Kishore Ramakrishnan is Delivery Partner and Regulatory Change Practice Lead (Europe) at Treliant. He has over 20 years of global industry and consulting experience across the banking, capital markets, asset, and wealth management businesses. Kishore is a trusted advisor and respected thought leader in the risk, regulation, and compliance domains…
- Source: eba.europa.eu
Treliant’s Capital Markets consulting services offers end to end program and implementation support covering the entire spectrum of Basel IV capital standards, including the credit risk, market risk, and operational risk. Treliant’s global multi-disciplinary team of risk & regulatory SME’s, legal and technology experts, and regulatory advisors can assist institutions in conducting the regulatory gap analysis, designing and implementing the target operating model, and helping obtain regulatory / supervisory approvals on the use of internal models.
The revised EU capital requirements regulation (CRR) introduces the alternative internal model approach (IMA) for market risk as part the Basel standards on ‘minimum capital requirements for market risk’. The capital requirements under the alternative IMA comprise three components:
- the capital requirements for modellable risk factors (expected shortfall i.e., ES measure);
- the capital requirements for non-modellable risk factors i.e., NMRF (stress scenario risk measure); and
- the default risk charge (DRC) requirement.
The DRC requirement aims to capture the default risk for positions in traded debt and equity instruments included in IMA trading desks. Institutions are required to compute this capital requirement using an internal default risk model. To simulate the default of issuers in the internal default risk model, estimates of the PDs and LGDs of the issuers and issuances of these trading positions are needed.
On the one hand, institutions that have been granted permission to use the IRB approach are required to use the methodology set out therein to calculate PD and LGD estimates, where those IRB estimates are available.
On the other hand, institutions with no IRB permission are required to develop an internal methodology or use external sources to estimate PDs and LGDs.
The lack of common requirements could result in the inconsistent application of the internal default risk model across institutions, undermining the calibration of the DRC requirements. Given that institutions may use different types of methodologies and/or external sources, it is important to set minimum requirements to ensure that the probability of default (PD) and loss given default (LGD) estimates used in the internal default risk model are appropriate for the intended use.
The specific objective of the draft regulatory technical standards (RTS) is to establish common requirements for the internal methodology or external sources that institutions need to fulfil for estimating PDs and LGDs for the internal default risk model. These requirements aim to ensure that the PD and LGD estimates are appropriate and consistent across institutions.
These draft RTS on PDs and LGDs for default risk model for institutions using the new Internal Model Approach (IMA) under the Fundamental Review of the Trading Book (FRTB) clarify that any internal methodology used to calculate PDs and LGDs under the default risk model should meet all requirements applied for the Internal ratings-based (IRB) approach.
In addition, these RTS specify the requirements that external sources are to fulfil for their use under the default risk model, thus reflecting similar qualitative requirements as those applicable to an internal methodology.