Assessment of the correlation structure
1. When assessing the methodology used by an institution to determine the default correlation between different issuers as required by Article 325bn(1), point (c), of Regulation (EU) No 575/2013, competent authorities shall:
(a)
verify whether only listed equity and credit spreads are used as data inputs for determining the correlation between different issuers;
(b)
where the institution uses copulas to model default correlations, assess the internal validation of the copula assumptions performed by the institution and verify whether there is compatibility between the historical data used for the calibration of the correlations and the issuers included in the institution’s portfolio;
(c)
identify whether the correlation among issuers is based on absolute or relative returns, and assess whether the rationale behind the choice of the return type is:
(i)
sound;
(ii)
consistent with the choices made by the institutions in relation to other aspects of the internal risk-measurement model;
(d)
assess whether the method that the institution uses to obtain a correlation on the applicable time-horizon from returns calculated on a shorter time horizon is sound;
(e)
assess how the institution determines the calibration period referred to in Article 325bn(1), point (c), of Regulation (EU) No 575/2013.
For the purposes of point (a), competent authorities may, where appropriate, require the institution to provide data used to model the correlation between a sample of issuers selected by competent authorities, and verify whether those data only relate to listed equities and credit spreads.
For the purposes of point (d), competent authorities shall verify whether, where the institution applies the derogation referred to in Article 325bn(3) of Regulation (EU) No 575/2013, a correlation of 60 business days is used only between equity positions for which that derogation is used, and that the correlation is otherwise measured over a one-year time horizon.
For the purposes of point (e), competent authorities shall verify whether the approach that the institution uses to select the period, including its length, is:
(a)
sound;
(b)
documented in the institution’s internal policies;
(c)
reviewed to account for any changes in the stress period referred to in Article 325bc(2) of Regulation (EU) No 575/2013.
2. For the purposes of paragraph 1, point (b), competent authorities shall, on a sample of issuers for which the institution has positions subject to the own funds requirements for default risk, verify whether the pairwise issuer correlations derived from the correlation modelling are compatible to the pairwise issuer correlations derived from observable market data.
Assessment of the hedging recognition
When assessing whether the recognition of hedges in the institution’s internal default risk model complies with Article 325bo of Regulation (EU) No 575/2013, competent authorities shall:
(a)
verify whether the institution’s internal policies:
(i)
describe how the netting is performed;
(ii)
specify:
(1)
those basis risks that are implicitly captured in the model by modelling two different positions;
(2)
those basis risk that are instead explicitly captured by introducing a basis risk factor;
(b)
review the internal policies of the institution, and verify the criteria envisaged in those internal policies to recognise netting and hedging or diversification effects;
(c)
assess whether the monitoring of potential significant basis risk that may arise in the interval between the maturity of an instrument and the one-year time horizon is robust;
(d)
require the institution to provide:
(i)
a sample of positions in the default risk model;
(ii)
the list of risk factors corresponding to the positions referred to in point (i).
When requesting the sample referred to in point (d)(i), competent authorities shall ensure that there is variety in the positions provided, and that, where applicable, both positions that are netted and positions that are not netted are included.
For the purposes of point (b), competent authorities shall verify whether the criteria in the internal policies of the institution ensure that the netting and hedging are efficient, also where a credit or any other event occurs.
For the purposes of point (d), competent authorities shall verify whether:
(a)
the institution’s mapping of positions to risk factors ensures that exposures to different obligors are not netted, and that such netting only takes place for positions that relate to the same financial instruments of the same obligor;
(b)
either exposures to different obligors are mapped to different risk factors, or there is a basis risk factor to capture the differences in those exposures, and the basis risk between obligors that are constituents of credit indices and other obligors is captured;
(c)
for positions in different financial instruments of the same obligor, the analysis performed by the institution to assess whether significant basis risk in the hedging strategies may arise due to different type of products, seniority in the capital structure, internal or external ratings, maturity, or vintage, is robust.
Assessment of compliance with particular requirements
When assessing the internal default risk model’s compliance with the requirements laid down in Article 325bp of Regulation (EU) No 575/2013, competent authorities shall:
(a)
in relation to the modelling of the default of individual as well as multiple issuers as required by Article 325bp(1) of Regulation (EU) No 575/2013:
(i)
identify the approach that the institution uses to model the default, and verify that the two types of systematic risk factors selected by the institution capture the most relevant systematic effects;
(ii)
verify whether the granularity of the two types of systematic risk factors is sufficient to capture the characteristics of the issuers in the portfolio subject to the own funds requirement for default risk;
(iii)
verify whether for each issuer, the institution uses a separate idiosyncratic risk factor in addition to the two types of systematic risk factors referred to in Article 325bp(1) of Regulation (EU) No 575/2013;
(iv)
verify whether the mapping of issuers to the appropriate systematic risk factors is sound;
(v)
verify whether the institution analyses the explanatory power of the factor model;
(vi)
when requesting the sample for the purpose of the assessment, consider the materiality of the issuers, and ensure that the sample encompasses issuers that have been mapped to different systematic risk factors;
(b)
in relation to the requirement to reflect the economic cycle in the internal default risk model as required by Article 325bp(2) of Regulation (EU) No 575/2013, assess how the modelling of losses given defaults, including stochastic ones, is performed for such losses given defaults to reflect changes in the properties taken by the systematic risk factors;
(c)
in relation to the requirement to capture non-linearities as required by Article 325bp(3) of Regulation (EU) No 575/2013, assess:
(i)
how institutions revalue a non-linear financial instrument following the default of an issuer, including how institutions revalue a financial instrument with multiple underlying following the default of an individual issuer or of multiple issuers corresponding to the underlyings;
(ii)
whether any simplifications introduced by the institution to calculate the price of a financial instrument leads to material inaccuracies or a systematic underestimation of the risk;
(iii)
the extent to which the revaluation of a financial instrument takes into account model risk;
(d)
in relation to the requirement to have an internal default risk model that is consistent with internal risk-management as required by Article 325bp(9) of Regulation (EU) No 575/2013, verify whether the institution has documented the differences between the internal default risk model and the models that the institution uses for its internal risk management for the same scope of positions, and whether the institution is able to explain those differences.
For the purposes of point (a)(i), competent authorities shall assess the rationale provided in the institution’s internal policies for the choice of the systematic risk factors, and their economic interpretation.
For the purposes of point (a)(iii), competent authorities may, where appropriate, verify on a sample of similar issuers that the idiosyncratic risk factors differ.
For the purposes of point (a)(iv), competent authorities may, where appropriate, verify on a sample of issuers, that the mapping is correct.
For the purposes of point (a)(v), competent authorities may, where appropriate and where the analyses performed by the institution do not seem sufficient for the portfolio subject to default risk as it stands, require the institution on a sample of issuers to assess the power of the systematic risk factors chosen by the institution in explaining the drivers of the default of each issuer’s asset.
For the purposes of point (b), competent authorities may, where appropriate, perform statistical analyses on a sample of issuers, including hypothesis testing, to test the dependency of losses given defaults on the systematic risk factors.
Source: EUR-Lex (Publications Office of the EU), © European Union, reuse permitted under Commission Decision 2011/833/EU.
