Chapter 4 Credit risk internal ratings based approach

credit risk definition

As the PRA proposes to remove AIRB modelling for exposures to institutions, the combined effect of these proposals would be that the AIRB approach would be removed for all exposures to regional and local governments, PSEs, MDBs, and international organisations that are assigned a 0% risk weight under SA. The PRA considers that this is appropriate due to the difficulty of modelling LGD and EAD for these exposures. 4.272 The PRA considers that the different changes proposed in this section would potentially have different impacts on competition but it does not expect that the proposals to adversely impact the facilitation of effective competition overall. 4.249 The PRA proposes to require the use of the alternative methodology if a firm is using the LGD modelling collateral method to recognise the effect of collateral and does not have sufficient data to model the effects of the collateral. The PRA proposes to set an expectation that the data would be considered insufficient where firms have fewer than 20 relevant data points for any non-financial collateral that the firm wishes to recognise in their LGD models.

  • However, the CRR also sets out a number of exceptions to this requirement, including that the treatment of the guarantees could be reflected in an adjusted obligor grade assignment.
  • The PRA also proposes to clarify that collateral that does not meet these requirements should be classed as ‘ineligible’ for the purpose of applying the LGD modelling collateral method.
  • 4.158 As set out in Chapter 13, the PRA has proposed a methodology for redenominating certain references to Euros (EUR) and US Dollars (USD) into Pound Sterling (GBP) in the PRA rules proposed in this CP.
  • The quantification of credit risk is the process of assigning measurable and comparable numbers to the likelihood that a borrower won’t repay a loan or other debt.
  • Those include the financial health of the borrower, the severity of the consequences of a default (for both the borrower and the lender), the size of the credit extension, historical trends in default rates, and a variety of macroeconomic considerations, such as economic growth and interest rates.

Optimally, the exercise should be undertaken both from a risk function and business perspective, helping ensure that risks are managed and value realized across the institution. To adapt to deepening uncertainty, leadership teams can benefit from developing a set of “prebaked” actions that can be implemented at short notice. Aligning in advance also allows for more creativity than decisions made at the spur of the moment, and will enable more clinical execution when required. Creating a longer horizon of predictability is no simple task, but it can help to break performance down into groups of significant drivers and assess relevant trends both at portfolio and obligor levels.

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The PRA consults on proposals for implementation…

4.52 The PRA proposes to restrict the scope of the ‘central governments and central banks’ exposure class to only include exposures to central governments and central banks. Under the CRR, some exposures to regional governments and local authorities, public sector entities (PSEs), multilateral development banks (MDBs), and international organisations can be assigned to this exposure class. 4.20 The PRA considers that these changes would improve the robustness of modelled risk weights and their timely implementation would promote the safety and soundness of firms and improve competition between SA and IRB firms. 4.13 Implementation of the PRA’s proposals relating to the IRB approach would require a number of changes to firms’ IRB models.

The PRA considers that it is challenging for firms to produce robust EAD models for issued off-balance sheet items given the lack of relevant data available. In contrast, the PRA considers that the benefits of continuing to allow modelling of revolving commitments in the form of revolving loan facilities outweigh the disadvantages as the SA is less able to capture the dynamics of flexible drawdowns. In order to apply either of these methods, it would be necessary for firms using the AIRB approach to estimate LGD values for the exposures as if there were no UFCP.

Regulatory Technical Standards on assessment methodology for IRB approach

This corresponds to a condition already in place in the PRA’s wholesale LGD framework (which the PRA proposes to remove as set out later in this section). The PRA does not propose to set an equivalent expectation for financial collateral, in line with its existing approach. 4.208 The proposed flat 5% LGD floor for retail residential mortgage exposures would be consistent with the floor that the PRA currently expects firms to apply to these exposures.

IFRS includes specific requirements related to credit risk management, such as the impairment model introduced in IFRS 9, which requires financial institutions to recognize credit losses based on expected credit losses rather than incurred losses. Credit risk focuses on the development of BTS, Guidelines and Reports regarding the calculation of capital requirements under the Standardised Approach and IRB Approach for credit risk and dilution risk in respect of all the business activities of an institution, excluding the trading book business. The objective is to provide a consistent implementation across the EU of the provisions related to topics such as credit risk adjustments, definition of default, permission to use Standardised/IRB approach, appropriateness of risk weights or credit risk mitigation techniques.

Table 2: Proposed unsecured and retail residential mortgage LGD floors

4.240 In addition, there is currently some ambiguity in the CRR regarding whether firms using the AIRB approach have the option to disregard eligible collateral. This is because firms are required to use ‘all relevant information’ when developing their models. 4.237 The PRA therefore proposes to align with the Basel 3.1 standards and reduce the FIRB LGD value for exposures to non-financial corporates that are senior claims to 40%. The PRA does not propose to change the existing 45% FIRB LGD value for exposures to financial corporates that are senior claims. 4.236 Firms using the FIRB approach currently apply a 45% LGD for all unsecured exposures to corporates that are senior claims. The Basel 3.1 standards reduce the FIRB LGD value for these exposures from 45% to 40%, with the exception of exposures to financial corporates where the FIRB LGD remains at 45%.

credit risk definition

4.218 The PRA has observed that, for PD estimation, continuous rating scales are used relatively infrequently by firms, and that most firms adopt discrete rating scales in their hybrid mortgage model applications. 4.176 The PRA considers that the proposals on IRB model governance and validation align with the Basel 3.1 standards, and the PRA considers that the proposals do so in a proportionate way that would increase clarity for firms. 4.164 This section sets out the PRA’s proposals relating to general requirements for use of the IRB approach. 4.108 There are currently no restrictions on the permanent partial use of the FIRB approach, except where firms wish to revert to a less sophisticated approach. As a result, there is a potential risk that firms may engage in ‘cherry-picking’ and select portfolios to remain on the FIRB approach in order to lower their RWAs. 4.33 The PRA considers that this is not proportionate and places firms seeking IRB approval (‘IRB aspirants’) at a competitive disadvantage relative to firms with IRB approval.

Importance of Credit Risk Management

This is to reduce undesirable volatility in risk weights arising from the introduction of the proposed transitional arrangements. 4.82 The PRA recognises that the proposed transitional arrangements could nevertheless still result in some volatility in RWAs which it considers would be undesirable. To mitigate this risk, the PRA proposes to allow firms the option to ‘opt-out’ of the IRB equity transitional arrangements entirely and to move to the final SA risk weights for all equity exposures at any point before or during the transitional period by notifying the PRA. The PRA proposes that in these circumstances firms would not be able to revert back to the transitional arrangements. 4.68 Specifically, the PRA considers that some of the BCBS’s concerns regarding low default portfolios also apply to central government and central bank exposures, including a lack of modellability and an insufficient comparative advantage of firms relative to regulators in assessing the risk.

credit risk definition

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