Annex 6
to the Regulations No. 60
of the Financial and Capital Market Commission
of 2 May 2007
Calculation of Capital Requirement for Credit Risk under the Internal
Ratings Based Approach
Section 1. Risk–weighted Exposure Amount and Expected Loss Amount
1. Calculation of Risk–weighted Exposure Amount
1. Unless noted otherwise, the input parameters of the probability of default (PD), loss
given default (LGD) and maturity value (M) shall be determined as set out in Section 2 and
the exposure value shall be determined as set out in Section 3.
2. The risk–weighted exposure amount for each exposure shall be calculated in
accordance with the formulae set out in Paragraphs 3–27.
1.1. Risk–weighted Exposure Amount for Exposures to Corporates, Institutions,
Central Governments and Central Banks
3. Subject to Paragraphs 5–9, the risk–weighted exposure amount for exposures to
corporates, institutions, central governments and central banks shall be calculated according
to the following formulae:
Correlation (R) = 0,12*(1─EXP(─50* PD))/(1─EXP(─50))+0,24*
[1─(1─EXP(─50*PD))/(1─EXP(─50))]
Maturity factor (b) = (0,11852─0,05478*ln(PD))2
Risk weighting (RW) = PD*(N[(1─R)–0,5*G(PD)+(R/(1─R))0,5*G(0,999)]─
PD*LGD)*(1─1,5*b)–1*(1+(T–2,5)*b)*12,5*1,06,
where:
N(X) denotes the cumulative distribution function for a standard normal random
variable (i. e., the probability that a normal random variable with mean zero and variance of 1
is less than or equal to X).
G(Z) denotes the inverse cumulative distribution function for a standard normal
random variable (i. e., the value X such that N(X)=Z)
Where PD = 0, RW shall be also 0%.
Where PD = 1, then:
— for defaulted exposures where an institution applies LGD in accordance with
Paragraph 44 of Section 2, RW shall be 0%;
— for defaulted exposures where an institution uses its own estimates of LGD, RW
shall be Max{0, 12,5 *(LGD–ELBE) where ELBE is the best estimate of expected loss
for defaulted exposures, in accordance with Paragraph 157 of Section 4 of this Annex.
Risk—weighted exposure amount = RW * exposure value.
4. The risk–weighted exposure amount for each exposure whose collateral meets the
requirements set out in Paragraph 14 of Section 1 of Annex 3 and Paragraph 40 of Section 2
of Annex 3 may be adjusted according to the following formula:
Risk—weighted exposure amount = RW * exposure value * ((0,15 + 160*PDPP)]
where PDPP is the PD of the protection provider.
In this case, RW shall be calculated using the formula set out in Paragraph 3 by
entering the following parameters:
– PD is the PD of the obligor;
– LGD is the LGD determined for direct exposures to protection provider;
– maturity factor (b) is calculated using the lower of PD of the protection
provider and the PD of the obligor.
5. For calculating risk weights for exposures to corporates in the consolidation group
where the total annual turnover is less than EUR 50 million, an institution shall be entitled to
use the following correlation formula:
Correlation (R) = 0,12*(1–EXP(–50*PD))/(1–EXP(–50))+0,24*
[1–(1–EXP(–50*PD))/(1–EXP(–50))]–0,04*(1–(S–5)/45),
where S is the total annual turnover, expressed in millions of euros, of the
consolidation group and S is larger than 5 million euros but smaller than 50 million euros.
Where the turnover is less than 5 million euros, it shall be treated as if it were equivalent to
5 million euros. For the purchased receivables the total annual turnover shall be determined in
proportion to the weighted average value for individual exposures in the portfolio.
An institution shall substitute the total annual turnover with the assets of the
consolidated group where the total annual turnover is not a meaningful indicator of a
corporate's size but total assets are a more meaningful indicator than the total annual turnover.
6. For specialised lending exposures in respect of which PD is determined not in
compliance with the minimum requirements set out in Section 4 of this Annex, risk weights
shall be assigned according to Table 1.
2
Table 1. Risk weights of specialised lending exposures
*
Residual maturity
Class 1*
Class 2
Class 3
Class 4
Class 5
Less than 2,5 years
50%
70%
115%
250%
0%
Equal to or more than 2,5
years
70%
90%
115%
250%
0%
Basel II document sets out the probable distribution of specialised lending exposures across classes
When assigning risk weights to specialised lending exposures, an institution shall take
into account the following factors: financial strength of a corporate, political and legal
environment, characteristics of a transaction or of an asset, strength of the sponsor and the
developer, including any public private partnership income flow, and security package.
7. In order that the treatment applied to exposures to corporate be applied to the
purchased receivables of corporates, they shall comply with the minimum requirements set
out in Paragraphs 182–186 of Section 4. Where the purchased receivables of corporates meet
also the conditions set out in Paragraph 14 of this Section and where it would be unduly
burdensome for an institution to apply the risk quantification standards for exposures to
corporates as set out in Section 4, an institution shall be entitled to use the risk quantification
standards for portfolio of retail exposures as set out in Section 4.
