for retail and SME portfolios.

During her career at Moody’s, Maria has been involved in onsite client projects including an end-to-end IRB submission for a

main UK challenger commercial bank and the development of an IFRS9 project for a middle sized overseas retail bank.

Maria had previously worked for two major global banks and a well-known data analytics company. During her experience

Maria has covered a wide spectrum of credit risk models including IRB, business as usual, stress testing, provisioning and

economic capital models. She holds an MSc in Mathematics by the University Complutense of Madrid.

Content Solutions – Economics & Business Analytics

Presenters

1 The Big Picture


Key Regulatory DocumentationOverview

Some of the products already finalised by the EBA are:Since its creation in 2011, the European Banking Authority

(EBA) has been actively engaged in the creation of

» Regulatory Technical Standards (RTS)

» Guidelines (GL)

aimed at providing a single set of harmonised prudential rules

for financial institutions throughout the EU.

The set of harmonised rules (the “Single Rulebook”) is

expected to ensure comparability of capital requirements

across the EU and to help create a level playing field.

In this context, the EBA has also extensively worked on the

development of an IRB roadmap, with the aim of reducing

RWA variability across institutions using IRB models.

As part of this effort, the EBA has completed a number of

regulatory products, covering topics identified as potential

drivers of variability across institutions.

IRB assessment methodology

Definition of default (Dod)

Risk parameters estimation and treatment of

defaulted assets

.

RTS on IRB assessment methodology (EBA/RTS/2016/03)

GL on the application of the Definition of Default under Article 78 (EBA/RTS/2016/07)

RTS on the materiality threshold of credit obligations past due (EBA/RTS/2016/06)

GL on the estimation of PD, LGD and treatment of defaulted exposures (EBA/GL/2017/16)

GL for the estimation of LGD appropriate for an economic downturn (EBA/GL/2019/03)

RTS on the specification of the nature, severity and duration of an economic downturn

(EBA/ RTS/2018/04)

The target deadline for the implementation IRB roadmap is

31 December 2020


Impacted areas The changes are expected to have significant impact for banks, across different areas

ITSignificant IT effort is expected in

terms of implementation of the new

definition, particularly to ensure

timely identification of default ,

including unlikeliness to pay

requirements and back-casting

historical data to recreate the new

default definition.

ModellingModelling teams need assess the impact of the

change in default in their IRB models and if

material, recalibrate the rating systems to the

new definition. As IRB models are often feeder

models to other models, the changes may impact

also on IFRS 9 and Stress Testing models.

Validation Changes in the rating systems as a result of the

implementation of the new definition are required

to be validated by the Internal Validation

function. Adequate Margin of Conservativism is

required when the new DoD cannot be fully

recreated in the historical period considered in the

reference datasets.

ProcessesThe internal processes should be

reviewed and updated, to gather the

necessary information in a timely

manner.

GovernanceBanks will need to perform a gap

analysis and update their internal

policies to reflect the new

requirements.

Audit Audit should review regularly the robustness and

effectiveness of the process used by the

institution for the identification of default

NOVA SBE Scorecards 7

IFRS9 & Stress Testing Provisioning/IFRS9, Forecasting, Scenario Analysis/Stress Testing

Business & Strategic Planning

IRB

PD, LGD, EAD

DecisioningScorecards and Rating Models

ICAAP, Risk Appetite & Credit Portfolio Management Correlations, Concentration, CVaR, RAROC, & Operational Risk

Affected ModelsStandard Model Landscape

NOVA SBE Scorecards 8

UK RMBS Data – European Data Warehouse

Small Difference for the UK Mortgages

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16

Loan C

ount

12-M

onth

Defa

ult R

ate

Loan countZero materiality threshold[100 GBP, 2.5%] Materiality threshold

2 EBA documents on the

Definition of Default (DoD)


Linking the new DoD to CRD IV and CRR EBA documents on the Definition of Default (DoD) (1/3)

The implementation of the Basel III rules in the EU is done via

1. The Capital Requirements Directive (CRD IV)

2. The Capital Requirements Regulation (CRR)

The CRD IV / CRR legislative package came into force in the EU in January 2014.

The CRR (regulation (EU) 575 / 2013) details the prudential requirements for credit institutions. The EBA has the mandate to

develop a number of Regulatory Technical Standards (RTS) and Guidelines (GL) in connection with some CRR articles.

