14
Own estimates of exposure at default (EAD) in IRB approaches
Estimation of EAD in place of conversion factors
14.1
The PRA considers that a firm may provide own estimates of EAD in place of the own estimates of CFs that it is permitted or required to provide under CRR Article 151.
- 01/01/2022
14.2
In this supervisory statement references to EAD refer to both direct estimates of EAD and CFs unless specified otherwise.
(CRR Article 151)
- 01/01/2022
General expectations for estimating EAD
14.3
The PRA expects that EAD estimates should not be less than current drawings (including interest accrued to date). Consequently, the PRA expects CF estimates not to be less than zero.
- 01/01/2022
14.4
The EAD required for IRB purposes is the exposure(s) expected to be outstanding under a borrower’s current facilities should it go into default in the next year, assuming that economic downturn conditions occur in the next year and a firm’s policies and practices for controlling exposures remain unchanged other than changes that result from the economic downturn conditions.
- 01/01/2022
14.5
- 01/01/2022
14.6
To the extent that a firm makes available multiple facilities, the PRA expects firms to be able to demonstrate:
- (a) how they deal with the fact that exposures on one facility may become exposures under another on which the losses are ultimately incurred; and
- (b) the impact of its approach on its capital requirements.
- 01/01/2022
14.7
The PRA expects firms using own estimates of EAD to have done the following in respect of EAD estimates:
- (a) applied EAD estimates at the level of the individual facility;
- (b) where there is a paucity of observations, ensured that all EAD estimates are cautious, conservative and justifiable. In accordance with Article 179(1)(a), estimates must be derived using both historical experience and empirical evidence, and must not be based purely on judgemental consideration. The PRA would expect the justification as to why the firm thinks the estimates are conservative to be documented;
- (c) identified and explained at a granular level how each estimate has been derived. This should include an explanation of how internal data, any external data, expert judgement or a combination of these has been used to produce the estimate;
- (d) ensured that where expert judgement has been used there is clear documentation of the process for arriving at and reviewing the estimates, and identifying the parties involved;
- (e) demonstrated an understanding of the impact of the economic cycle on exposure values and be able to use that understanding in deriving downturn EAD estimates;
- (f) demonstrated sufficient understanding of any external benchmarks used and identified the extent of their relevance and suitability to the extent that the firm can satisfy itself that they are fit for purpose;
- (g) evidenced that they are aware of any weaknesses in their estimation process and have set standards that their estimates are designed to meet (eg related to accuracy);
- (h) ensured, in most cases, that estimates incorporate effective discrimination on the basis of at least product features and customer type. In cases where these drivers are not incorporated into EAD estimates then the PRA expects the firm to be able to demonstrate why they are not relevant;
- (i) have an on-going data collection framework in place to collect all relevant internal exposure data required for estimating EAD and a framework to start using this data as soon as any meaningful information becomes available;
- (j) made use of the data they are collecting to identify all relevant drivers of EAD and to understand how these drivers will be affected by a downturn; and
- (k) identified dependencies between default rates and conversion factors for various products and markets when estimating downturn EADs. Firms are expected to consider how they expect their own policies regarding exposure management to evolve in a downturn.
- 01/01/2022
14.8
The PRA has developed a framework for assessing the conservatism of firms’ wholesale EAD models for which there are a low number of defaults. The PRA is in the process of using this framework to assess the calibration of firms’ material EAD models for low-default portfolios.
- 01/01/2022
14.9
In the following cases, the PRA expects firms to determine the effect of applying the framework set out in Appendix C to models which include EAD values that are based on fewer than 20 ‘relevant’ data points (as defined in Appendix C):
- (a) the model is identified for review by the PRA; or
- (b) the firm submits a request for approval for a material change to its EAD model.
- 01/01/2022
14.10
In such cases firms should contact their supervisor to obtain the relevant data templates that should be populated and submitted to the PRA.
(CRR Articles 4(56), 166, Section 6)
- 01/01/2022
Time horizon
14.11
The PRA expects firms to use a time horizon of one year for EAD estimates, unless they can demonstrate that another period would be more conservative.
- 01/01/2022
14.12
EAD estimates can be undertaken on the basis that default occurs at any time during the time horizon (the ‘cohort approach’), or at the end of the time horizon (the ‘fixed-horizon approach’). The PRA considers that either approach is acceptable in principle.
- 01/01/2022
14.13
The PRA expects the time horizon for additional drawings to be the same as the time horizon for defaults. In effect this means that EAD estimation need cover only additional drawings that might take place in the next year, such that:
- (a) no capital requirement need be held against facilities, or proportions of facilities that cannot be drawn down within the next year; and
- (b) where facilities can be drawn down within the next year, firms may in principle reduce their estimates to the extent that they can demonstrate that they are able and willing, based on a combination of empirical evidence, current policies, and documentary protection to prevent further drawings.
(CRR Article 182)
- 01/01/2022
Direct estimates of EAD
14.14
- 01/01/2022
14.15
A ‘momentum’ approach can be used either:
- (a) by using the drawings/limit percentage to formulaically derive a conversion factor on the undrawn portion of the limit; or
- (b) by using the higher of percentage of the limit and the current balance as the EAD.
- 01/01/2022
14.16
The PRA considers that the use of momentum approaches in both of the ways outlined above is acceptable in principle as an alternative to direct estimation of conversion factors.
