Amongst mortgage lenders, variations in banks' Risk Weighted
Assets (RWAs) are observed in the market. This information is
published in firms' Pillar 3 disclosures, as well as by the
Prudential Regulation Authority (PRA). As an example, in January
2015 the PRA reported performing risk weights ranging from 10.8% to
14.6% for performing residential mortgages with 70%-80% Loan To
Value (LTV) amongst firms using the Internal Ratings Based (IRB)
approach to calculating RWAs. The variations lend credence to a
distrust of banks' internal models by regulators, shareholders
and the general public.
The PRA has issued Consultation Paper CP29/16, in which updates
to Supervisory Statement 11/13 (SS11/13) are proposed. CP29/16
expands the PRA's expectations of compliant approaches, with
key points including:
The PRA believes that Point In Time
(PIT) Probability of Default (PD) models do not adequately reflect
the long term nature of mortgage lending, and so proposes that
banks should not use PIT models for mortgages.
The PRA believes that Through the
Cycle (TTC) PD models are not able to differentiate between
cyclical and non-cyclical (e.g. internal policy and process
changes) changes in default risk, and so proposes that banks should
not use TTC PD models for mortgages.
The PRA proposes that firms
incorporate the 1990s recession into their mortgage PD model
calibration and cyclicality assessments.
The PRA proposes a 30% cap on the
level of cyclicality assumed in mortgage PD models.
The PRA proposes a 25% floor on
peak-to-trough house price falls assumed in mortgage LGD
The consultation comes at a time when many firms' mortgages
IRB models are reaching the end of their service life, but are also
used for a wide variety of internal applications including debt
pricing and estimation of credit losses for IFRS 9. If incorporated
into the next update of SS11/13, action is likely to be required by
all IRB mortgage lenders, lenders with IRB aspirations, and
standardised lenders with proxy-IRB Pillar 2 models. Although IRB
firms are likely to take the opportunity to critically revalidate
their mortgages RWA models, the potential downstream impacts are
likely to complicate the scope and scale of remediation activity,
as well as influence firms' solution designs.
The PRA has requested responses by 31 October 2016.
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