The following table summarises some of the documents finalised so far:

Area Regulatory products EBA code CRR article mandate

IRB assessment methodology RTS on IRB Assessment Methodology (EBA/RTS/2016/03)Articles 144 (2), 173 (3),

180(3b)

Definition of Default RTS on the materiality threshold of credit obligations past due (EBA/RTS/2016/06) Article 178 (6)

GL on the application of the Definition of Default under Article 78 (EBA/RTS/2016/07) Article 178 (7)

Risk parameter estimation and

treatment of defaulted assets

RTS on the specification of the nature, severity and duration of an economic downturn

(EBA/ RTS/2018/04)

(EBA/ RTS/2018/04) Article 502

GL on the estimation of PD, LGD and treatment of defaulted exposures (EBA/GL/2017/16)Article 502

GL for the estimation of LGD appropriate for an economic downturn (EBA/GL/2019/03) Article 502


Two regulatory products relating to the DoD EBA documents on the Definition of Default (DoD) (2/3)

GL

RTS

Guidelines (GL)On the application of the Definition of Default (DoD) under Article 178

(EBA / GL / 2016 / 07)

Applicable for firms using either the IRB or the Standardised approach

for regulatory capital calculation.

Regulatory Technical Standards (RTS)On the materiality threshold for credit obligations past due

(EBA / RTS / 2016 / 06)

Applicable for firms using either the IRB or the Standardised approach

for regulatory capital calculation.

Definition of Default

Article 178

Regulation (EU) No 575 / 2013

(CRR)

In addition, the EBA published an opinion on the use of 180 days past due (EBA / Op/ 2017/ 17) which applies only to banks using IRB

approach for regulatory capital calculation.


An overview of the RTS and the GL EBA documents on the Definition of Default (DoD) (3/3)

GL

RTS

RTS on the materiality threshold for credit obligations past due (EBA/RTS/2016/06)

The RTS specify the conditions according to which a competent authority shall set the threshold for

credit obligations past-due.

» Cover one aspect of the definition of default, which regards the threshold against which the materiality

of a credit obligation past due is assessed. The RTS is referenced in the Guidelines.

» It is expected to have a significant implications for banks and represents a step forward towards the

comparability of default risk and capital requirements across the EU.

» It is been endorsed European Commission a transformed into EU regulation (Commission delegated

Regulation (EU) 2018 / 171). Therefore it is legally binding and directly applicable in all Member States.

» Deadline for the application is no later than 31 December 2020.

GL on the application of the DoD under Article 178 (EBA/GL/2016/07)

The GL specify the requirements on the application of Article 178 of the CRR on the definition of default.

» Cover all the aspects regarding the definition of default, that is, the entirety of Article 178.

» Addressed to competent authorities and to financial institutions.

• Competent authorities should comply with the guidelines by incorporating them in their supervisory

processes and legal framework. The RTS is referenced in the Guidelines.

• By extension, the financial institutions within each jurisdiction should comply with the guidelines as

adopted by their supervisor.

» Deadline for the application is no later than 01 January 2021.

(EBA / RTS / 2016 / 06)

(EBA / GL / 2016 / 07)

3RTS on the materiality

threshold for credit obligations

past due


Summary of EBA / RTS/ 2016 / 06RTS on the materiality threshold for past due obligations (1/4)

Key elements

The materiality threshold consists of an absolute and a relative

component:

• absolute component - maximum amount for the sum of

all amounts past due owed by an obligor to the

institution, the parent undertaking or any of its subsidiaries

• relative component – percentage reflecting the amount

of the credit obligation past due in relation to the total

amount of all on-balance sheet exposures to the

institution, the parent undertaking and any of its

subsidiaries.

» The obligor should be considered defaulted when both the

absolute and the relative threshold are exceeded during 90

consecutive days.

» For retail exposures the definition can be applied at facility level.

» Different absolute components of the threshold between retail

and non-retail.

The following table summarises the thresholds values specified in

the regulation:

» The RTS gives some flexibility to competent authorities to

adopt a relative threshold different than 1%, but always in the

range between 0% and 2.5%, if considered more reasonable

within their jurisdiction (needs to be justified to the EBA).

The RTS on the materiality threshold for credit obligations past

due (EBA/RTS/2016/06) was endorsed transformed into EU

regulation on February 2018 ( Regulation (EU) 2018/171) . It is

legally binding and directly applicable to all Member States.

Deadline for the application is 31/12/2020


Examples of Application RTS on the materiality threshold for past due obligations (2/4)

European Central Bank (ECB)

» In order to comply with the RTS, the ECB published Regulation (EU) 2018/1845 on the materiality threshold for credit

obligations past due, applicable to at all significant institutions within the Single Supervisory Mechanism (SSM).

» In line with the EBA recommendations, the following thresholds apply:

• Retail - 1% relative threshold, € 100 absolute threshold.

• Non-Retail – 1% relative threshold € 500 absolute materiality threshold.

Prudential Regulatory Authority (PRA)

» Following the release of the Policy Statement 7/19, the PRA has amended Article 11.4 of the Supervisory Statement 11/17 in

order to comply with the EBA requirements. Financial Institutions in the PRA jurisdiction have to comply with the requirements by

December 2020.

» In line with the EBA recommendations, the following thresholds apply:

• Retail - 0% relative threshold, £0 absolute threshold.

• Non-Retail – 1% relative threshold, a sterling equivalent of €500 absolute materiality threshold.

Other EU competent authorities

Competent authorities may determine the absolute threshold in local currency equivalent of €100 / €500 or re-set it to better align

with the domestic price levels.


Thresholds Significantly Differ Within the ECB Jurisdiction RTS on the materiality threshold for past due obligations (3/4)

Source: ECB Costs and benefits analysis

Situation before the implementation Target situation

All banks in the

SSM

by December

2020

*Banks under the ECB jurisdictions should have notified the

ECB (before June 2019) the exact date they intend to comply

with the deadline.

https://www.bankingsupervision.europa.eu/legalframework/publiccons/pdf/materiality_threshold/ssm.materiality_threshold_cb_analysis.en.pdf


A Bit of History… and Deadlines on the Horizon

(EBA / RTS / 2016 / 06)

Application deadline

(31/12/2020)

EC publishes the draft EU

regulation

Final RTS published by EBA reflecting

the public consultation feedback.

Passed to the European Commission.

Published in the Official

Journal of the EU.

Jun 2016 Feb 2018

Jan 2015 Oct 2017 Dec 2020

First draft published – start

of the consultation

Consultation ended, 22

responses collected and

published on the EBA’s

website.

Oct 2014

RTS on the materiality threshold for past due obligations (4/4)

4 GL on the application of the

DoD under Article 178


Overview of EBA / RTS / 2016 / 07 Overview GL on the application of the DoD under Article 178

Overview

» The deadline for the application is 1 January 2021

» Applicable for firms using either the IRB or the Standardised approach for regulatory capital calculation.

» Institutions using the IRB approach should assess and, where necessary, adjust their rating systems (PD, LGD & EAD) so as to reflect

the new definition of default, applying the following principles:

• Adjust the historical data based on the new definition of default, particularly as a result to the introduction of the new

materiality threshold.

• Assess the impact on all risk parameters and on RWAs after the relevant adjustments on historical data.

• Include additional margin of conservativism (MoC) in order to compensate for possible distortions in risk estimates resulting from

inconsistent definition of default in the historical data used for modelling purposes.

» All changes to IRB models due to the implementation of the new default definition are required to be verified Internal validation function

Topics

» The guidelines provides detail requirements for the following aspects of the DoD:

Past due criterion Unlikeliness to pay External data Return to non-default Consistency Retail ExposuresDocumentation,

management & processes


Past Due Criterion in the Identification of Default

Past due criterion – summary of requirements

This section of the GL specifies the requirements for :

» The counting of days past due, including:

✓ details for specific cases such as:

• changes in the payment schedule

• disputes between the obligor and the institution

• changes of obligor due to merger & acquisitions

✓ requirements regarding the calculation (i.e. sum of all

amounts past due that are related to any credit obligation of the

obligor) and the frequency of update, which should ensure a

timely identification of default.

» Technical past dues , which should not to be classified as

defaults.

» The materiality threshold, in line with the requirements of the RTS

(EBA/RTS/2016/06) previously discussed.

» Specific guidance/requirements for Exposures to central

governments, local authorities and public sector entities as well

as a set of provisions applicable for factoring and purchased

receivables.

Topics covered in the GL on the application of the DoD under Article 178 (Topic 1/ 7)Past due criterion Unlikeliness to pay External data Return to non-default Consistency Retail Exposures

Documentation, management

& processes

01

02

03

The introduction of the new material thresholds is

expected to have as significant impact in risk

parameters and capital requirements. Models will

need be to recalibrated to the new default definition.

The calculation of sum past due should allow for a

timely identification of default and up-to-date

and consistent whatever the scope is (decision

making, internal risk management, reporting, etc.)

All detected errors that lead to a

technical past due situations should

be rectified by the institutions in the

shortest timeframe possible. For IRB

institutions, technical past dues should

not be flagged as defaults in the

reference dataset.

Challenges and / or areas of attention


Indications of Unlikeliness to Pay

Unlikeliness to pay – summary of requirements

This section of the GL provides details regarding the requirements

necessary for an obligor to qualify as unlikely to pay.

