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:
- Days Past Due /DpD/
- Materiality Thresholds for Days Past Due /DpD/: Absolute and relative materiality thresholds for counting Days Past Due until reaching the event of Default at 90 Days Past Due. /Retail: 1% relative and 100 euros absolute; Non-Retail: 1% relative and 500 euros absolute/ PRA Requirements: 0% relative and £0 absolute thresholds to minimize the operational impacts of changing the widespread practice of determining DpD from ‘Months in Arrears’
- The amounts Past Due represents the sum of all amounts Past Due, including all fees, interest, and principal. For the relative threshold, this amount is divided by the total off-balance exposure. In the event the principal is not repaid or refinanced when an interest only loan expires DpD counting starts from that date even if the obligor continues to pay interest.
- DpD Counting can be specifically stopped when the credit arrangement specifically allows the obligor to change the schedule, when there are legal grounds for suspended repayment and when the structure of the obligor entity changes due to a merger, acquisition or a similar event.
- Technical Defaults: False positives caused by Technical Issues, Missing or Limited Availability of Data to perform adequate Extrapolation for Forecasting techniques; System Errors; Implementation inconsistencies due to Deficiencies in Model Risk Adjustments; Data, Policies or Model related incoherencies and delays in recognizing payment.
- Removal of 180 Days Past Due: Following the EBA recommendation to remove the CRR option to use 180 DpD instead of 90 DpD /as applicable under the rules for residential and SME commercial real estate and exposures to public sector entities, ECB has removed this option for systemically important institutions /SIIs/ in the Single Supervisory Mechanism /SSM/
- Factoring and Purchased Receivables: In the event a factor does not recognize the receivables on the balance sheet, DpD Counting should start when the client account is in debit, otherwise DpD Counting should start when a single receivable becomes due.
- Unlikeliness to Pay Criteria /UTP/
- Non-Accrued Status: UTP will be triggered if the credit obligation is placed on non-accrued status under the applicable accounting framework,
- Specific Credit Risk Adjustment /SCRA/:
- Sale of Credit Obligation: It needs to be classified as defaulted if economic loss exceeds 5%
- Distressed Restructuring: Concessions extended to obligors with current or expected difficulties to meet their financial obligations need to be assessed to establish materiality. If the Net Present Value /NPV/ of the obligation decreases by more than 1% /or a lower threshold set by the institution, the obligation is considered defaulted.
- Bankruptcy: Clarification on arrangements to be treated similar to bankruptcy including but not limited to all arrangements in Annex A of Regulation /EU/ 2015/848 on insolvency proceedings. This includes arrangements involving the institution and arrangements the debtor currently holds wil third parties.
- Additional Indications of Unlikeness to Pay: Examples include fraud, significant increase in obligor leverage, significant delays in payment to other creditors, impaired credit history indicators, individual voluntary arrangements, expected worst statuses.
- Return to Non-Default Status
- Probation Periods: Minimum regulatory probation period of 3 months is required for all defaults with the exception of distressed restructurings, where a 1-year minimum probation period applies. Banks are required to monitor the behaviour of obligor in probation to support cure after the probation period expires. There is an option for banks to apply different probation periods as long as they meet the minimum requirement. In the event, the defaulted exposure is sold, the entity must ensure that the probation period requirements are applied to the new exposure with the same obligor.
- Monitoring Policy Effectiveness: Monitoring the effectiveness of the cure policy on a regular basis is required, including impact on cure rates and impact on multiple defaults. Extensive statistical analyses are implemented prior to the selection of adequate probationary periods for types of products ranging from Secured Collateralized Exposures to Unsecured Short or Revolving Lines of Credit.
- Other Significant Changes
- External data: When External Data is used for the estimation of Risk Parameters, the institution must document the DoD used in this external data, identify differences to the institution’s internal definition, and perform required adjustments in the external data for the differences identified, providing substantiated evidence such differences are immaterial
- Consistency in the Application of Default: Banks must ensure that the default of an obligor is identified consistently across IT systems, legal entities with the group, and geographical locations. In addition, financial institutions utilizing the IRB or A-IRB approach need to assess the materiality of impact on risk estimates on portfolio, segment, product and account level to the extent a granularity view is acceptable.
- Level of DoD Application: The Standards provide guidance of DoD application at facility and obligor level for retail exposures. In the event, the obligor defaults, all exposures related to the account level of this specific obligor default as well. In the circumstance, the default is observed at facility level, the institution should consider other UTPs to determine default of all exposures at obligor level.
- Timeliness of Default Identification: Institutions should rely on automated processes of identification of default on a daily basis. In addition, data quality assessment reconciliations should be performed to capture deviations between ‘Months in Arrears’ reporting and ‘Days Past Due’ as well as transformation requirements of delinquency indicators from obligor to facility level.
- Documentation: Banks must document all their internal DoDs, including generations of DoDs, structure, scope and triggers for defaults and cure. Furthermore, Banks must document how the default and cure logic is operationalized in detail, including governance, processes and information sources for each trigger.