8. For the purchased receivables of corporates, refundable purchase discounts,
collateral or partial guarantees that provide first–loss protection for default losses, dilution
losses, or both, may be treated as first–loss positions under the IRB securitisation framework.
9. Where an institution provides credit protection for a number of exposures under
terms that the nth default among the exposures shall be the threshold at which payments for
the credit protection under the contract shall be made and that this credit event shall terminate
the contract for the protection, the risk weight for such protection credit derivative instrument
shall be determined as follows:
9.1. where the protection instrument has an ECAI rating, the risk weight established in
accordance with the requirements of Section 5 of Title II of the Regulations shall apply to
exposures subject to protection;
9.2. where the protection instrument does not have an ECAI rating, the risk weight for
the basket of protected exposures shall be determined as the sum of proportional risk weights
of exposures included in the basket, excluding n–1 exposures. The risk–weighted value of the
basket of exposures shall be calculated by multiplying the sum of proportionate risk weights
with the sum of the exposure values in the basket, excluding n–1 exposures. Where the sum of
the risk–weighted exposure amount of the basket of protected exposures and of the expected
loss, multiplied with 12,5, is larger than the protection payment ensured by the credit
derivative instrument, multiplied with 12,5, the risk–weighted exposure amount of the basket
of protected exposures shall be the result of the last result (protection payment multiplied with
12,5). When establishing n–1 exposures to be excluded from the aggregation, the basis shall
be that for each exposure the risk–weighted value is lower than the risk–weighted value for
any exposure included in the aggregation.
1.2. Risk–weighted Exposure Amount of a Portfolio of Retail Exposures
3
10. Subject to the requirements set out in Paragraphs 12 and 13, the risk–weighted
exposure amount for a portfolio of retail exposures shall be calculated according to the
following formulae:
Correlation (R) = 0,03*(1─EXP(─35*PD))/(1─EXP(─35))+0,16*
[1─(1─EXP(─35*PD))/(1─EXP(─35))]
Risk weight (RW) =
(LGD*N[(1─R)–0,5*G(PD)+(R/(1─R))0,5*G(0.999)]─PD*LGD)*12,5*1,06,
where:
N(X) denotes the cumulative distribution function for a standard normal random
variable (i. e., the probability that a normal random variable with the mean value of zero and
variance of one is less than or equal to X);
G(Z) denotes the inverse cumulative distribution function for a standard normal
random variable (i. e,. the value X such that N(X)=Z).
Where PD=1 (defaulted exposure), RW shall be Max {0, 12.5*(LGD–ELBE)}, where
ELBE is the institution’s own best estimate of EL in respect of defaulted exposures according
to the conditions of Paragraph 157 of Section 4 of this Annex.
Risk—weighted exposure amount (RWE) = RW * exposure value.
11. Subject to the criteria set out in Paragraph 123 of Chapter 2 of Title II, the risk–
weighted exposure amount for each exposure to small and medium sized entities as included
in the portfolio of retail exposures may be adjusted in accordance with Paragraph 4 of this
Annex provided that the collateral meets the requirements of Paragraph 14of Section 1 of
Annex 3 and of Paragraph 40 of Section 2 of Annex 3.
12. For the portfolio of retail exposures secured by a real estate collateral, a correlation
(R) of 0,15 shall replace the figure produced by the correlation formula in Paragraph 10.
13. For qualifying revolving exposures included in the portfolio of retail exposures as
defined in Paragraphs 13.1–13.5, the correlation (R) of 0,04 shall replace the figure produced
by the correlation formula in Paragraph 10. The set of qualifying revolving exposures in the
portfolio of retail exposures constitute a sub–portfolio of retail exposures. Exposures shall
qualify as qualifying revolving exposures in the portfolio of retail exposures where they meet
the following conditions:
13.1. the exposures are to natural persons;
13.2. the exposures are revolving, unsecured, and an institution shall be entitled to
cancel them immediately and unconditionally to the extent they are not drawn (in this context,
revolving exposures are defined as those exposures where customers' outstanding balances are
permitted to fluctuate based on their decisions to borrow and repay, within the limit
established by an institution.). Undrawn granted credits may be considered as unconditionally
cancellable where the terms of the credit permit the institution to cancel them to the full extent
allowable under consumer protection and related legislation. An institution shall be entitled to
recognise as unsecured those exposures that are secured with a balance in the salary account.
4
In that case the balance of the exposure that is secured with the balance on the salary account
shall not be taken into account when estimating LGD;
13.3. the maximum permissible qualifying revolving retail exposure to a single natural
person in the sub–portfolio is EUR 100 000 or less;
13.4. an institution can demonstrate that the use of the correlation formula as set out in
this Paragraph is limited to sub–portfolios that have exhibited low volatility of loss rates
relative to their average level of loss rates, especially within the transactions of low PD bands;
13.5. the Commission concurs with the institution’s assessment and procedures
whereby a qualifying revolving retail exposure is included in the respective sub–portfolio.