» Non-accrued status

» Specific Credit Adjustment (SCRA)

» Sale of a credit obligation at a material credit-related loss

• Non credit-related sales are not to be considered default.

• The credit related loss (L) is considered material L > 5%, where ✓ L = (E – P) / E

✓ E is outstanding amount of the obligations subject to sale.

✓ P = Price agreed for the sold obligations

P is the price agreed for the sold obligations

» Distressed restructuring

• Concessions towards debtors facing financial difficulties, likely to

result in a diminished financial obligation.

• The diminished financial obligation (D0) is considered material if

D0>1%, where ✓ D0 = (NPV0-NPV1) / NPV0

✓ NPV0 is the net present value of cash flows (including unpaid interest and fees)

expected under contractual obligations before the changes in the terms and

conditions of the contract, discounted using the customer’s original effective

interest rate.

✓ NPV1 is the net present value of the cash flows expected based on the new

arrangement, discounted using the customer’s original effective interest rate.

» Bankruptcy.

» Other indications of unlikeliness to pay - including the use of external

information.

Topics covered in the GL on the application of the DoD under Article 178 (Topic 2 / 7)Past due criterion Unlikeliness to pay External data Return to non-default Consistency Retail Exposures


& processes

01

02

03

Implementation the detailed requirements

regarding the definition of distressed

restructuring formula, may imply

significant IT effort, particularly om the

timely identification of default.

Institutions should have clear policies and

procedures of application of the criteria for

unlikeliness to pay.

Institutions should consider information

available in external databases

(credit registers, public information

sources, and financial analyst’s

reports,…) indicating financial

difficulties of the debtor as indicator of

unlikeliness to pay.



Application of the Definition of Default to External Data

External data – summary of requirements

IRB banks using external data for the purpose of estimating their internal

models, should take into account the following requirements:

» Verify whether the definition of default used in the external data is in

line with Article 178 of the CRR.

» Verify whether the definition of default used in external data is

consistent with the definition of default as implemented by the institution

in terms of:

• the counting of days past due

• the type and level of materiality threshold

• the definition of distressed restructuring

• the type and level of specific credit risk adjustments and criteria

to return to non-default status

» Document performed analysis and identified differences.

» For each difference (1) assess whether the alignment to the internal

definition of default would lead to an increased or decreased default rate

or if it is possible to determine (2) perform appropriate adjustments in

the external data or be able to demonstrate that the difference is

negligible in terms of impact in risk parameters and own funds.



& processes

01

02

Institutions should be able to

demonstrate competent authorities the

broad equivalence with the internal

DoD.

When differences exist but are not possible to

overcome with adjustments in the external

data, institutions are required to adopt an

appropriate Margin of Conservativism (MoC).



Criteria for the Return to a Non-Defaulted Status

Return to non-default – summary of requirements

This section of the GL provide the requirements for the cure definition.

» In terms of probation period the guidelines specify it should be

a. At least 3 months for all types of defaults (except distressed

restructured)

b. At least 1 year for defaults due to distressed restructuring

» The probation period can be different for different types of

exposures.



& processes

01

02

03

Banks should define clear criteria and

internal policies reflecting the

definition of cure.

An excessive number of multiple

defaults would be an indication that the

bank should update the policy.

Banks should monitor the

effectiveness of the policy in terms

of:

• Impact in cure rates

• Impact on multiple defaults

• changes of status



Consistency and Retail Exposures

Consistency in the application of the DoD

This section of the GL specifies the requirements for the consistent

application of the definition of default:

» Across single obligors

» Across types of exposures

Retail Exposures - Level of application

» For retail exposures, the DoD can be applied at facility level.

» Banks should choose the level of application (facility vs. obligor) in a

way that reflects their internal risk management practices.

» Banks can apply the DoD at the facility level for some types of retail

exposures and at the obligor level for some other type of exposures

(e.g. Other Retail vs. Retail SME asset classes).

» Even when the DoD is applied at facility level, if there are indications

of unlikeliness to pay that affect the overall situation of the obligor rather

that of the individual exposures, all the exposures to the obligor should

be considered defaulted regardless of the level of application of the

DoD.

Topics covered in the GL on the application of the DoD under Article 178 (Topic 5-6 / 7)Past due criterion Unlikeliness to pay External data Return to non-default Consistency Retail Exposures


& processes

01

Where the exchange of client data among different

legal entities within an institution is not possible due

to consumer protection regulations, bank secrecy

or other legislation institutions should inform their

competent authorities of this impediment and

estimate the materiality.

