Length of the historical observation period
When assessing the length of the period used for LGD estimation for the purpose of point (j) of paragraph 1 and subparagraph 2 of paragraph 2 of Article 181 of Regulation (EU) No 575/2013 and Delegated Regulation (EU) 2017/72, (‘historical observation period’), competent authorities shall verify that:
(a)
the length of the historical observation period covers at least the minimum length in accordance with the requirements laid down in paragraph 1(j) and the second subparagraph of paragraph 2 of Article 181 of Regulation (EU) No 575/2013 and, where applicable, Delegated Regulation (EU) 2017/72;
(b)
where the available historical observation period is longer than the minimum period according to point (j) of paragraph 1 of Article 181 and subparagraph 2 of paragraph 2 of Article 181 of Regulation (EU) No 575/2013 for a data source, and the data obtained from it are relevant for the LGD estimation, that the information for that longer period is used;
(c)
for retail exposures, where the institution does not give equal importance to all historical data used, that this is justified by better prediction of loss rates and that a zero or very small weight applied to a specific period is either duly justified or leads to more conservative estimates.
Method of LGD estimation
When assessing the method of own-LGD estimation, as referred to in Article 181 of Regulation (EU) No 575/2013, competent authorities shall verify that:
(a)
the institution assesses LGD by homogenous facility grade or pool;
(b)
the average realized LGD by facility grade or pool is calculated using the number of default weighted average;
(c)
all observed defaults within the data sources are used, in particular that the incomplete recovery processes are taken into account in a conservative manner for the purposes of LGD estimation, and that the choice of workout period and methodologies for estimating additional costs and recoveries after and, where necessary, during that period, are relevant;
(d)
the LGD estimates of secured exposures are not solely based on the estimated market value of the collateral and that they take into account the realised revenues from past liquidations and the potential inability of an institution to gain control of the collateral and liquidate it;
(e)
the LGD estimates of secured exposures take into account the potential decreases in collateral value from the point of time of LGD estimation to the eventual recovery;
(f)
the degree of dependence between the risk of the obligor and that of the collateral as well as the cost of liquidating the collateral are taken into account conservatively;
(g)
any unpaid late fees that have been capitalised in the institution’s income statement before the default are added to the institution’s measure of exposure and loss;
(h)
the possibility of future drawings after the default is taken into account appropriately;
(i)
all of the following aspects are appropriate for the type of exposures to which they are applied:
(i)
the functional and structural form of the estimation method;
(ii)
the assumptions regarding the estimation method;
(iii)
the estimation method for a downturn effect;
(iv)
the length of data series used;
(v)
the margin of conservatism;
(vi)
the use of the human judgement;
(vii)
where applicable, the choice of risk drivers.
Treatment of multiple defaults
For the treatment of obligors that default and recover several times in a limited period of time as defined by the institution (‘multiple defaults’), competent authorities shall assess the adequacy of the methods used by the institution and shall verify that:
(a)
explicit conditions are defined before a facility is considered to have returned to a non-default status;
(b)
multiple defaults identified within a period of time specified by the institution are considered to be a single default for the purpose of LGD estimation, using the default date of the first observed default as the relevant default date and considering the recovery process from that date until the end of the recovery process after the last observed default in this period;
(c)
the length of period within which multiple defaults are recognised as a single default is determined taking into account the institution’s internal policies and analysis of the default experience;
(d)
defaults used for the purpose of PD and conversion factors estimation are treated consistently with defaults used for the purpose of LGD estimation.
Use of LGD estimates appropriate for economic downturn
When assessing whether the requirement to use LGD estimates that are appropriate for an economic downturn as laid down in point (b) of Article 181(1) of Regulation (EU) No 575/2013 is fulfilled, competent authorities shall verify that:
(a)
the institution uses LGD estimates that are appropriate for an economic downturn, where those are more conservative than the long-run average;
(b)
the institution provides both long-run averages and LGD estimates appropriate for an economic downturn for justification of its choices;
(c)
the institution applies a rigorous and well documented process for identifying an economic downturn and assessing its effects on recovery rates and for producing LGD estimates appropriate for an economic downturn;
(d)
the institution incorporates in the LGD estimates any adverse dependencies that have been identified between on the one hand selected economic indicators and on the other hand the recovery rates.
LGD, ELBE and UL estimation for exposures in-default
1. When assessing the requirements for LGD estimates for the exposures in default, and for the best estimate of expected losses (‘EL BE
’) as referred to in Article 181(1)(h) of Regulation (EU) No 575/2013, competent authorities shall verify that the institution uses one of the following approaches and shall assess the approach used by the institution:
(a)
direct estimation of the LGD for defaulted exposures (‘LGD in-default’) and direct estimation of ELBE;
(b)
direct estimation of ELBE and estimation of the LGD in-default as the sum of ELBE and an add-on capturing the unexpected loss related to exposures in default that might occur during the recovery period.
2. When assessing the approach of the institution in accordance with paragraph 1, competent authorities shall verify that:
(a)
the LGD in-default estimation methods, either as a direct estimation or as an add-on to ELBE, take into account possible additional unexpected losses during the recovery period, and in particular consider possible adverse changes in economic conditions during the expected length of the recovery process;
(b)
the LGD in-default, either as a direct estimation or as an add-on to ELBE, and the ELBE estimation methods take into account the information on the time in- default and recoveries realised so far;
(c)
where the institution uses a direct estimation of the LGD in-default, the estimation methods are consistent with the requirements of Articles 47, 48 and 49;
(d)
the LGD in-default estimate is higher than the ELBE, or, where the LGD in- default is equal to the ELBE, that for individual exposures such cases are limited and duly justified by the institution;
(e)
the ELBE estimation methods take into account all currently available and relevant information and in particular consider current economic circumstances;
(f)
where the specific credit risk adjustments exceed the ELBE estimates the differences between the two are analysed and duly justified;
(g)
the LGD in-default, either as a direct estimation or as an add-on to EL BE , and the EL BE estimation methods are clearly documented.
Requirements on collateral management, legal certainty and risk management
When assessing whether the institution has established internal requirements for collateral management, legal certainty and risk management which are generally consistent with those set out in Chapter 4, Section 3 of Regulation (EU) No 575/2013, as referred to in Article 181(1)(f) of that Regulation, competent authorities shall verify that at least the policies and procedures of the institution relating to the internal requirements for collateral valuation and legal certainty are fully consistent with the requirements of Section 3 of Chapter 4 of Title II in Part Three of Regulation (EU) No 575/2013.
Source: EUR-Lex (Publications Office of the EU), © European Union, reuse permitted under Commission Decision 2011/833/EU.
