Guidelines on review of the IRB Approach

In February 2016, the EBA published a Report on the regulatory review of the IRB Approach, outlining the initiatives that have undertaken to reduce the unjustified variability in the outcomes of internal models while preserving the risk sensitivity of capital requirements.

Modifications to regulatory standards affect nearly all aspects of the IRB Approach and it is expected that they will be able to significantly reduce the unjustified RWA variability which is deemed to stem from the lack of sufficiently specified requirements with regard to certain aspects of the IRB Approach.

In this context, the EBA published in November 2017 Guidelines on PD and LGD estimation and on the treatment of defaulted assets, which is one of those regulatory products above-mentioned.

These Guidelines (GL) are focused on the definitions and modelling techniques used in the estimation of risk parameters for both non-defaulted exposures (PD and LGD) and for defaulted exposures (best estimate of expected loss and LGD-in default).

In particular the GL aim at:

• Aligning the terminology and definitions, and provide clarification on the application of certain regulatory requirements that were until now interpreted in various ways.
• Specifying aspects common for all risk parameters such as the use of human judgement, the margin of conservatism (MoC) that should be incorporated in risk parameters, the regular reviews of the models that should be conducted in order to ensure timely implementation of necessary changes in case of deteriorated performance of the models, etc.

The technical note prepared by Management Solutions’ R&D department includes an analysis of the requirements arising from these GL.

Executive Summary

These GL on estimation of credit risk parameters for IRB provide guidance on the following aspects: i) general estimation requirements; ii) PD estimation; iii) LGD estimation; iv) estimation of risk parameters for defaulted exposures; v) application of parameters; and vi) review of estimates.

Scope of application

This document applies to institutions using the IRB approach and subject to the Capital Requirements Directive (CRD IV) and to the Capital Requirements Regulation (CRR).

Main content

• General estimation requirements: range of application of the rating systems, general data requirements, human judgement, and Margin of Conservatism.
• PD estimation (non-defaulted exposures): general requirements, PD model development and PD calibration requirements (observed default rate, long-run average default rate and PD estimation methodology).
• LGD estimation (non-defaulted exposures): general requirements, specific data requirements, eligibility of collaterals (calculation of economic loss and realised LGD, long-run LGD rates and LGD estimation methodology).
• Estimation of risk parameters for defaulted exposures: general requirements, specific EL_BE and LGD model development requirements, and calibration.
• Application of risk parameters: conservatism, human judgement and guidance for the use of parameters and the estimation of the IRB shortfall.
• Requirements for the definition of internal policies for the review of estimates.

Download the technical note by clicking here.