If the unique identification of defaults across

the different legal entities, geographies, etc.

is excessively burdensome for the institution

– e.g. requiring the development of overly

complex mechanisms - banks can deviate

from this requirements if they can

demonstrate that there are very few obligors

in common and their exposure is not material

(e.g. retail).


Ensure that the internal and external

figures reflect a situation where all

exposures are correctly classified.

02

03


Documentation, Policies and Risk Management Process

Documentation, policies and process – summary of

requirements

Timeliness identification of default

» Automatic processes such as counting days past due should be

performed on a daily basis.

» Manual processes should be updated with a frequency that

guarantees the timely identification of default.

» Control mechanisms should ensure that the relevant information is

used in the default identification process.

Documentation

» Document policies regarding the DoD including all triggers for the

identification of default and the cure criteria.

» Produce specifications for the definition of default.

» Keep an updated register of the definition of default.

Governance

» Adopt adequate mechanisms and procedures in order to ensure that

the DoD is implemented and used in a correct way.


Documentation, policies &

processes

02

03

Institutions to update their IT

specifications and to keep a register of

the DoD. Internal Audit reviews

regularly the robustness and

effectiveness of the process.


The daily calculation requirement for

automatic processes may imply

significant IT efforts for some

financial institutions.

01

Where the exchange of client data among different

legal entities within an institution is not possible due

to consumer protection regulations, bank secrecy

or other legislation institutions should inform their

competent authorities of this impediment and

estimate the materiality.


A Bit of History… and Deadlines on the Horizon

Application deadline

(01/01/2021)

EBA publishes the Quantitative Impact

Study (QIS) related to the

questionnaire.

EBA/GL/2016/07 draft published.

Questionnaire is sent out to banks to

inquire information about the expected

impact.

Competent authorities

communicate to the EBA their

intention to comply with the GL.

Sep 2015 Jul 2016 Mar 2017

Jan 2016 Sep 2016 Jan 2021

Consultation Paper on the

GL first published

(EBA/CP/2015/15).

Four months consultation

period ends.

Timeline for GL on the application of the DoD under Article 178


New Definition Will Reduce Unwarranted RWA VariabilityQuantitative impact assessment hints at a modest increase in the capital charge

Qualitative

Responses to the EBA questionnaire re-affirmed that some of

the RWA variability stems from key differences in terms of

DPD rule, materiality thresholds across banks.

Quantitative

Using banks’ self-reported data in conjunction with COREP

EBA found that the impact on SA banks might be negligible,

while a change in the capital charge is on the cards for IRB

Banks where the new DoD has an impact on the estimated

risk parameters.

CET-1

Impact

New default definition will likely reduce the average Common

Equity Tier 1 ratio of around 20 basis points for IRB Banks

leading to a modest increase in capital charge.

EBA’s QIS contains a qualitative and a quantitative part to better assess the DoD impact:

∆𝐶𝐴𝑅𝐶𝐸𝑇1 =𝐶𝐸𝑇1 + ∆𝐶𝐸𝑇1

𝑅𝑊𝐴 + ∆𝑅𝑊𝐴−𝐶𝐸𝑇1

𝑅𝑊𝐴

∆𝑫𝑹∆ 𝑳𝑮𝑫

𝐝𝐮𝐞 𝐭𝐨 ∆𝑪𝑹, ∆𝑹𝑹

∆𝑬𝑳 ∆𝑹𝑾𝑨 ∆𝑬𝑳𝑩𝑬

Treatment of SCRA

Contagion effect

Materiality threshold

Probation period

Sale of credit obligations

Technical default recognition

5 Checklist


Is My Institution Ready?

Gap analysis

Perform detailed gap analysis covering all aspects of

the DoD framework. Areas covered should include data,

processes, systems, models & policies.

Modelling

Assess the impact of the new DoD on risk parameters,

including the dependencies with other models.

Perform re-calibrations of PDs, LGDs and EADs to the

new default definition and more generally to the new

requirements of the IRB regulatory roadmap.

Remediation

Design a remediation plan with clear timelines and

responsibilities aimed at addressing the identified

gaps.

Documentation

Review internal policies to reflect the new requirements

and ensure compliance with regulations.

Implementation

Produce IT specifications to translate the new

requirements in the internal bank’s IT systems and

retrospectively apply the new default definition to the

historical data. Maintain a register of the changes to

the default definition.

Impact assessment

Conduct assessment to understand the impact on re-

calibrated parameters and in terms of Risk Weighted

Assets (RWA).

5

3 6

4

2

1

Checklist


Q&A

Question? Contact us at [email protected]

mailto:[email protected]

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