The European Banking Authority (EBA) launched a consultation on its draft Regulatory Technical Standards on assessment methodology for internal ratings-based approach. These draft RTS are a key component of the EBA's work to ensure consistency in models outputs and comparability of risk-weighted exposures and will contribute to harmonize the supervisory assessment methodology across all EU Member States. The consultation runs until 12 March 2015.

1. EuropeanBankingAuthorityRTS on AssessmentMethodologyfor IRB approach
November 26, 2014
Stephanie Baruksbaruk@chappuishalder.com

2. 2
RTS on Assessment Methodology for IRB approachCommon standards to assess the compliance with the requirements to use the IRB Approach
Almost all Member States are mostly/fully compliant with the content of the draft RTS therefore the expected costs are expected to be somewhat negligible at the EU level
Source: EBA analysis
Common standards toestablish a harmonized regulatory framework

On 12 November 2014, EBA launched a consultation on its draft Regulatory Technical Standards (RTS) on assessment methodology for the internal ratings-based (IRB) approach under the CRR. The RTS will replace the CEBS “Guidelines on the Implementation, Validation and Assessment of Advanced Measurement (AMA) and Internal Ratings Based (IRB) Approaches” (GL-10 CEBS, issued in 2006).

Deadline for submission of comments is 12 March 2015.

The objective of the draft RTS is to establish a harmonized regulatory framework by introducing a set of criteria and methods that competent authorities must use in the IRB Approach assessment applied by the institution for the purpose of own funds requirements calculation.

It aims to provide authorities with more information in terms of benchmarking and cross-jurisdiction comparison when they assess the robustness, consistency and accuracy of the rating systems used by the institutions.

The proposeddraft RTS have been mapped into 14 chapters with the following main features and changes:
−
Governance| Further clarification is provided on the independence of validation function from the credit risk control unit
−
LGD estimates| Own-LGD estimates should be calculated as the average based on the number of defaults, i.e. default-weighted average
−
IRB shortfall| The calculation of the difference between expected loss amounts and credit risk adjustments that should be performed on an aggregate level separately for the portfolio of defaulted and non- defaulted exposures

3. 3
RTS on Assessment Methodology for IRB approach14 chapters to harmonize the regulatory framework (1/2)
•
Institutions will be evaluated according to the proportionality principle (depending on the nature, size and complexity)
•
Ensure the quality and auditability of the documentation
•
In case of outsourced processes, validate that controls are adequately implemented to ensure continuity of the processes
GeneralRules
1
•
Roll-out plan to be further documented with at least the scope of application of each rating system, the planned dates of implementation and the information about the current exposure values and RW exposures amounts
•
Stricter monitoring of the roll-out plan is expected, any change will have to be approved
Implementation Plan & Permanent Partial Use
2
•
Governance, management and resources of the Credit Risk Control Unit to be reviewed
•
Ensure adequate level of independence between the validation function and credit risk control unit that is responsible for the development of the models
•
Carry out backtestingof each rating system at least annually
•
Ensure all areas of IRB approach are covered by internal audit plans
Internal Governance and Validation
3
•
Same data and parameters to be used in the internal risk management and decision making processes, any differences in the relevant data and risk estimates have to be properly justified
•
Experience testing period of three years needs to be documented
Use Test and Experience Test
4
•
Ensure an independence of the assignment of exposures to grades and pools from the origination or renewal of exposures
•
If ratings are older than 12 months, or if the review of the assignment hasn’t been performed in due time, conservative adjustments should be performed in terms of RWA calculation
Assignment of Exposures to Grades and Pools
5
•
Provide documentation on the definition of default, especially differences between various types of exposures, legal entitiesor geographical locations
•
Set up robust criteria and processes to reclassify previously defaulted exposures back to a non-defaulted status
Definition of Default and Loss
6
•
Provide a map of rating systems (including all current and past versions for a period of at least 3 years)
•
Properly document model capabilities and limitations, control and justify the application of human judgment
Design, operational details and documentation of the rating systems
7
Chapter
EBA expectations / Impactsfor financial institutions

