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    EBA Consults on PD/LGD Estimation Under Internal Market Risk Approach

    July 22, 2020

    EBA proposed regulatory technical standards on default probabilities (PDs) and losses given default (LGDs) for default risk model for institutions using the new internal model approach under the Fundamental Review of the Trading Book (FRTB). These draft regulatory standards are part of the deliverables included in the June 2019 EBA roadmap for the new market and counterparty credit risk approaches. The proposed standards are based on the requirements specified in the Capital Requirements Regulation 2 or CRR2. The comment period for this consultation ends on October 22, 2020.

    The Capital Requirements Regulation 2 or CRR2, which amends Regulation No 575/20131, implements, in EU legislation, the revised requirements to compute own funds requirements for market risk. Institutions using an alternative internal model to compute own funds requirements for market risk and holding positions in traded debt and equity instruments in trading desks covered by the internal models approach permission are required to additionally compute an own funds requirement using an internal default risk model (or DRC). One of the requirements to be met under the internal default risk model is for institutions to be capable of modeling the default of individual issuers and the simultaneous default of multiple issuers as well as of computing the impact of those defaults on the market values of the positions that are included in the scope of that model. To simulate the default of issuers under the internal default risk model, institutions need to estimate PDs and LGDs of those issuers in accordance with the requirements set out in CRR2.  

    These draft regulatory standards specify the requirements that an institution’s internal methodology or external sources are to fulfill for estimating PD and LGD in accordance with CRR2. The proposed regulatory technical standards clarify the requirements to be met for the estimation of PDs and LGDs under the default risk model. The draft standards specify that any internal methodology used to calculate PDs and LGDs under the default risk model should meet all requirements applied for the Internal ratings‐based (IRB) approach. In addition, these standards specify the requirements that external sources are to fulfill for their use under the default risk model, thus reflecting similar qualitative requirements as those applicable to an internal methodology. External sources should provide estimates of PDs and LGDs that are appropriate with respect to the institution’s portfolio. These estimates should be validated on a periodic basis for their use under the default risk model. In case multiple external sources are used by an institution for the default risk model, the institution should provide a hierarchy of such sources, to ensure the overall consistency of PD and LGD estimates used in the model. Requirements were also added to specify more in detail how the general documentation requirement should be applied in the case of the external sources used by institutions for estimating PDs and LGDs.


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    Comment Due Date: October 22, 2020

    Keywords: Europe, EU, Banking, Basel, Market Risk, FRTB, Probability of Default, Loss Given Default, Internet Model Approach, CRR2, Default Risk, EBA

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