14. To be eligible for the inclusion in the portfolio of retail exposures, the purchased
receivables shall comply with the minimum requirements set out in Paragraphs 182–186 of
Section 4 and the following conditions:
14.1. an institution has purchased the receivables from unrelated third parties and its
exposure to the obligor as a result of the purchase does not include any exposures that are
directly or indirectly originated by the institution itself;
14.2. the purchased receivables were generated on an arm's–length basis in a
transaction between the seller and the obligors. As such, inter–company transactions giving
rise to accounts receivable as well as the receivables between corporates that engage in
trading and make the settlement by means of mutual netting are ineligible;
14.3. an institution that purchased receivables shall be entitled to all proceeds from the
purchased receivables or to a part of the proceeds that represents the part of the receivables
purchased;
14.4. the portfolio of purchased receivables is sufficiently diversified.
15. For the purchased receivables in the portfolio of retail exposures, refundable
purchase discounts, collateral or partial guarantees that provide first–loss protection for
default losses, dilution losses, or both, may be treated as first–loss positions under the IRB
securitisation framework.
16. In the case of a sub–portfolio of hybrid portfolio of the portfolio of purchased
retail receivables where the purchasing institutions cannot separate exposures secured by a
real estate collateral and qualifying revolving exposures included in the portfolio of retail
exposures from other exposures of the portfolio of retail exposures, the risk weight function
applicable to the portfolio of retail exposures that produces the highest capital requirements
for the sub–portfolio of hybrid purchased exposures shall apply.
1.3. Risk–weighted Exposure Amounts for Equity Securities
17. An institution shall be entitled to employ the following approaches to calculating
the risk–weighted exposure amounts for equity securities:
17.1. the Simple Risk Weight Approach in accordance with Paragraphs 19–21;
17.2. the PD/LGD Approach in accordance with Paragraphs 22–24;
17.3. the Internal Models Approach in accordance with Paragraphs 25 and 26;
17.4. an institution shall be entitled to apply different approaches to different
portfolios where the institution itself uses different approaches to manage credit risk
internally. Where an institution uses different approaches, it shall demonstrate to the
Commission that the choice is made consistently and is not determined by regulatory
arbitrage considerations.
5
18. Notwithstanding the requirements of Paragraph 17 the risk–weighted exposure
amounts for equity securities to ancillary services undertakings may be calculated in
accordance to the treatment of other assets that do not constitute institution’s claims against
obligors (see Paragraph 27).
1.3.1. Simple Risk Weight Approach
19. The risk–weighted exposure amounts for equity securities shall be calculated
according to the following formula:
Risk–weighted exposure amounts = RW * exposure value.
where:
RW = 190% for private equity securities in sufficiently diversified portfolios,
hereinafter PE exposures;
RW = 290% for exchange traded equity securities, hereinafter ETE exposures;
RW = 370% for all other equity securities.
20. Short cash positions and derivative instruments held in the non–trading book,
future short positions in underlying assets and long positions in the same individual securities
may be offset provided that these instruments have been explicitly designated as hedges of
specific equity securities and that they provide a hedge for at least another year. Other short
positions shall be treated as long positions with the relevant risk weight assigned to the
absolute value of each position. In the calculation of the risk–weighted exposure amount the
absolute values of short positions shall be used. In the case of maturity mismatched positions,
the method is that for exposures to corporates.
21. An institution may recognise unfunded credit protection obtained on an equity
security in accordance with the methods set out in Section 4 of the Regulations.
1.3.2. PD/LGD Approach
22. The risk–weighted exposure amounts of equity securities shall be calculated
according to the formulae in Paragraph 3. Where an institution does not have sufficient
information to use the definition of default set out in Paragraphs 120–125 of Section 4 of the
Regulations, a scaling factor of 1,5 shall be assigned to the risk weights.
23. At the individual exposure level the sum of the EL amount multiplied with 12,5
and the risk–weighted exposure amount shall not exceed the exposure value multiplied with
12,5.
24. An institution shall be entitled to recognise unfunded credit protection for an
equity securities in accordance with the methods set out in Section 4 of the Regulations. For
exposures to the protection provider LGD shall be 90 %. For private equity securities LGD of
65 % may be used. For these purposes M shall be 5 years.
1.3.3. Internal Models Approach
6
25. The risk–weighted exposure amounts of equity securities shall be the potential loss
on the equity securities as derived using internal value–at–risk (hereinafter, VaR) models
provided that they use the 99th percentile one–tailed confidence interval for the difference
between quarterly returns and an appropriate long–term sample returns computed at a risk–
free rate on the calculation date, multiplied with 12,5. The risk–weighted exposure amounts at
the individual exposure level shall not be less than the sum of minimum risk–weighted
exposure amounts as calculated under the PD/LGD Approach and the corresponding expected
loss amounts multiplied with 12,5 and calculated on the basis of the PD values set out in
Paragraph 60.1 of Section 2 and the corresponding LGD values set out in Paragraphs 61 and
62 of Section 2.
26. An institution may recognise unfunded credit protection for the position in equity
securities.
