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    PRA Consults on Approach to Overseas IRB Credit Risk Models

    October 12, 2020

    PRA published the consultation paper CP16/20 setting out its approach to the firms’ use of overseas internal ratings-based, or IRB, credit risk models, built to non-UK regulatory requirements, in the calculation of UK group consolidated capital requirements. The proposals would result in changes to the supervisory statement SS11/13 on the internal ratings-based approaches, the draft amendments for which have been presented as an Appendix to CP16/20. PRA is clarifying its approach to the overseas models built to non-UK requirements, as the UK is departing EU and PRA has observed challenges and concerns with allowing the use of overseas models in some instances, including how these are effectively supervised. The proposals are relevant to UK banks, building societies, and PRA-designated UK investment firms and the consultation closes on January 12, 2021.

    At present, PRA permits the solo capital requirements generated by non-European Economic Area internal ratings-based models to be included in the UK group consolidated capital requirements of firms. These overseas models may not be fully compliant with all relevant UK internal ratings-based requirements, as they are designed to comply with the non-UK internal ratings-based requirements, although the PRA criteria seek to ensure a prudent approach. As part of the proposal, PRA is considering that it may allow the UK-headquartered groups to use the non-UK internal ratings-based models (that are developed to meet non-UK IRB requirements) for group consolidated capital requirements, provided certain criteria are met. This includes the proposed reflection of any regulatory floors or add-ons mandated by the relevant overseas regulator into the calculation of group consolidated requirements. If an overseas model does not meet the proposed criteria, then the overseas model cannot be used for group consolidated requirements and a model built to UK requirements would need to be used instead, unless PRA has granted permission to use the standardized approach. This proposed approach would apply to all internal ratings-based models built to non-UK requirements. The proposed criteria that would need to be met to use a model built to non-UK internal ratings-based requirements are:

    • Aggregate overseas models' risk-weighted assets calculated using overseas models built to non-UK requirements make up no more than 5% of total group credit risk risk-weighted assets and aggregate overseas models exposure value makes up no more than 5% of total group exposure value
    • Scope of the model only encompasses exposures that are within a subsidiary in an equivalent jurisdiction, the model has been reviewed and approved by the overseas regulator, and the model is used to calculate local capital requirements in that jurisdiction. Models in subsidiaries in non-equivalent jurisdictions would not be able to use the approach.
    • The model scope only encompasses exposures that are in the retail exposure class, including retail small and medium-size enterprise exposures.
    • Modeled outputs are derived using both historical experience and empirical evidence, the estimates are plausible, and intuitive and based on the material risk drivers.
    • The population of exposures represented in the data used for estimation, the lending standards used when the data were generated, and other relevant characteristics are comparable with those of exposures and standards of firm. The number of exposures in the sample and the data period used for quantification are sufficient to provide confidence in the accuracy and robustness of its estimates.
    • The model provides a meaningful differentiation of risk and produces accurate and consistent quantitative estimates of risk. Material model weaknesses would be adequately compensated by an adjustment to parameter estimates.
    • The model is subject to appropriate internal governance processes, with senior management in the overseas subsidiary possessing a general understanding of the rating systems of the institution and detailed comprehension of its associated management reports.
    • The model is subject to an appropriate validation of internal estimates process, with the process being objective, consistent, and accurate.
    • The model is used to inform credit risk decisions.

    Firms would submit to PRA evidence that these criteria have been met via an application form that will be made available as part of the policy statement resulting from this consultation. For the overseas internal ratings-based models built to non-UK requirements that are not currently used for UK consolidated capital requirements, the proposed implementation date for the changes resulting from CP16/20 would be July 01, 2021. However, the existing overseas internal ratings-based models built to non-UK requirements and used for UK consolidated capital requirements that meet the proposed criteria can continue to be used for UK consolidated capital requirements. There may be existing overseas models that do not meet the criteria for use of the revised approach from July 01, 2021 and firms may, therefore, need to remediate these models to meet UK internal ratings-based requirements. PRA expects the models that do not meet the proposed criteria to be remediated by January 01, 2023, in line with the planned implementation of Basel 3.1.

    The proposals set out in CP16/20 have been designed in the context of withdrawal of UK from EU and entry into the transition period, during which time UK remains subject to European law. PRA will keep the policy under review to assess whether any changes would be required due to changes in the UK regulatory framework at the end of the transition period, including those arising once any new arrangements with EU take effect. PRA has assessed that the proposals would not need to be amended under the EU (Withdrawal) Act 2018.

     

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    Comment Due Date: January 12, 2021

    Effective Date (Proposed): July 01, 2021/January 01, 2023

    Keywords: Europe, UK, Banking, IRB Approach, Credit Risk, Regulatory Capital, CRR, Basel, CP16/20, Internal Ratings Based, SS11/13, PRA

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