The views and opinions expressed in this article are those of the thought leader and not those of CeFPro.
By Maria Kostova, Credit Risk Specialist, European Central Bank
Can you provide any more on default definitions and requirements of the future?
As a subsequent response to the financial crisis, the European Banking Authority /EBA/ established tighter standards around the ‘Definition of Default’ /CRR Article 178/ to achieve greater alignment and a higher degree of comparability and consistency in Credit Risk Measurement and Capital Frameworks across Banking Institutions and Financial Entities. These requirements are subject to implementation by the end of 2020.
The New ‘Definition of Default’ Requirements concern how Banks specifically recognize credit defaults for prudential purposes and include quantitative impact analysis and new standards of materiality, in which number and timing of defaults affect the validity of existing models and processes via updated risk management practices and supporting pricing and accounting decisions related to the Expected Credit Loss Methodology /IFRS9/ and Capital Models /IRB and ICAAP/.
The Guidelines are extensive and detailed and challenge internal IT infrastructure, processes, analytical data engines, common Model Risk platforms, Model Deployment and execution and automated baseline architecture solutions. In addition, the new standards are detailed and prescriptive and have significant impact on Governance, Risk Management Framework Methodologies, Data Quality Assessments, Model Re-Calibrations and internal Management Policies and Approvals.
When evaluating the impact of the New ‘Definition of Default Changes’ a series of influencing factors are taken in consideration, such as the type of approach for estimating capital requirements / Standardized or Internal Ratings based Approach/, generations of implemented ‘Default Definitions’ and portfolio specifics.
The key changes are summarized below:
Across the EU, what impact do you foresee in credit risk as a result of Covid and regulatory change – can banks expect a storm of economic downturn, falling credit risk, substantial regulatory change?
In the inception of Quarter 1 in 2020, the effects of Covid 19 were observed across the European Union, United Kingdom and United States. In Europe, in particular Q1 is characterized by an increase in the Expected Default Frequency in the Corporate Sector / Please, refer to Exhibit 1/
Furthermore, Option Adjusted Spreads on Euro Area Corporate Bonds observed a spike in March, at the end of Q1, followed by a downward trend moving towards Q2. The Option Adjusted Spread /OAS/ is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is subsequently adjusted to take into account the embedded option. In this specific circumstance, embedded options quoted refer to Mortgage Backed Securities and the Option Adjusted Spread /OAS/ provide reference of the fixed income security’s cash flows to reference rates against market volatility. With the sharp increase in OAS, partially accounting for the portion of systematic risk, as a market component that could not be diversified. Exhibit 2 provides insight into the variability of interest rates and the prepayment behaviour of mortgage borrowers compared to the ‘Yield to Maturity’ /YTM/ on a Benchmark Security, or a Treasury Security with similar maturity plus a premium or a spread above the risk free rate to compensate investors for the added risk.
Quarter 1 and Quarter 2 in 2020 are characterized by increasing volatility of fixed-income security with embedded options. In other words, uncertainty arising from unprecedented volatility due to changes in interest rates and prepayment risk is reflecting the rise in Credit and Market Risk. The shortfall of this approach is that OAS estimates are derived from historical data and do not factor in cyclical market adjustments, as in the event of Covid 19, capital markets signals are expected to converge into trends of V-shaped recovery due to the sequence of Regulatory Change and Policy Improvements.
Moving forward, these fluctuations are forecasted to level off the cyclicality of the economic downturn at the inception and midyear capital horizon of 2021. Volatility in the capital markets is an example of the ‘uncertainty’ prevailing post adoption of the series of Monetary and Financial Economic Policy changes, with the lags primarily observed in the European Markets and counter-cyclical adjustments of Negative Interest Rates noted in the UK.
As a final comment, quantification of credit risk has been impacted via transitory changes in the risk appetite and market conditions, characterized by volatility and uncertainty, adaptations in the balance sheet management techniques and interest rate environment fluctuations with increasing long term funding requirements. Optimization of internal Risk Management Frameworks have been transformed to leverage market wide and idiosyncratic stress elements resulting in capital induced liquidity buffers and management buffers to accommodate Risk Weighted Assets Variability and unexpected credit losses.
Exhibit 1: Expected Default Frequency in the Corporate Sector /ECB Research and Statistics Database
Exhibit 2: ECB Statistics- Option Adjusted Spreads on Euro Area Corporate Bonds /ECB Research and Statistics Database/
Negative Interest rates in the UK
For fixed-rate Mortgages, negative interest rates will not have a direct impact on monthly mortgage payments, however for Standard Variable /SVR/ Rate Mortgage Products to which a Fixed Term Mortgage is typically converging towards the end of the product, the rate could decrease with the base rate decline.
The Bank of England cites the institution of negative interest rates as a means to speed up economic recovery, however this might impact personal deposits and regular funds storage in the banking system. Concerns prevail that job losses might push the unemployment rate beyond the bank’s forecast of 7.5% by the end of the year as GDP and labour market indicators currently stand at levels below historically observed for a recession.
With the anticipated LIBOR transition to SONIA, current market factors have raised concerns whether capital conditions are prepared for the new Risk-Free Rates. According to the Bank of England and ICE Benchmark Administration Guidelines the transfer is required to measure the Risk Free Rate on Sterling Short-Term Wholesale Funds, with the trimmed mean calculated as the volume weighted- mean rate, based on the central 50% of the volume-weighted distribution of rates. SONIA has been selected as the ’Risk Free Rates’ alternative based on evaluation of the Bank Rate predictability, representing an overnight rate, set in arrears and based on actual transactions in overnight index swaps /OIS/ discounting methodology, divided by 360 and added to 1. The transition to SONIA will impact the General Methodology for ‘Hedging of Internal Credit Component and Economic Value Transfer Risk Mitigation’ and the Bank Credit Risk Component’ Framework including ‘Contractual Fallback Provision.’
What regulatory changes, including Basel 4, will impact measurement and management of credit risk?
A direct impact of Covid 19 and substantially on the measurement of Credit Risk has been observed with the implementation of the New Guidance of ‘Initial and Further Payment Deferrals’ which specifies a key theme in the March accounting guidance on measurement and quantification of payment deferrals that impact the contractual terms of the loan and the borrower’s capacity to fulfil a credit obligation. The recent guidance stipulates that a request for a payment holiday would not typically be regarded as an indicator of Significant Increase in Credit Risk /SICR/ or credit impairment for ECL, if substantiated information is available on the obligor level to demonstrate a temporary credit deterioration. /IFRS 9 Requirements for Forward Transitions apply in classification of exposures as Performing, Significantly Deteriorated or Credit Impaired based on changes of Behaviour Risk during lifetime of the loan since origination/
The link between a payment deferral and SICR and credit impairments is not as strong in the case of the Covid-19 related payment deferrals, because:
Payment Deferrals and Significant Increase in Credit Risk/ Flow to Delinquency or Arrears
Significant Changes in Credit Risk as a Result of Covid 19- Credit Impairment Assessment Methodology:
The list of Regulatory changes that impact the Measurement and Classification of Credit Risk are presented below:
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