4. 4
RTS on Assessment Methodology for IRB approach14 chapters to harmonize the regulatory framework (2/2)
•
Reinforce controls on the data used: data to reflect the definition of default, sufficient length of the historical observation is requested, margin of conservatism will be appreciated by the authorities
•
LGD estimates to be based on the average weighted by the number of defaults, LGD in-default to take into account possible reverse changes in economic conditions during the recovery period
•
Treat multiple defaults of the same obligor in a similar manner
RiskQuantification
8
•
Ensure robustness of the process of assigning exposures to exposure classes: first, based on the characteristics of the transaction then on the characteristics of the obligor. Other exposures will be classified as corporate exposures
Assignment of Exposures to Exposure classes
9
•
Integration of the stress tests with the risk and capital management processes
•
Default rates and rating migrations under stress conditions should be taken into account in the assessment of the adequacy of the calculation of the long-run averages of one-year default rates and the dynamics of rating systems
Stress Tests Used in Assessment of Capital Adequacy
10
•
Set up a reconciliation between the data used for the purpose of own funds requirements calculation with the accounting data and values of risk parameters used for internal purposes
•
Ensure correctness of the assignment of risk parameters (e.g. maturity to be based on expiry date)
•
Perform the calculation of the difference between expected loss amounts and credit risk adjustments on an aggregate level separately for the portfolio of defaulted and non-defaulted exposures
Own Funds Requirements Calculation
11
•
Ensure proper and regular data quality assessment and monitoring
•
Provide detailed documentation on the IT infrastructure related to gathering and storing the information as well as the relevant procedures
Data Maintenance
12
•
Use non-overlapping observations of returns on equity exposures both for the purpose of development as well as validation of internal models to ensure higher quality of predictions
Requirement for Equity Exposures under the Internal Models Approach
13
•
Notify and submit for approval any material changes to the rating systems
•
Implement and document the policy to define the classification of the changes and the related internal processes to manage them
Management of changes to the rating systems
14
Chapter
EBA expectations / Impactsfor financial institutions

5. 5
EBA Main Objectives
Implications for the Financial Institutions

Launch a gap analysis between the proposed RTSand the GL10 issued in 2006

Assess the impactson governance, internal models, processes and documentation

Set up working groupsand prepare a response to the EBA

Establish a clear work plan with all the stakeholders (top management, risk, finance, compliance) prioritising quick wins while planning medium and long term projectsto meet the new requirements
Next Steps
Governance and Validation
Independence of the validation function on the basis of proportionalityprinciple to:

Ensure an objective assessment of the ratingsystems and limited pressure on the results of the validation

Allow for objective and robust view on the rating systems by staff that is not involved in the development process

Structure, governance, staffing and processes of the Credit Risk Control Unit and Validation functions need to be reviewed

Redevelopment of LGD models may be necessary to comply with the rule on weighted average of LGD

Assignment of exposures to grades and pools may lead to the increase of own fund requirements

Recovery of historical information and data may be needed in order to improve or complete the documentation

Enhancement of IT systems and improvement of data management practices are expected

Improvement of the quality and auditability of the documentation will be crucial
1
Weighted Average of LGD
Calculate the weighted average of LGD by the number of defaults rather than exposure weighted to:

Ensure consistency with PD calculation

Facilitate segregation or risk differentiation of LGD

Avoiddisproportionate effects of a few big defaults on LGD
2
Calculationof the IRB Shortfall
Calculationof the IRB shortfall separately for the defaulted exposures and non-defaulted exposures portfolios to:

Ensure that negative amounts resulting from the calculation for the defaulted portfolio are not used to offset the positive amounts linked to non defaulted portfolios
3
RTS on Assessment Methodology for IRB approachHow to prepare

6. MONTREAL
202 –1819 BdRene Levesque O.
Montreal, Quebec, H3H2P5
PARIS
25, rue Alphonse de Neuville
75017, Paris, France
NIORT
19 avenue Bujault
79000 Niort, France
NEW YORK
1441 BroadwaySuite 3015, New YorkNY 10018, USA
SINGAPORE
Level 25, North Tower,
One Raffles Quay, Singapore 048583
HONG KONG
905, 9/F,
KinwickCentre 32 Hollywood Road,
Central, Hong Kong
LONDON
Palladia
60 Lombard street
London EC3V 9EA, UK
GENEVA
Rue de Lausanne 80CH 1202 Genève, Suisse