1.4. Risk–weighted Exposure Amounts of Other Exposures in Non Credit–
obligation Assets
27. The risk–weighted exposure amounts shall be calculated according to the formula:
Risk–weighted exposure amount = 100% * exposure value,
where exposure value is the book value of the exposure, except leasing exposures
whose value is their residual value The risk–weighted value for such exposures shall be
calculated under the following formula:
Risk–weighted exposure amount = 1/t*100% * exposure value,
where t is the number of years of the lease contract.
2. Calculation of the Risk–weighted Exposure Amounts for Dilution Risk of
Purchased Receivables
28. Risk weights for dilution risk of the purchased receivables of corporates and retail
receivables shall be calculated according to the formula in Paragraph 3. The input parameters
PD and LGD shall be determined as set out in Section 2, the exposure value shall be
determined as set out in Section 3 and maturity shall be 1 year. Where an institution can
demonstrate to the Commission that dilution risk is immaterial, it may not be taken into
account.
3. Calculation of Expected Loss Amount
29. Unless noted otherwise, the input parameters PD and LGD for the formulae in this
Section shall be determined as set out in Section 2 and the exposure value shall be determined
as set out in Section 3.
30. The EL amount for exposures to corporates, institutions, central governments and
central banks and retail exposures shall be calculated according to the following formulae:
7
EL = PD * LGD
EL amount = EL * exposure value
Where an institution uses its own LGD, then for defaulted exposures (PD=1), EL is ELBE that
is an institution’s own best estimate of EL in respect of defaulted exposures as estimated in
accordance with the provisions of Paragraph 157 of Section 4 of this Annex.
For exposures subject to the option provided for in Paragraph 4 of Section 1 of this
Annex, EL shall be 0%.
31. For specialised lending exposures where an institution uses the methods set out in
Paragraph 6 for assigning risk weights, EL amount shall be established according to Table 2.
Table 2. EL for specialised lending exposures
Residual maturity
Less than
years
Category 1
Category 2
Category 3
Category 4
Category 5
2,5
Equal or longer
than 2,5 years
0%
0.4%
2.8%
8%
50%
0.4%
0.8%
2.8%
8%
50%
32. For equity securities whose risk–weighted exposure amounts is calculated under
the Simple Risk Weight Approach referred to in Paragraphs 19–21, EL shall be calculated in
accordance with the following formula:
EL amount = EL * exposure value
EL for various equity securities shall be as follows:
─ EL = 0,8% for private equity securities;
─ EL = 0,8% for exchange traded equity securities;
─ EL = 2,4% for all other equity securities.
33. Equity securities whose risk–weighted exposure amounts is calculated under the
PD/LGD Method referred to in Paragraphs 22–24, EL shall be calculated in accordance with
the following formula:
EL amount = EL * exposure value
EL = PD * LGD
34. For equity securities whose risk–weighted exposure amounts is calculated under
the Internal Models Approach referred to in Paragraphs 25 and 26, EL amount shall be 0.
35. The EL amount for dilution risk of the purchased receivables shall be calculated
according to the following formula:
8
EL amount = EL * exposure value
An institution shall determine EL depending on the parameter values set by itself as in
Table 3.
Table 3. Provisions for calculating EL
EL
PD
LGD
PD * LGD
Institution itself determines
PD
Institution itself determines
LGD
PD * LGD
Institution itself determines
PD
75%
Institution itself
designs and
determines EL
EL
100%
Institution itself
designs and
determines EL
Institution itself determines
PD
EL/PD
Institution itself
designs and
determines EL
EL/PD
Institution itself determines
LGD
4. Inclusion of Expected Loss in the Calculation
36. The EL amount calculated in accordance with Paragraphs 30, 31 and 35 shall be
subtracted from the provisions of the exposure for impaired loans and the sum of value
adjustments of other exposures. Discounts as set out in Paragraph 64 of Section 3 of this
Annex shall be treated as value adjustments. EL for securitised exposures and provisions for
impaired loans related to these exposures and value adjustments shall not be included in this
calculation of capital requirements. The negative result of the calculation as set out in the first
sentence shall be deducted from Tier II capital in accordance with Paragraph 348.6 of the
Regulations, but the positive result may be used to partially increase Tier II own funds of the
institution in accordance with Paragraph 343.7 of the Regulations.
9
Section 2. PD, LGD and Maturity
37. The input parameters PD, LGD and M for the calculation of the risk–weighted
exposure amount and the EL amount specified in the calculations in Section 1 shall be those
estimated by the institution in accordance with the requirements of Section 4, subject to the
following provisions.
1. Exposures to Corporates, Institutions, Central Governments and Central
Banks
1.1. PD
38. The PD of an exposure to a corporate or an institution shall be at least 0,03%.
39. Where for the purchased receivables of corporates in respect of which an
institution cannot demonstrate that its PD estimates meet the minimum requirements set out in
Section 4, the PD for these exposures shall be determined as follows:
39.1. for senior claims on the purchased receivables of corporates PD shall be the
institution’s estimate of EL divided by LGD for these receivables;
39.2. for subordinated claims on the purchased receivables of corporates PD shall be
the institution's estimate of EL;
39.3. where an institution is permitted to use own LGD estimates for exposures to
corporates and it can decompose its EL estimates for the purchased receivables of corporates
into PD and LGD in a reliable manner, the PD estimate may be used.
