EBA published the final guidelines specifying how institutions should quantify the estimation of loss given default (LGD) appropriate for conditions of an economic downturn. The guidelines focus on requirements for the quantification of the calibration target used for downturn LGD estimation. The guidelines will apply as of January 01, 2021, but earlier implementation is encouraged. These guidelines are an amendment to the guidelines on PD, LGD estimation, and treatment of defaulted assets (EBA/GL/2017/16), which were published on November 20, 2017.
Starting from the relevant downturn period(s) identified in accordance with the related regulatory technical standard (RTS), the final guidelines set out requirements for the appropriate quantification of the calibration target used for downturn LGD estimates and include three types of approaches:
- Type-1 approaches can be applied when banks have sufficient loss data for the identified downturn period. In this case, institutions are allowed some modeling flexibility, but subject to a harmonized and prescriptive impact assessment.
- Type-2 approaches can be applied when banks do not have sufficient loss data for the identified downturn period. In this case, institutions are given the choice between two approaches, the so-called haircut, or extrapolation approaches This will harmonize the approaches used by banks.
- Type-3 approaches can be applied in rare cases, where neither type-1 nor type-2 approaches can be used. In this case, banks have to apply a minimum margin of conservatism requirement of 15 percentage points on LGD estimates.
Finally, a reference value is put in place that acts as a non-binding challenger to the final downturn LGD estimation. The guidelines complete the broader work of EBA on the review of the internal ratings-based (IRB) approach and aim to reduce the unjustified variability in the outcomes of internal models, while preserving the risk-sensitivity of capital requirements.
Effective Date: January 01, 2021
Keywords: Europe, EU, Banking, Credit Risk, IRB Approach, LGD, Economic Downturn, EBA
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