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New Definition of Default New definition of default What banks need to do by the end of 2020 Minds made for transforming financial services Contents 02 Executive summary 03 Regulatory overview 10 Key challenges and considerations 13 What banks should do now 14 Publications 16 New DoD on a page 21 Key contacts and country representatives Following the financial crisis, the European Banking Authority (EBA) has established tighter standards around the definition of default (CRR Article 178) to achieve greater alignment across banks and jurisdictions. These need to be implemented by the end of 2020. New definition of default What banks need to do by the end of 2020 | 1 Executive summary European regulators have adopted new But time is short and the changes, detailed standards on how banks need to considered material for all capital recognize credit defaults for prudential models, require substantial efforts purposes to increase consistency across from both banks and regulators alike. countries and banks. The deadline for IRB banks subject to ECB supervision compliance is the end of 2020. have already had to submit detailed impact assessments and implementation Banks that have carried out a plans as part of the model re-approval quantitative impact analysis have found process. All IRB models also need to be that the new standards can materially updated to reflect additional changes impact the number and timing of introduced by the EBA as part of the ‘IRB defaults, calling into question the validity repair work’, by the end of 2021. But of existing models and processes. The progress across the industry is far from impact varies significantly across banks uniform and some national regulators (depending on approach for estimating have been less engaged with the banks regulatory capital and pre-existing they supervise. default definition) as well as across individual portfolios within the banks. Furthermore, these changes are only But where the impact is material it a few among a series of ongoing needs to be reflected in updated risk challenges, such as refining IFRS9 management and supporting decisions implementation, meeting ongoing (e.g., pricing), accounting (e.g., IFRS9, demands to improve stress testing Effective Interest Rate) and capital capability and implementing Basel III models (IRB and ICAAP). reforms. This leaves banks, and supervisors, with a lot to do and little The guidelines are extensive and time to do it. detailed, challenging legacy IT infrastructure and processes that have In this paper we provide a summary often evolved organically over the years. of the new regulation, and highlight For some banks this is an opportunity points for consideration based on the to cleanse historical data, refresh and challenges banks have faced so far in modernize supporting infrastructure, their implementation efforts. At the end and establish the foundation of a more of this paper we also reference a list of sustainable data strategy to support relevant publications and a “New DoD on advanced analytics. New processes and a page” summary of the new definition controls also need to be established. of default (DoD) standards. 2 | New definition of default What banks need to do by the end of 2020 Regulatory overview What is the new DoD and what does Who does it impact? it mean? • All firms subject to the Capital Requirements • A new set of standards that are more detailed Regulation (CRR) and holding capital against and prescriptive, and will have significant impact credit activities. on governance, data, processes, systems and • IRB banks need to recalibrate their credit models but credit models. banks under the Standardised Approach (SA) also • The impact on capital requirements depends need to identify, use and report defaults according to on several influencing factors, including type of the new DoD. approach for estimating capital requirements (IRB or Standardised Approach), current implemented default definition and portfolio specifics. • For approved IRB capital models, the new standards are deemed to be a material change and hence requiring formal re-approval of a Competent What are other relevant publications Authority, irrespective of capital impact. to consider? • All banks need to implement the new standard • New requirements for internal models that must be by 31 December 2020 for reporting to start developed and implemented by the end of 2021, e.g., 1 January 2021. EBA guidelines for estimating Probability of Default (PD) and Loss Given Default (LGD); ‘IRB Repair’. • The broader regulatory reform agenda, specifically Basel III finalization and forthcoming regulation What are the new guidelines? (CRR2/CRR3), as it impacts the model landscape and capital beyond 2021. • European Banking Authority (EBA) guidelines on the application of the definition of default. • Regulations on the definition and/or management of forborne and non-performing exposures, notably • European Commission (EC) regulation on the guidelines from the EBA and the Basel Committee on materiality threshold for credit obligations past due. Banking Supervision (BCBS). • National Competent Authorities (NCAs) and ECB have • The EBA, ECB and NCAs have also published published their own consultation papers and policies additional guidance and impact assessments related where the regulation provides national discretion to the new DoD. (materiality thresholds and 180 days past due). • See Publications at the end of this paper for an extended list of references to relevant publications. New definition of default What banks need to do by the end of 2020 | 3 Summary of the new rules Materiality thresholds There are also specific requirements for when DPD counting may be Introduction of new absolute and stopped — when the credit arrangement relative materiality thresholds for the specifically allows the obligor to change purposes of DPD counting; when both 01 the schedule, when there are legal thresholds have been breached for grounds for suspended repayment, in 90 days, a default has occurred. ECB Days past case of formal legal disputes over the and most NCAs have adopted the EBA repayment or when the obligor changes due (DPD) RTS thresholds: due to a merger or similar event. • Retail: 1% relative and €100 absolute • Non-retail: 1% relative and €500 Technical default absolute The standards specify a strict and limited set of so called technical defaults, The notable exception to this being the i.e. false positives that are caused by PRA in the UK which has adopted a 0% technical issues; generally data or relative and a zero absolute threshold system errors, or failures or delays in for retail exposures to minimize the recognizing payment. operational impact that changing the widespread practice of determining 90 DPD through a ‘months-in-arrears’ Removal of 180 DPD approach would imply. It should be Following the EBA recommendation noted that NCAs outside the Eurozone to remove the CRR option to use 180 have adopted absolute thresholds in DPD instead of 90 DPD (as applicable local currency; these have so far been under the rules for residential and SME specified in even amounts broadly commercial real estate and/or exposures equivalent to €100 and €500. Where to public sector entities), ECB has banks apply default at obligor level, they removed this option for Systemically should ensure materiality thresholds Important Institutions (SIIs) in the Single are also applied at obligor level. Banks Supervisory Mechanism (SSM) and all may opt to use lower thresholds NCAs that have previously exercised as an additional unlikeliness to pay the CRR option to allow 180 DPD have trigger (see below). followed suit. Past due amount and DPD Factoring and purchased counting receivables The amount past due shall be the sum of Specific requirements for factoring and all amounts past due, including all fees, purchased receivables; where a factor interest and principal. For the relative does not recognize the receivables on threshold, this amount should be divided its balance sheet, DPD counting should by the total on-balance exposure. In case start when the client account is in the principal is not repaid or refinanced debit, otherwise DPD counting should when an interest-only loan expires, DPD start from when a single receivable counting should start from that date even becomes due. if the obligor continues to pay interest. 4 | New definition of default What banks need to do by the end of 2020 Non-accrued status Bankruptcy UTP will be triggered if the credit Clarification on arrangements to be obligation is put on non-accrued treated similar to bankruptcy, including 02 status under the applicable accounting but not limited to all arrangements in framework. annex A of Regulation (EU) 2015/848 Unlikeliness on insolvency proceedings. This includes Specific Credit Risk not only such arrangements directly to pay (UTP) Adjustment (SCRA) involving the institution but also such arrangements the debtor has with Added guidelines on cases where SCRAs third parties. trigger UTP. Additional indications of Sale of the credit obligation unlikeliness to pay The sale of a credit obligation needs to Banks must define additional UTP be assessed and classified as defaulted if indicators. the economic loss exceeds 5%. The standards specify additional UTP Distressed restructuring indications that must be included, e.g., fraud. The standards also provide Concessions extended to obligors with guidance on optional UTP indications to current or expected difficulties to meet be considered, e.g., significant increase their financial
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