40. The PD of obligors in default shall be 100%.
41. When determining PD, an institution shall be entitled to take into account the
unfunded credit protection in accordance with the provisions of Section 4 of Chapter 2 of
Title II.
42. Where an institution is permitted to use own LGD estimates, it shall be entitled to
take into account the unfunded credit protection by adjusting PDs subject to the provisions of
Paragraph 46.
43. For determining dilution risk of the purchased receivables of corporates, PD in
respect of the purchased receivables of corporates shall be set equal to the EL estimate for that
risk. Where an institution is permitted to use own LGD estimates for the exposures to
corporates and it can decompose its EL estimates for dilution risk of the purchased
receivables of corporates into PD and LGD in a reliable manner, the PD estimate derived as a
result of the decomposition may be used. An institution may recognise the unfunded credit
protection as eligible in accordance with the requirements of Section 4 of Chapter 2 of Title
II.
1.2. LGD
44. An institution shall use the following LGD values:
44.1. for senior exposures without eligible collateral, 45%;
44.2. for subordinated exposures without eligible collateral, 75%;
10
44.3. for covered bonds defined in Paragraph 12 of Section 1 of Annex 2, 12,5%;
44.4. for senior purchased receivables of corporates in respect of which an institution
cannot demonstrate that its PD estimate meets the minimum requirements set out in Section 4,
45%;
44.5. for subordinated purchased receivables of corporates in respect of which an
institution cannot demonstrate that its PD estimate meets the minimum requirements set out in
Section 4, 100%;
44.6. for dilution risk of purchased receivables of corporates, 75%;
44.7. for the purposes of determining LDG, an institution shall be entitled to take into
account the funded and unfunded credit protection in accordance with the requirements of
Section 4 of Chapter 2 of Title II.
45. Notwithstanding the requirements of Paragraph 44, where an institution is
permitted to determine its own LGD estimates for exposures to corporates and it can
decompose its EL estimates for the purchased receivables of corporates into PD and LGD in a
reliable manner, for dilution and default risk the institution shall be entitled to use the LGD
estimate derived as a result of the decomposition for the purchased receivables of corporates.
46. Notwithstanding the requirements of Paragraph 44, where an institution is
permitted to use its own LGD estimates for exposures to corporates, institutions, central
governments and central banks, upon the Commission’s approval it shall be entitled to
recognise the unfunded credit protection by adjusting PD and/or LGD subject to minimum
requirements as specified in Section 4. An institution shall not assign to the secured exposures
the adjusted PD and/or LGD where the risk weight calculated in accordance with the adjusted
PD and/or LGD would be lower than that of a comparable, direct exposure to the protection
provider.
47. Notwithstanding the requirements of Paragraphs 44 and 46, when using the
adjustments referred to in Paragraph 4 of Section 1, the LGD of a comparable direct exposure
to the protection provider shall either be the LGD associated with the unhedged liabilities of
the protection provider or the unhedged liabilities of the obligor, depending upon whether in
the event of default of both the protection provider and the obligor during the life of the
hedged transaction, the available evidence or the structure of the guarantee indicate that the
amount recovered would depend on the financial condition of the protection provider or the
obligor, respectively.
1.3. Maturity
48. For repurchase transactions or securities or commodities lending or borrowing
transactions a maturity of 0,5 years and to all other exposures not listed in paragraph 49 a
maturity of 2,5 years shall apply.
49. Where an institution is permitted to use own LGD and/or own conversion factors
for exposures to corporates, institutions, central governments or central banks, it shall
calculate M for each of these exposures as set out in Paragraphs 49.1–49.5, taking into
account the requirements of Paragraphs 50–52. In all cases M shall be no greater than 5 years:
49.1. for instruments subject to a cash flow in settlements before maturity, M shall be
calculated according to the following formula:
11
T = MAX{1; MIN{  t * CFt /  CFt ; 5}},
t
t
where CFt denotes the cash flows (the principal, interest payments, fees and other)
contractually payable by the obligor in period t;
49.2. for derivative instruments subject to a master netting agreement, M shall be the
weighted average residual maturity of the exposure and it shall be at least 1 year. The notional
amount of each exposure shall be used for weighting the maturity;
49.3. for exposures arising from fully or nearly–fully collateralised derivative
instruments and for fully or nearly–fully collateralised margin lending transactions which are
subject to a master netting agreement, M shall be the weighted average residual maturity of
the transactions and it shall be at least 10 days. The notional amount of each transaction shall
be used for weighting the maturity;
49.4. where an institution is permitted to use own PD estimates for the purchased
receivables of corporates, M shall equal the purchased receivables exposure weighted average
maturity, but at least 90 days. The same M shall also be used for undrawn credit lines for the
purchase of receivables of corporates provided that the credit contract contains effective
conditions, an early amortization trigger or other features that protect the purchasing
institution over the credit term against a significant deterioration in the quality of the future
receivables. In the absence of such effective protections, M for undrawn credit lines shall be
calculated as the sum of the longest–dated potential receivable under the purchase agreement
and the remaining maturity of the credit line contract and M shall be at least 90 days;
49.5. for any other exposures than those mentioned in this Paragraph or where an
institution is not in a position to calculate M as set out in Paragraph 49.1, M shall be the
maximum remaining time (in years) that the obligor is permitted to take to fully discharge its
contractual obligations and it shall be at least 1 year;
49.6. where an institution uses the Internal Model Method set out in Section 6 of
Annex 1 to calculate the exposure values, M shall be calculated for exposures to which they
apply this method and for which the maturity of the longest–dated contract contained in the
netting set is greater than one year according to the following formula:
tk 1 year

T = MIN
maturity
Effective EEk *∆tk*dfk+
 SRDV *. ∆tk*dfk
tk 1 year
k 1
tk 1 year

Effective EEk *∆tk*dfk
k 1
where dfk is the risk–free discount factor for future time period tk (for the remaining
variables see Annex 1). Notwithstanding that, where an institution uses internal models for
one–sided credit valuation adjustment, upon the Commission's approval it shall be entitled to
use the credit modified duration estimated as M under the internal model;
49.7. for netting sets in which all transactions have an original maturity of less than
one year, the maturity shall be established by using the requirements of Paragraph 49.1 and in
view of the requirements of Paragraph 50;
49.8. when using the formula of Paragraph 4 of Section1, M shall be the effective
maturity of the credit protection but at least 1 year.
