November 16, 2018

EBA published the final draft regulatory technical standards specifying the nature, severity, and duration of an economic downturn. EBA is in the process of finalizing the related guidelines on the estimation of loss given default (LGD) appropriate for conditions of an economic downturn. The draft standards will be submitted to EC for endorsement, before being published in the Official Journal of the European Union. The technical standards will apply from January 01, 2021, as this will allow institutions to prepare for the implementation of technical standards and to integrate the approach into existing modeling practices.

These standards complete the EBA's regulatory review of the internal ratings-based (IRB) approach, with the objective of restoring the trust of market participants in internal models by reducing the unjustified variability in the resulting risk-weighted exposure amounts. The final draft regulatory technical standards set out the notion of economic downturn to be taken into account when estimating the LGD and the conversion factors. Given the specificities of the types of exposures covered by a rating system, the economic downturn should be identified separately for each rating system. However, as a rating system may cover exposures from different businesses, sectors, and geographical areas, the notion of an economic downturn included in these technical standards may comprise several disjunctive downturn periods.

In addition, the final draft standards specify the nature of an economic downturn via macroeconomic or credit-related factors (economic factors) that are explanatory variables or indicators for the business cycle of the considered type of exposure. The severity of an economic downturn is specified by the set of the most severe observations on the economic factors constituting the nature of an economic downturn, based on historical values of these factors over the last 20 years. The duration of an economic downturn is determined by the duration of the identified downturn periods and is generally specified as the twelve-month period where the most severe values are observed. However, some flexibility is embedded in the draft policy to ensure that the severity and duration are appropriately specified. 

 

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Keywords: Europe, EU, Banking, IRB Approach, Regulatory Technical Standards, LGD Estimation, Economic Downturn, EBA

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