- Internal Governance Requirements for IRB Banks: Additional Governance Requirements are introduced for Banks utilizing the IRB approach, including Model Risk Assessments and Internal Audit to regularly review the robustness and effectiveness of the process of identifying defaults.
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:
- Such payment deferrals are available to borrowers against the economic backdrop of wide scale, but in many cases temporary, loss of income related to lockdown measures.
- Some of the borrowers taking up payment deferrals will have financial difficulties that need to be recognized as a SICR or credit impairment. However, some will only have temporary liquidity issues that make it difficult for them to make the next few payments but do not have a significant impact on life-of-loan probability of default or the attributes consistent with a loan that is credit impaired.
Payment Deferrals and Significant Increase in Credit Risk/ Flow to Delinquency or Arrears
- Initial payment deferrals: Under the FCA’s guidance it has not been necessary to tailor the payment deferral to the individual financial circumstances of the borrower; Under PRA’s Guidance- payment deferrals should not automatically result in a loan being regarded as having suffered a SICR or becoming credit-impaired. In order to determine whether a SICR or credit impairment has occurred, firms will need to consider indicators other than the use of the payment deferral.
- Borrowers that resume full payments at the end of a payment deferral: The PRA would not expect the immediate resumption of full payments at the end of a Covid 19 related payment deferral to be regarded as an indicator of SICR or credit impairment for ECL purposes or default for CRR purposes. However, any payments on the revised schedule are missed, normal processes for identification of SICR, credit impairment and default would apply.
- Borrowers that do not resume full payments at the end of a payment deferral: Identifying whether a significant increase in credit risk or credit impairment has occurred for ECL purposes; Further payment deferrals do not automatically mean a SICR or credit impairment; nor should the assumption be that all the loans involved remain in stage 1: Specific indicators need to be re-assessed to determine borrower behaviour.
Significant Changes in Credit Risk as a Result of Covid 19- Credit Impairment Assessment Methodology:
- Payment history or utilization of credit limits on other products with the same borrower, including current account turnover.
- Adverse credit bureau payment scores consistent with arrears on other products or high indebtedness.
• The last known debt-to-income ratio, including consideration of economic conditions
- The last known industry or sector the borrower is in or exposed to (i.e. based on the original loan application).
- A determination whether the borrower is close to a SICR threshold based on loan-level PDs, after updating for economic scenarios
The list of Regulatory changes that impact the Measurement and Classification of Credit Risk are presented below:
- BCBS 239- Principles for Effective Risk Data Aggregation and Risk Reporting
- IFRS 9- Expected Credit Loss Methodology- ‘Initial and Further Payment Deferrals’ Amendments
- A-IRB Capital Framework Requirements; CRR/CRD IV; EBA Requirements for Estimates of PD, LGD and Defaulted Exposures under the Advanced Internal Ratings Based Approach (A-IRB) Guidelines.
- Basel III Adjustments: Liquidity Coverage Ratio /LCR/ and Net Stable Funding Ratio /NSFR/ for Off-Balance Sheet Restructurings
- Internal Capital Adequacy Provisions /ICAAP/Threshold for Capital coverage of Total Risk Exposure Amount (TREA)- Economic vs Normative Perspective Capital Adequacy allocation /regulatory funds requirement/
- Governance Credit Risk: Quantification of material risks, time horizon, diversification assumptions and confidence levels; Risk Management Framework and Post Model Adjustments- Management Buffers Requirements
- PRA Requirements: Re-assessment of Pillar 2A Capital Framework to incorporate additional resilience associated with higher Macro Prudential Buffer Requirements- Countercyclical Buffer Requirements /CCyB/ rate of 2% in standard risk environment
- PRA Requirements: Re-Evaluation of Pillar 2A Capital Adequacy Requirements for the Internal Capital Adequacy Assessment Process (ICAAP) aligned with new regulations to utilize fixed nominal amount irrespective of changes of Risk Weighted Assets (RWAs)
- Regulatory Guidance Updates ECB/ EBA– Default Trigger analysis (short-term vs long-term liquidity and solvency matrices): Margin of Conservatism adjustment requirements in PD and LGD flooring for Risk Weighted Assets (RWAs) evaluation /Capital requirements or Capital Adequacy Ratio- CAR/
- Low Default Portfolios Evaluation /Addendum/ Regulation EU EBA/ GL/ 2017. Article 16(3) Regulation EU No 1993/2010, Article 157, No 575/ 2013- Guidelines on PD, LGD Estimation and Treatment of Defaulted Exposures
- Compliance- Reporting Requirements, Calibration Approach /MoC/; ECB Guide for the Targeted Review of Internal Models /TRIM/; RWA Variability Reduction Requirements- Low Default Portfolio Adjustments; PD/ LGD Flooring; Correlation Coefficient Matrices; Capital Ratios adequacy