50. Notwithstanding the requirements of Paragraph 49.1, 49.2, 49.4 and 49.5 M shall
be at least one day for the following transactions:
12
50.1. fully or nearly–fully collateralised derivative instruments listed in Paragraph 92
of the Regulations;
50.2. fully or nearly–fully collateralised margin lending transactions;
50.3. repurchase transactions, securities or commodities lending or borrowing
transactions provided that for transactions referred to in Paragraphs 50.1–50.3 documented
procedures and a manual for carrying out transactions shall be ensured setting out daily
revaluation and daily re–margining, and their supplementing depending on the revaluation
result and they include provisions that allow for the prompt liquidation (realisation) or set–off
of collateral and claim in the event of bankruptcy or failure to re–margin due to other reasons.
51. An institution shall be entitled to derogate from the requirements of Paragraphs 49
and 50 and establish M, in accordance with Paragraph 48, for exposures to corporates located
in the Community with turnover of the consolidation group and assets of the consolidation
group less than 500 million euros.
52. Maturity mismatch shall be included in the calculation in accordance with the
requirements of Section 4 of Chapter 2 of Title II.
2. Retail Exposures
2.1. PD
53. The PD of an exposure shall be at least 0,03%.
54. The PD of obligors of exposures in default shall be 100%.
55. For dilution risk of the purchased receivables PD shall be set equal to an
institution's EL own estimates for dilution risk. Where an institution can decompose its EL
estimates for dilution risk of the purchased receivables into PD and LGD in a reliable manner,
the PD estimate shall be used.
56. Unfunded credit protection may be recognised when adjusting PD subject to
Paragraph 58. Where an institution does not use own estimates of LGD for dilution risk
purposes, unfunded credit protection shall be subject to Section 4 of Chapter 2 of Title II.
2.2. LGD
57. Where an institution is permitted by the Commission, it shall be entitled to provide
own estimates of LGD subject to the minimum requirements as specified in Section 4. For
dilution risk of the purchased receivables, an LGD value of 75% shall be used. Where an
institution can decompose its EL estimates for dilution risk of the purchased receivables into
PD and LGD in a reliable manner, the LGD estimate derived as a result of decomposition
may be used.
58. Where the Commission approves it, the unfunded credit protection may be taken
for individual exposures or a pool of exposures by adjusting PD or LGD estimates subject to
Paragraphs 173–181 of Section 4. An institution shall not adjust PD or LGD of guaranteed
exposures where the adjusted risk weight would be lower than that of a comparable, direct
exposure to the protection provider.
13
59. Notwithstanding the provisions of Paragraph 58, when using the adjustments
referred to in Paragraph 11 of Section 1, the LGD of a comparable direct exposure to the
protection provider shall either be the LGD associated with unhedged claims to the protection
provider or the LGD for unhedged claims against the obligor, depending upon whether, in the
event both the protection provider and obligor default during the life of the hedged
transaction, available evidence or the structure of the guarantee indicate that the amount
recovered would depend on the financial condition of the protection provider or the obligor,
respectively.
3. Equity Securities whose Risk–weighted Exposure Amounts is Calculated under
the PD/LGD Method
3.1. PD
60. PDs shall be determined according to the methods for exposures to corporates. The
following minimum PD shall apply:
60.1. 0,09% for exchange traded equity securities where the investment is part of a
long‑term customer relationship;
60.2. 0,09% for private equity securities where the returns on the investment are based
on regular and periodic cash flows not derived from capital gains;
60.3. 0,40% for exchange traded equity securities including other short positions in
such equity securities as set out in Paragraph 20 of Section 1, but excluding equity securities
referred to in Paragraph 60.1;
60.4. 1,25% for all other equity securities, including other short positions as set out in
Paragraph 20 of Section 1.
