ECB published a working paper that presents a proposal to construct advanced internal ratings-based (IRB) models for defaulted exposures, in line with the current regulations, to preserve the risk-sensitivity of capital requirements. The proposed models would not only serve for institutions permitted to use advanced models for the Own Funds Requirements (OFR) calculation but for all other institutions, since it may entail an enhancement on their internal risk management regarding defaulted assets.
To this end, Expected Loss Best Estimate (ELBE) and Loss Given Default (LGD) in-default are obtained, backed by an innovative indicator (Mixed Adjustment Indicator) that is introduced to ensure an appropriate estimation of expected and unexpected losses. The presented parameters for defaulted exposures are calibrated to preserve the crucial risk-sensitivity of capital requirements.Moreover, the unexpected losses are estimated in a sufficiently conservative manner to cover potential adverse changes in economic conditions. MAI allows to select significantly high levels of percentiles of a distribution of variables that are correlated with the losses of recovery processes and based on the recent historical data as well as data collected in periods of economic downturn.
Afterward, the mentioned parameters are empirically estimated on the basis of the database of two institutions. The methodology presented has low complexity and is easily applied to the databases commonly used at these institutions, as illustrated by two examples. The paper shows that the proposed methodology performs adequately within the macroeconomic context of certain jurisdictions of diverse nature, namely France and Spain, and enables the viability of the proposal for its successful implementation.
Related Link: Working Paper (PDF)
Keywords: Europe, EU, Banking, NPLs, Defaulted Exposures, Credit Risk, Advanced IRB Models, ECB