UK: Singing From The Same Hymn Sheet: Harmonising Definition Of Default

On 27th July 2018, the PRA published its Consultation Paper (CP) 17/18 on Credit Risk Definition of Default (DoD). This paper sets out the PRA's proposed approach to implementing the European Banking Authority's (EBA's) three regulatory packages relating to DoD in the Capital Requirements Regulation (575/2013) (CRR) specifically:

  • Regulatory Technical Standards (RTS) for the materiality threshold for credit obligations past due1;
  • Guidelines (GL) on the application of the DoD2; and
  • Opinion paper ('the EBA Opinion')3 on the use of the 180 days past due (DPD) criterion in the DoD. 

The proposals are relevant to UK banks, building societies and PRA-designated UK investment firms. Importantly, they apply to firms using both the Standardised Approach ('SA firms') and Internal Ratings Based approaches ('IRB firms') as they affect the DoD which is fundamental to the application of supervisory risk weights within the SA, as well as to the estimation and application of IRB risk parameters.

The proposed implementation date is 31st December 2020. This is consistent with the EBA's implementation timeline of 31st December 2020 for its regulatory review of the IRB Approach4.

The key changes to highlight are:

  • removal of PRA's discretion to allow firms to use 180 DPD in their default definition; 
  • setting a zero materiality threshold for retail exposures alongside a 1% relative and a sterling equivalent of €500 absolute materiality threshold for non-retail exposures in the application of DoD; and
  • requirement to comply in full with the EBA GL on the application of DoD.

Overview of the current framework

CRR Article 178 sets out the DoD, which includes two triggers: 'unlikeliness to pay'; and 'days past due'. The latter is defined as 'the obligor is past due more than 90 days on any material credit obligation to the institution, the parent undertaking or any of its subsidiaries'. The regulation requires each national competent authority to outline how the RTS and GL should be applied. This includes:

  • setting a threshold against which the materiality of a credit obligation past due shall be assessed (the 'materiality threshold'); and
  • confirming whether the option to replace 90 days past due, with 180 days past due, in the DoD will be adopted (for exposures secured by residential or SME commercial real estate in the retail exposure class, as well as exposures to public sector entities). 

Under the current framework, firms in the UK have been allowed to use 180 DPD in their DoD for specified exposures, subject to PRA approval, as part of their IRB permission with variable application of materiality thresholds currently across the industry.

Proposals that will change the status quo on DoD

Table 1 below summarises the PRA proposals and their alignment with the EBA recommendations. Whilst the PRA proposals mostly align with the EBA recommendations, one of the major differences is the materiality threshold for retail exposures which in turn leaves room for UK firms to continue using the months in arrears (MIA) measure.

Table 1: Summary of the PRA's proposed changes compared to the EBA recommendations

N.B. The proposals relating to the RTS and GL apply to both SA firms and IRB firms, whereas the proposals relating to the EBA Opinion apply to IRB firms only.

Key implications for UK firms

These proposals will have implications both in terms of operational costs and, more importantly, potential additional capital requirements for firms. Specifically, we see the following key implications which will need to be considered:

  • Continued use of MIA as a proxy for DPD with zero materiality threshold may create inconsistency.

The CP leaves room for UK firms to continue to apply a MIA-driven measure of DPD within the DoD. On the face of it, this is an appealing option for firms already using MIA given that legacy systems and processes would need to be overhauled to accommodate a mandatory change. However, it is important to recognise that this remains inconsistent with the CRR definition (and associated technical standards) and may ultimately not be sufficiently conservative or consistent with other uses. For example, the definition of 'credit impaired' (used in IFRS 9), which emphasises the importance of counting material DPD by applying 90 DPD as a Stage 3 backstop trigger. 

It may of course be possible to demonstrate that the continuing use of MIA does not generate material differences in capital impacts across the credit cycle relative to the DPD counting approach. The broader questions are about RWA comparability across CRR firms and the extent to which the use of MIA could distort this picture, creating unintended impacts for the retail market, particularly in relation to mortgages. UK firms should challenge themselves as to whether they wish to align themselves with the dwindling number of MIA reporters, or the growing number of European reporters which have adopted compliant DPD counting whilst addressing IFRS 9 expectations

  • Capital requirements are likely to rise for firms currently using 180 DPD.

For IRB firms currently using 180 DPD, the proposal to use 90 DPD will accelerate the recognition of defaults. The EBA Assessment3 for UK and French firms noted that this will likely lead to higher PD estimates and lower LGD estimates, driven by a reallocation of exposures that are currently non-defaulted into a default status, and the resulting change in risk parameter calibrations. The absolute impact on capital requirements, however, is less clear and will depend on the extent to which a potential decrease in LGD offsets the increase in PD, if it does at all. For example, some firms may not be able to realise the full decrease in LGD due to the CRR's current 10% portfolio-level LGD floor for retail exposures secured by residential property and the 15% portfolio-level LGD floor for retail exposures secured by commercial immovable property. 

The materiality threshold proposal is also likely to affect the number of defaults and therefore the PD and LGD estimates. For IRB firms, the RWA and EL treatment for the increased default population will be directly affected. For SA firms the proposals on materiality threshold will result in a direct impact from a change in the stock of defaulted accounts which attract higher risk weights. Firms will therefore need to assess the impact of these proposals on their capital position and engage with the PRA to agree an appropriate transitional period which in some cases, may need to extend beyond the implementation date to meet the capital impact.

  • Internal systems and controls will need to be upgraded. 

Both IRB and SA firms will incur implementation costs from introducing non-zero relative and absolute materiality thresholds in their systems. IRB firms currently using 180 DPD will face an implementation burden to change their systems, controls and default database to a 90 DPD measure.