3.2. LGD
61. For equity securities in a sufficiently diversified portfolio an LGD of 65% may be
applied.
62. To all other equity securities an LGD of 90% shall apply.
3.3. Maturity
63. Maturity (M) assigned to all exposures shall be 5 years.
14
Section 3. Exposure Value
1. Exposures to Corporates, Institutions, Central Governments and Central
Banks and Retail Exposures
64. Unless noted otherwise, the exposure value of on–balance sheet exposures shall be
measured before the reduction for provisions for impaired loans and value adjustments. For
the purposes of this Paragraph, value adjustments applies to assets purchased at a price
different than the amount owed. For the purchased assets, the difference between the amount
owed and the net value recorded on the balance sheet of an institution is denoted as discount
where the amount owed is larger than the acquisition price and as a premium where it is
smaller than the acquisition price.
65. Where an institution uses master netting agreements in relation to repurchase
transactions or securities or commodities lending or borrowing transactions, the exposure
value shall be calculated in accordance with Section 4 of Chapter 2 of Title II.
66. For on–balance sheet netting of loans and deposits the methods set out in Section 4
of Chapter 2 of Title II shall be used.
67. The exposure value for leases shall be the discounted minimum lease payment
flow. The minimum lease payments are the payments over the lease term that the lessee is or
can be required to make and any bargain option, i. e., an option the exercise of which is
reasonably certain. Any guaranteed residual value fulfilling the requirements of
Paragraphs 12–13 of Section 1 of Annex 3 regarding the recognition of eligibility of
protection provider as well as the minimum requirements for recognising other types of
guarantees provided for under Paragraphs 32–39 of Section 2 of Annex 3 should also be
included in the minimum lease payments.
68. The exposure value for the derivative instruments referred to in Paragraph 92 of
the Regulations shall be determined using one of the methods set out in Annex 1.
69. The exposure value for the purchased receivables shall be the outstanding amount
owed before using the credit risk mitigation methods reduced by the respective capital
requirements for dilution risk.
70. Where an exposure takes the form of securities or commodities sold, posted (re–
recorded) to another account or lent under repurchase transactions or securities or
commodities lending or borrowing transactions, long settlement transactions and margin
lending transactions, the exposure value shall be the book value of the securities or the
commodities as disclosed in the balance sheet. Where the Financial Collateral Comprehensive
Method as set out in Section 3 of Annex 3 is used for risk mitigation, the exposure value shall
be increased by the volatility adjustment appropriate to such securities or commodities, as set
out in Section 3 of Annex 3. The exposure value of repurchase transactions, securities or
commodities lending or borrowing transactions, long settlement transactions and margin
lending transactions may be determined by using the methods set out in Annex 1 for such
transactions or the credit risk mitigation methods referred to in Paragraphs 89–97 of Section 3
of Annex 3.
15
71. The claims arising in settlement with a counterparty in the exposure referred to in
paragraph 70 shall be valued in accordance with Paragraph 33 of Section 2 of Annex 1
provided that the central counterparty's counterparty credit risk exposures with all participants
in its arrangements are fully collateralised on a daily basis.
72. Hereinafter in this Paragraph, the exposure value shall be the credit equivalent of
an exposure calculated by multiplying the committed but undrawn amount of the contract
(transaction) with the respective conversion factor:
72.1. for credit lines in the amount which is undrawn, where an institution is entitled to
unilaterally and unconditionally cancel at any time without a prior notice or that effectively
provide for automatic cancellation due to deterioration in a obligor's credit worthiness, a
conversion factor of 0% shall apply where the institution actively monitors the financial
condition of the obligor and its internal control systems enable it to immediately detect a
deterioration in the credit quality of the obligor. Undrawn credit lines included in the portfolio
of retail exposures may be considered unconditionally cancellable where the terms permit the
institution to cancel them to the extent allowable under consumer protection and related
legislation;
72.2. for short–term letters of credit arising from the dispatch of goods, a conversion
factor of 20% shall apply for both the issuing and confirming institutions;
72.3. for granted, yet undrawn credit lines for a contract of revolving purchased retail
receivables that an institution is entitled to unconditionally cancel or terminate or that
effectively provide for automatic cancellation at any time by the institution without prior
notice, a conversion factor of 0% shall apply where an institutions actively monitors the
financial condition of the obligor and its internal control systems enable it to immediately
detect a deterioration in the credit quality of the obligor;
72.4. for other credit lines, note issuance facilities (NIF) and revolving underwriting
facilities (RUF), a conversion factor of 75% shall apply;
72.5. an institution which meets the minimum requirements for the use of own
estimates of conversion factors as specified in Section 4 shall be entitled, upon receipt of the
Commission's approval, to use its own estimates of conversion factors across the contingent
liabilities as referred to in Paragraphs 72.1–72.4.
73. Where contingent liabilities to a customer refer to the extension of other contingent
liabilities, the lower of the two conversion factors associated with the individual contingent
liabilities shall be used.