(CRR Article 4(56))
- 01/01/2022
Distortions to conversion factor estimates caused by low undrawn limits
14.17
In cases where firms estimate CFs directly, using a reference data set that includes a significant number of high CFs as a result of very low undrawn limits at the observation date, the PRA expects firms to:
- (a) investigate the distribution of realised CFs in the reference data set;
- (b) base the estimated CF on an appropriate point along that distribution that results in the choice of a CF appropriate for the exposures to which it is being applied and consistent with the requirement in CRR Article 179 for estimates to include a margin of conservatism related to errors; and
- (c) be cognisant that while the median of the distribution might be a starting point, they should not assume without analysis that the median represents a reasonable unbiased estimate. The PRA expects firms to consider whether the pattern of distribution in realised CFs means that some further segmentation is needed (eg treating facilities that are close to full utilisations differently).
(CRR Article 182(1)(a))
- 01/01/2022
Identification of exposures for which an EAD must be estimated
14.18
The PRA expects firms to treat a facility as an exposure from the earliest date at which a customer is able to make drawings under it.
- 01/01/2022
14.19
Where the facility is of the type that it is customary not to advise the borrower of its availability, the PRA expects an EAD/CF to be applied from the time that the existence of the facility is recorded on the firm’s systems in a way that would allow the borrower to make a drawing.
- 01/01/2022
14.20
If the availability of a facility is subject to a further credit assessment by the firm, an EAD/CF may not be required. However, the PRA expects this to be the case only if the subsequent credit assessment were of substantially equivalent rigour to that of the initial credit approval, and if this includes a re-rating or a confirmation of the rating of the borrower.
- 01/01/2022
14.21
Firms are not expected to include in their EAD/CF estimates the probability of increases in limits between observation and default date. If the reference data set included the impact of such increases, the PRA expects firms to be able to adjust their estimates accordingly with the aim of assessing what the exposure would have been at default if the limit had not been increased.
- 01/01/2022
14.22
The PRA expects firms to investigate the incidence of exposures existing at default that arise from products or relationships that are not intended to result in a credit exposure and, consequently, have no credit limit established against them and are not reflected in their estimates of EAD. Unless such exposures are immaterial, the PRA expects firms to apply a Pillar 1 capital charge on a portfolio basis to such exposures.
- 01/01/2022
14.23
The PRA expects firms to investigate how their EAD estimates are impacted by exposures that are in excess of limits at either the observation date (if in the reference data set) or at the current reporting date (for the existing book to which estimates need to be applied). Unless a momentum approach is being used exposures in excess of limit should be excluded from the reference data set (as the undrawn limit is negative and nonsensical answers would result from their inclusion). The PRA expects firms to ensure that their EAD estimation includes the risk of further drawings on accounts that are in excess of their limits.
(CRR Article 4(56))
- 01/01/2022
Accrued interest
14.24
Exposures include not only principal amounts borrowed under facilities but also interest accrued which will fluctuate between payment dates. In order to ensure proper coverage of interest, the PRA expects firms to take the following approach:
- (a) accrued interest to date should be included in current exposure for performing exposures;
- (b) firms may choose whether estimated increases in accrued interest up to the time of default should be included in LGD or EAD;
- (c) in the estimation of EAD increases in accrued interest may be offset against reductions in other outstandings;
- (d) estimation of changes in accrued interest needs to take account of changes in the contractual interest rate over the time horizon up to default, and in a way consistent with the scenario envisaged in the calculation of the downturn/default weighted average;
- (e) inclusion of estimates of future post-default interest is not necessary in either EAD or LGD; and
- (f) firms’ accounting policies will determine the extent to which interest accrued to date is reflected in current exposure as opposed to LGD for defaulted exposures.
(CRR Article 166(1))
- 01/01/2022
Netting
14.25
The PRA considers that there is scope within the CRR for firms to recognise on-balance sheet netting (including in respect of cross-currency balances) through EAD as an alternative to LGD in those cases where the general conditions for on-balance sheet netting set out in CRR Article 205 are met.
- 01/01/2022
14.26
As regards the CF on undrawn limits, this may be applied on the basis of the net limit provided the conditions in the CRR for the use of net limits are met. However, firms are reminded that the purpose of the measure is to estimate the amount that would be outstanding in the event of a default. This implies that their ability in practice to constrain the drawdown of credit balances will be particularly tested. Moreover the PRA expects the appropriate conversion factor to be higher as a percentage of a net limit than of a gross limit.
- 01/01/2022
14.27
The lower the net limit as a percentage of gross limits or exposures, the greater will be the need on the part of the firm to ensure that it is restricting exposures below net limits in practice and that it will be able to continue to do so should borrowers encounter difficulties. The application of a zero net limit is acceptable in principle, but there is consequently a very high obligation on the firm to ensure that breaches of this are not tolerated.
(CRR Article 166(3))
- 01/01/2022
Underwriting commitments
14.28
Estimation of CFs on underwritten facilities in the course of primary market syndication may take account of anticipated sell down to other parties.
- 01/01/2022
14.29
Firms are reminded that since the basis of EAD estimation is that default by the borrower is expected to take place in a one-year time horizon, and quite possibly in downturn conditions, the PRA expects any reduction in their CF in anticipation of syndication to take account of this scenario.
(CRR Article 4(56))
- 01/01/2022