Model monitoring will need to be enhanced to incorporate the proposals in addition to the GL provisions for monitoring the effectiveness of 'unlikeliness to pay' indicators and 'criteria for return to non-defaulted status'.

  • Model landscape and infrastructure will need to be refreshed. 

For IRB firms, the proposals regarding materiality threshold and removal of 180 DPD in the DoD would at a minimum require a reassessment of the models' performance with the revised DoD across PD, LGD and EAD/CF models. Where this results in a need to recalibrate or redevelop the models, it will require a programme of work with close coordination across the related implications for controls, capital and compliance as well as other regulations.

  • Compliance assessment will need to be conducted to identify any gaps.

The PRA has not proposed to deviate from any chapter / article of the EBA GL on DoD and proposes that firms should comply with the GL fully. The onus will therefore be on firms to undertake a thorough assessment of the GL and request clarifications where required.

For example, the minimum probation period of 3 months for defaults meeting the DPD criterion is an area we believe firms will seek to clarify. Any choice of probation period requires careful consideration given its effect on the portfolio cure rate and the resulting effects on PD and LGD estimates. Further, the GL will add to the ongoing requirement to attest to compliance with the CRR, probably as part of the enhanced annual self-assessment process that should exist currently.

  • Policies and processes will need to be subsequently updated.

Firms will be required to update their policies and processes to implement the materiality threshold, removal of 180 DPD and meet the GL regarding identification, application and monitoring of 'unlikeliness to pay' indicators. The provisions to meet the documentation standards set out, as well as how it is consistent with IFRS 9. Firms will also need to look at the implications for stress testing and Pillar 2 as well as the recently published standards in this space. The business will then have to be trained to use the updated model suite to enable continued compliance with the use test. This will apply to all levels of the organisation up to the Board, depending on the relevant governance framework.

  • Governance will need to be refreshed to align to the GL.

The GL ask for effective internal governance arrangements for correct and consistent application of definition of default. Firms should reassess the internal governance arrangements for compliance with the GL, including the scope of internal audit.

In addition to the above, firms in the process of seeking IRB permission ('IRB Aspirants'), especially those in the early stages of this process, will need to carefully consider the proposed changes in conjunction with all the other in-flight regulatory changes from the PRA, EBA and BCBS to optimise delivery timescales and avoid 'regret spend'.

 Regulatory programme of work interactions

The DoD PRA changes add to the significant number of regulatory requirements and proposals relating to credit risk capital requirements which have recently been finalised by the PRA, EBA and BCBS. The over-arching objective of the proposals is to reduce RWA variability under the IRB approach and to increase risk sensitivity under the SA.

Figure 1: Key regulatory requirements and proposals affecting credit risk capital requirements

The proposed changes to DoD create a fundamental dependency in firms' implementation plans as they affect both the application of supervisory risk weights under Basel III final reforms6 and the recalibration / redevelopment of IRB models to meet the new and upcoming PRA and EBA requirements. For example, UK firms will need to understand the impact of these proposed changes alongside the PRA-imposed requirements for the IRB approach for residential mortgage portfolios5 which also need to be implemented by 31st December 2020. Firms undertaking financial and business impact assessments, in order to understand how credit risk capital requirements will change following these reforms will need to adapt them for the proposed changes to DoD. This will make developing (or updating) the implementation plan for Basel III final reforms, to capture inter-dependencies between regulations and ensure the overlapping timelines can be met, an immediate priority.

How firms are getting ahead on this new requirement

Sophisticated firms are seeking an accurate assessment of the impact of these proposals on capital, even where they do not expect to be affected. Once they have further clarity on the range and sources of potential impacts, we expect these firms will apprise their stakeholders (not least given the level of market interest in this paper on the day it was released) and are well advanced with plans to engage with the PRA, to agree an appropriate transitional period to meet any capital impact. This is the case for both SA and IRB firms.

Those firms transitioning to IRB have typically incorporated assumptions relating to DoD within existing quantitative impact studies. They will also have completed an assessment of the GL to understand whether there will be broader operational changes. The changes proposed will either reinforce or build on the expected impacts, which may require time and budget to be revised, redesigned and then implemented, including technology updates. This is particularly important given we are operating in a time when data regulation such as BCBS239 is hugely topical7

We anticipate that those firms looking at the emerging regulation holistically will already be working with their partners to reassess already full regulatory books of work in an effort to update their implementation plans to ensure overlapping timelines are met without incurring 'regret' spend.

Conclusion

The CP provides clarity around the PRA's approach to the implementation of the EBA's roadmap and offers some flexibility for UK firms. It also increases the number of prudential regulatory changes that we expect to see in the near future, implementation of which will need to be carefully coordinated.

The proposals in this CP are part of the jigsaw of several inter-connected regulatory products arising from the reforms developed by the PRA, EBA and BCBS.

The challenge for firms is to complete the jigsaw by mapping out the requirements, timelines and impact on individual credit risk components and to avoid multiple cycles of extended implementation effort and significant cost.

Footnotes

 1 http://data.europa.eu/eli/reg_del/2018/171/oj

2 www.eba.europa.eu/regulation-and-policy/credit-risk/guidelines-on-the-application-of-the-definition-of-default

3 http://www.eba.europa.eu/documents/10180/2071742/EBA+BS+2017+17+%28Opinion+on+the+use+of+180+DPD%29.pdf

4 www.eba.europa.eu/documents/10180/1359456/EBA-Op-2016-01+Opinion+on+IRB+implementation.pdf.

5 https://www.bankofengland.co.uk/prudential-regulation/publication/2016/residential-mortgage-risk-weights

6 For a detailed understanding of the emerging implications of the Basel III final reforms, refer to our publication: Basel III – The calm before the reform

7 https://www.bis.org/bcbs/publ/d443.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions