Assessment of default probabilities
Article 48
1. When assessing an institution’s compliance with Article 325bi(1), point (e), of Regulation (EU) No 575/2013 in relation to the requirements on the estimation of default probabilities, competent authorities shall verify whether the internal documentation covers all aspects laid down in Article 5 of Delegated Regulation (EU) 2023/1578, and whether the institution’s internal policies require the production of an up-to-date inventory specifying: (a) the methods that the institution uses to estimate default probabilities, including the materiality of each different method in terms of number of issuers, size of positions, and contribution to the default risk own funds requirements; (b) for each issuer, the default probability value, the rating, where available, and whether: (i) the default probability is available under the IRB approach for a non-trading book exposure of the issuer, and whether it is used for the trading book exposure as required by Article 325bp(5), point (d), of Regulation (EU) No 575/2013; (ii) the default probability is not available under the IRB approach for a non-trading book exposure of the issuer, and whether the institution employs the IRB approach to obtain the issuer’s default probability as required by Article 325bp(5), point (d), of Regulation (EU) No 575/2013, on the basis that the institution has the IRB approval for the exposure class to which the exposure of the issuer belongs; (iii) the default probability is not available under the IRB approach for a non-trading book exposure of the issuer, and whether the institution uses an internal methodology fulfilling the requirements of the IRB approach laid down in Article 1(1) of Delegated Regulation (EU) 2023/1578 to obtain that default probability; (iv) the default probability is not available under the IRB approach for a non-trading book exposure of the issuer, and whether the institution uses an internal methodology fulfilling the requirements laid down in Article 1(3) or (4) of Delegated Regulation (EU) 2023/1578 to obtain that default probability; (v) the default probability is not available under the IRB approach for a non-trading book exposure of the issuer, and whether the institution uses external sources as referred to in Article 2 of Delegated Regulation (EU) 2023/1578 to obtain that default probability; (c) for all issuers, the exposure class referred to in Article 147(2) of Regulation (EU) No 575/2013 to which their exposure belongs; (d) for issuers for which an estimate of default probability is obtained by using external sources as referred to in Article 2 of Delegated Regulation (EU) 2023/1578, whether the estimate is obtained in combination with current market prices as referred to in Article 325bp(5), point (c), of Regulation (EU) No 575/2013 and Article 2(4), point (b), of Delegated Regulation (EU) 2023/1578. 2. When assessing whether an institution’s internal model is implemented with integrity as required by Article 325bi(1) of Regulation (EU) No 575/2013 in relation to requirements on the estimation of default probabilities, competent authorities shall: (a) verify whether: (i) default probability estimates and the data inputs used to derive them are updated at a frequency that ensures that the own funds requirements for default risk are risk-sensitive; (ii) any new relevant information is reflected timely, as required by Article 325bp(4) of Regulation (EU) No 575/2013; (b) by using the inventory referred to in paragraph 1 of this Article, verify whether all estimates are floored as required by Article 325bp(5), point (a), of Regulation (EU) No 575/2013; (c) verify whether any method used for scaling a default probability to the applicable time horizon referred to in Article 325bp(5), point (b), or Article 325bn(3) of Regulation (EU) No 575/2013, is conceptually sound and whether such method is supported by robust analysis; (d) verify whether: (i) where the institution estimates the default probability using the method referred to in paragraph 1, points (b)(iv) and (b)(v), the definition of default used by the institution for issuers in the scope of the internal default risk model is documented in the institution’s internal policies; (ii) whether material differences to the definition of default used in the IRB framework are identified; (e) assess whether and how extreme declines in market prices as referred to in Article 325bp(5), point (c), of Regulation (EU) No 575/2013 are considered when the institution determines the estimates of default probabilities and whether and how those declines relate to the credit worthiness of an issuer; (f) for default probabilities that are obtained in accordance with paragraph 1, points (b)(i) to (b)(iii), of this Article verify whether those default probabilities take into account the margin of conservatism referred to in Article 179(1), point (f), and Article 180(1), point (e), of Regulation (EU) No 575/2013; (g) for default probabilities that are obtained in accordance with paragraph 1, point (b)(i): (i) verify whether any additional levels of conservatism applied to the default probabilities under the IRB approach are applied when the default-risk requirement is calculated; (ii) on a sample of issuers, verify whether the default probability used in the IRB approach does not differ from the one used in the calculation of the default risk requirement; (h) for default probabilities that are obtained in accordance with paragraph 1, point (b)(ii): (i) verify whether the process to estimate the default probability under the IRB approach is followed; (ii) on a sample of issuers, verify whether the default probability used is identical to the one that would be produced by the IT systems used under the IRB approach; (iii) assess input variables used in the rating process in the IRB approach and verify on a sample of issuers whether the data inputs exist and are sufficiently reliable to determine an accurate default probability; (i) for default probabilities that are obtained in accordance with paragraph 1, point (b)(iii), of this Article review the reports produced by the internal validation or the internal audit regarding the compliance of the internal methodology used to obtain the default probabilities with Part Three, Title II, Chapter 3, of Regulation (EU) No 575/2013; (j) for default probabilities that are obtained in accordance with paragraph 1, point (b)(iv): (i) verify whether the internal documentation supporting the compliance of the institution with the conditions laid down in Article 1(2) of Delegated Regulation (EU) 2023/1578 is complete; (ii) on a sample of issuers, assess the rationale for estimating the default probability by using neither the internal methodology referred to in Article 1(1) of Delegated Regulation (EU) 2023/1578, nor the external sources referred to in Article 2 of that Delegated Regulation; (iii) on a sample of issuers for which the rationale referred to in point (ii) relates to the lack of input data as referred to in Article 1(2), point (b)(i), of Delegated Regulation (EU) 2023/1578, verify whether the institution substantiates the fact that the input data are missing; (iv) verify whether, as part of its internal policies, the institution specifies the holding period referred to in Article 1(2), point (b)(ii), of Delegated Regulation (EU) 2023/1578, below which the institution deems acceptable not to use the internal methodology meeting the requirements set out for the IRB approach, and assess whether such holding period fits with the institution’s portfolio, in terms of size, complexity and trading strategy; (v) review the value of ‘m’ calculated in accordance with Article 1(5) of Delegated Regulation (EU) 2023/1578 and, where applicable, require the institution to explain the source of any significant changes in its value over the previous quarters; (vi) review the process followed by the institution to investigate whether any additional external sources are available as referred to in Article 1(2), point (c)(ii)(1), of Delegated Regulation (EU) 2023/1578; (vii) for a quarter where the value of ‘m’ is higher than 10 %, verify that the analysis performed in accordance with Article 1(2), point (c)(ii)(2), of Delegated Regulation (EU) 2023/1578 is robust; (viii) assess whether the determination of the default probability referred to in Article 1, (3) and (4) of Delegated Regulation (EU) 2023/1578, is performed correctly, by using the inventory referred to in paragraph 1 of this Article, and verify whether the institution updates the highest default probability assigned to investment grade issuers and the equally weighted average of default probabilities. as referred to Article 1(3), points (a) and (b), of Delegated Regulation (EU) 2023/1578, respectively, with the same frequency at which the default risk requirement is calculated; (k) for default probabilities that are obtained in accordance with paragraph 1, point (b)(v): (i) on a sample of issuers, verify whether the data used to estimate the default probability are representative for the issuer; (ii) verify whether the hierarchy of external sources referred to in Article 2(3) of Delegated Regulation (EU) 2023/1578 is well specified in the institution’s internal documentation and verify on a sample of issuers whether that hierarchy of external sources is implemented correctly; (iii) verify whether the methodology employed by the institution to obtain the expected range of estimation errors as referred to in Article 2(4), point (a)(i), of Delegated Regulation (EU) 2023/1578 is sound; (iv) assess how the institution ensures that the requirements laid down in Article 2(4), point (a), of Delegated Regulation (EU) 2023/1578 are fulfilled, and verify whether there are cases of default probabilities set at 0 before the institution applies the floor referred to in Article 325bp(5), point (a), of Regulation (EU) No 575/2013; (v) where applicable, verify whether the method that the institution uses to transform default probabilities that are obtained in combination with current market prices into a real-world probability is sound, and whether the analysis referred to in Article 2(4), point (b), of Delegated Regulation (EU) 2023/1578 is robust. For the purposes of point (a), competent authorities may, where appropriate: (a) identify issuers for which the estimated default probability has not changed for an extensive period; (b) assess whether the default probability estimates are up-to-date; (c) verify whether the institution can explain the reasons behind the unchanged values. For the purposes of point (b), competent authorities shall analyse the materiality and the characteristics of the positions subject to the floor, including their rating and exposure class. For the purposes of point (c), competent authorities shall: (a) identify the effective time horizon that is used before applying any scaling to obtain the applicable time horizon; (b) assess the rationale for using, as a starting point of the scaling, a different time horizon than the time horizon that is applicable in accordance with Article 325bp(5), point (b), or Article 325bn(3) of Regulation (EU) No 575/2013. For the purposes of point (k)(i), competent authorities shall verify whether the data used are reflective of the sector or region of the issuer. For the purposes of point (k)(iii), competent authorities may require the institution to provide a sensitivity analysis following the principles of the sensitivity analysis referred to in Article 1(2), second subparagraph, of Delegated Regulation (EU) 2023/1578 to assess the potential impact of changes in the PD estimate. 3. For the purposes of paragraph 2, competent authorities may, where appropriate, require an institution to estimate default probabilities with another method among the methods laid out in Delegated Regulation (EU) 2023/1578, and explain the differences in the results obtained.