It's been two years since the European Banking Authority (EBA) published its final Guidelines on harmonising the definition of default (DoD) (EBA/GL/2016/ 07) - an essential step towards creating a level playing field between European banks. The Guidelines and their accompanying Regulatory Technical Standard (EBA/RTS/2016/06) set out a long list of clarifications and changes to default triggers, materiality thresholds and closely related topics including the days past due criteria; indications of likeliness to repay; restructurings; conditions for a return to non-default status; treatment in external data; the harmonisation with IFRS 9 impairments; and standards for the application across banking groups.

Another two years remain until the new rules enter force, at the end of 2020. Understandably, many banks have taken advantage of this unusually long implementation period to focus their limited resources on more urgent priorities - such as the introduction of IFRS 9. However, with time running low, the ECB finally published in June a `non-binding expectation' regarding the regulatory approval process - six months later than anticipated. As a result, banks now need to act fast in response.

An operational issue

The new DoD will trigger a “material” model change, requiring banks to revise their models and submit them to supervisors for ex-ante approval (cf. Delegated Regulation No 529/2014). This will pose a major challenge for Europe's more than one hundred Internal Ratings Based (IRB) banks, many of which have dozens of Probability of Default (PD) and Loss Given Default (LGD) models. The exercise will putt significant strain on resources for both banks and supervisors.

In order to break up the process, the ECB has proposed a “two step approach” separating the changes of the default recognition itself and potential consecutive recalibration, which could in some cases be immaterial and only subject to ex-post notification requirements. As usual, this approach is accompanied by a standardised Excel application format to facilitate the process.

Capital impacts

The problem, however, is that this approach might cause significant temporary biases to capital requirements resulting from the conceptual mismatch when applying the `old' calibrations (i.e. parameter estimates) and the `new' standards of default recognition (through Expected Loss Best Estimates, ELBE, and RWAs for defaulted exposures). Moreover, the separated front-loading of the DoD change neglects the fact that there are relevant interactions with the ECB's TRIM exercise (tied up resources for the recently started LDP on-sites and resulting remedial action plans) and other IRB-related EBA Guidelines with the same due date. Similarly, the compressed timeline for these remaining challenges is likely to increase capital requirements due to banks inability to parallel-run their models - a fact that usually triggers the need for additional margins of conservatism (MoC).

In addition to procedural challenges and likely capital quota effects, the new DoD will also impact banking operations, such as credit recovery processes and NPL management, and accounting practices such as IFRS 9 staging.

Although the EBA's initial assessment (PDF, 2.83 MB) predicts that overall capital requirements are unlikely to change in the aggregate, we expect that some institutions could see significant mid-to-long term effects on RWA, Expected Loss and provisioning levels (shift in the balance of stage 2 and stage 3 assets and effects from increased NPL quotas). The scale of the impact, however, will vary significantly between banks depending on their business models, historic practices and national variations.

Potential consequences for the overall model strategy

Nonetheless, we see the following steps as important elements of best practice:

  • Banks shouldn't underestimate the potential consequences of the new DoD and its secondary effects on issues such as NPL management, accounting practises, credit recovery processes, pricing, product design and overall attractiveness of internal models (together with expected Basel IV changes).
  • Develop a comprehensive model strategy, aligning and integrating all refinement needs (DoD, TRIM, PD/LGD), while at the same time maintaining eligibility for the ECB's two-step approach to model applications. This will not only reduce the risk of supervisory attention, but also introduces some leeway regarding the materiality of second step changes.
  • Invest in data collection and cleaning, with the aim of avoiding cliff effects, data variations and the need for MoC.
  • Engage with supervisors over the possibility of reducing any material mismatches between the `old' calibration and `new' definitions of default.

The long-awaited harmonisation of default recognition is the perfect example of a technical change that will cause major practical headaches for banks - and their supervisors. Acting now with clear targets and objectives is crucial to minimising the resulting disruption.

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