Credit risk: Probability of Default and Loss Given Default estimation

Policy Statement 11/20 | Consultation Paper 21/19

Published on 14 May 2020

Update

14 October 2020: The PRA published presentation slides from the virtual ‘internal ratings based (IRB) mortgage roundtable’, which was hosted on Monday 5 October 2020, following the publication of PS11/20 ‘Credit risk: Probability of Default and Loss Given Default estimation’.

Credit risk: Probability of Default and Loss Given Default estimation – PS11/20

Overview

This Prudential Regulation Authority (PRA) Policy Statement (PS) provides feedback to responses to Consultation Paper (CP) 21/19 ‘Credit risk: Probability of Default and Loss Given Default estimation’ (page 2 of 2), which consulted on proposals to implement the European Banking Authority’s (EBA’s) regulatory products that relate to Probability of Default (PD) estimation and Loss Given Default (LGD) estimation. It also contains the PRA’s final policy in an updated Supervisory Statement (SS) 11/13 ‘Internal Ratings Based (IRB) approaches’ (see Appendix).

This PS is relevant to UK banks, building societies and PRA-designated UK investment firms.

This PS should be read in conjunction with PS12/20 ‘Responses to Occasional Consultation Paper 25/19 – Chapter 5: Retirement interest-only mortgages’, which also makes an update to SS11/13.

Summary of responses

The PRA received eight responses to the CP, which were generally supportive. Responses also outlined specific concerns and requests for clarification. Specific areas where the PRA has amended or clarified the proposals are detailed in Chapter 2.

After considering the responses, the PRA has made several changes to the draft policy in the CP. These are:

extending of the implementation deadlines for the EBA roadmap and the mortgage hybrid approach, including removing the transitional period outlined in paragraph 2.8 of PS7/19;
amending the approach to discounting cured exposures;
accepting temporary divergence between accounting impairment models and approved IRB models for defaulted exposures, due to the need to make timely changes to impairment models; and
clarifying the use of Sterling Overnight Index Average (SONIA), including for defaults that occurred before the first date SONIA is available from the Bank of England.

Implementation [and next steps]

The policy set out in this PS will take effect from Saturday 1 January 2022. Further information on the implementation dates for the EBA roadmap is set out in paragraphs 2.3 to 2.15.

The policy set out in this PS has been designed in the context of the UK’s withdrawal from the European Union and entry into the transition period, during which time the UK remains subject to European law. The 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 the European Union take effect.

The PRA has assessed that the updated parts of SS11/13 would not need to be amended under the EU (Withdrawal) Act 2018 (EUWA). Please see PS5/19 ‘The Bank of England’s amendments to financial services legislation under the European Union (Withdrawal) Act 2018’ for further details.

The SS attached to this PS should be read in conjunction with SS1/19 ‘Non-binding PRA materials: The PRA’s approach after the UK’s withdrawal from the EU’.

As these changes relate to EU Guidelines, the updated SS11/13 should be read in conjunction with the joint Bank and PRA Statement of Policy (SoP) ‘Interpretation of EU Guidelines and Recommendations: Bank of England and PRA approach after the UK’s withdrawal from the EU’.

Appendix

Published on 18 September 2019

Credit risk: Probability of Default and Loss Given Default estimation - CP21/19

Update 20 March 2020: Implementation of the proposals in this CP, will be delayed by one year to 1 January 2022. The move to ‘hybrid’ IRB models will also be delayed until the same date, 1 January 2022. Firms using the standardised approach to credit risk will also benefit from a delay to changes they need to make as part of guidelines on definition of default. For more information on this please see our statement ‘Bank of England announces supervisory and prudential policy measures to address the challenges of Covid-19’.

Overview

In this Consultation Paper (CP), the Prudential Regulation Authority (PRA) sets out its proposed approach to implementing the European Banking Authority’s (EBA’s) recent regulatory products relating to Probability of Default (PD) estimation, Loss Given Default (LGD) estimation and the treatment of defaulted exposures in the Internal Ratings Based (IRB) approach to credit risk.

The PRA proposes to update the PRA’s expectations in Supervisory Statement (SS) 11/13 ‘Internal Ratings Based (IRB) approaches’ to implement the EBA’s regulatory products that relate to PD and LGD estimation and the treatment of defaulted exposures (see Appendix).

The proposals are relevant to UK banks, building societies and PRA-designated UK investment firms.

Background

The EBA has developed a roadmap of regulatory products (‘EBA roadmap’) with the aim of reducing unwarranted variability in the risk-weighted assets (RWAs) calculated using banks’ IRB models.

The PRA has decided to consult on its implementation of the EBA roadmap in two phases:

First phase: definition of default. The PRA consulted on its approach to implementing these products in CP17/18 and published its final approach in Policy Statement (PS) 7/19 ‘Credit risk: The definition of default’.
Second phase: PD and LGD estimation.

This CP sets out the PRA’s proposed approach to implementing these three products. The PRA notes that the RTS on economic downturn are at the time of publication in draft. This CP (including the proposed changes to SS11/13) assume that the RTS will be made in this form. The PRA will consider further changes that may be required to SS11/13 if the final RTS differ from the final draft.

Responses and next steps

This consultation closes on Wednesday 18 December 2019. The PRA invites feedback on the proposals set out in this consultation. The PRA also invites feedback from firms on the expected impact of the proposals on capital requirements, particularly for the proposals set out in paragraphs 2.6 to 2.8. Please address any comments or enquiries to CP21_19@bankofengland.co.uk.

The policy proposals set out in this CP have been designed in the context of the current UK and EU regulatory framework. In the event that the UK leaves the EU with no implementation period in place, the PRA has assessed that the proposals would not need to be amended under the EU (Withdrawal) Act 2019 (EUWA). Please see PS5/19 ‘The Bank of England’s amendments to financial services legislation under the European Union (Withdrawal) Act 2018’ for further details.