74. For off–balance sheet exposures other than those mentioned in Paragraphs 64–73,
the exposure value shall be the determined in accordance with Paragraph 90 of Section 2 of
Title II as a credit equivalent established when calculating exposure value with the conversion
factors referred to in Paragraph 90 of the Regulations.
2. Equity Securities
75. The exposure value shall be the value presented in the financial accounts.
Admissible equity securities measures are as follows:
75.1. for investments held at fair value and for which the changes in value are
reflected in the profit or loss statement and into own funds, the exposure value is the fair
value presented in the balance sheet;
16
75.2. for investments held at fair value and for which the changes in value are not
reflected in the profit or loss statement, but in the item "Revaluation Reserve", the exposure
value is the fair value presented in the balance sheet;
75.3. for investments held at their purchase price or at the lower of the purchase price
or the market price, the exposure value is the purchase price or the market price presented in
the balance sheet.
3. Other Assets that Do Not Constitute Credit Obligations to an Institution
76. For the exposures included in other assets that do not constitute liabilities of an
institution to the obligor, the value shall be the book value presented in the financial accounts.
17
Section 4. Minimum Requirements for Using the Internal Ratings Based
Approach
1. Rating System
77. A rating system shall comprise all methods, processes, controls, data collection
and IT systems that support the assessment of credit risk, the assignment of exposures to
grades or pools (rating), and determine default and loss estimates for a certain type of
exposure.
78. Where an institution uses multiple rating systems, the rationale for assigning an
obligor or a transaction to a rating system shall be documented and applied in a manner that
appropriately reflects the level of risk.
79. The criteria and processes for assigning the rating shall be periodically reviewed to
determine whether they remain appropriate for the relevant portfolio and external conditions.
1.1. Structure of Rating Systems
80. Where an institution uses direct estimates of risk parameters, these may be seen as
the conditions of each exposure category for being graded on a continuous rating scale.
1.1.1. Exposures to Corporates, Institutions, Central Governments and Central
Banks
81. A rating system shall take into account the characteristics of the obligor and the
transaction risk.
82. A rating system shall have an obligor rating scale which reflects exclusively the
quantification of the risk of the obligor's default. The obligor rating scale shall have a
minimum of seven grades for non–defaulted obligors and one for defaulted obligors.
83. An obligor grade is a risk category within a rating system's obligor rating scale, to
which obligors are assigned on the basis of a specified and distinct set of rating criteria, from
which estimates of PD are derived. An institution shall document the relationship between
obligor grades in terms of the level of default risk each grade implies and the criteria used to
distinguish the level of default risk.
84. An institution whose portfolios are concentrated in a particular market segment
and range of default risk shall have enough obligor grades within that range to avoid undue
concentrations of obligors in a particular grade. Significant concentration within a single
grade shall be supported by convincing empirical evidence that the obligor grade covers a
reasonably narrow PD band and that the default risk posed by all obligors in the grade falls
within that band.
85. In order that the Commission could permit an institution to use own estimates of
LGD for capital requirement calculation, a rating system shall incorporate a distinct facility
rating scale which exclusively reflects LGD–related transaction characteristics.
18
86. A facility grade is a risk category within a rating system's facility scale to which
exposures are assigned on the basis of a specified and distinct set of rating criteria from which
estimates of LGD or of correction factors are derived. The grade definition shall include both
a description of how exposures are assigned to the grade and of the criteria used to distinguish
the level of risk in each grade.
87. A significant concentration within a single facility grade shall be supported by a
convincing empirical evidence that the facility grade covers a reasonably narrow LGD band
and that the risk posed by all exposures in the grade falls within that band.
88. An institution that uses the methods set out in Paragraph 6 of Section 1 for
assigning risk weights for specialised lending exposures shall be exempt from the requirement
to have an obligor rating scale which reflects exclusively the quantification of the risk of
obligor default for these exposures. Notwithstanding the requirements of Paragraph 83, an
institution shall have for these exposures at least four grades for non–defaulted obligors and at
least one grade for defaulted obligors.
1.1.2. Portfolio of Retail Exposures
89. Rating systems shall reflect both obligor and transaction risk and shall capture all
relevant characteristics of the obligor and the transaction.
90. The level of risk differentiation shall ensure that the number of exposures in a
given grade or pool is sufficient to allow for a meaningful quantification and validation of the
loss characteristics at the grade or pool level. The distribution of exposures and obligors
across grades or pools shall be such as to avoid excessive concentration.
91. An institution shall demonstrate that the process of assigning exposures to grades
or pools provides for a meaningful differentiation of risk, for a grouping of sufficiently
homogenous exposures, and for accurate and consistent estimation of loss characteristics at
the grade or the pool level. For the purchased receivables the grouping shall reflect the seller's
underwriting practices and the heterogeneity of its customers.
92. When assigning exposures to grades or pools, an institution shall consider the
following risk drivers:
92.1. obligor risk characteristics;
92.2. transaction risk characteristics, including product and/or collateral types. An
institution shall explicitly address cases where several exposures benefit from the same
collateral;
92.3. delinquencies, unless an institution demonstrates to the Commission that
delinquency is not a material risk driver for the particular exposure.
1.2. Assignment to Grades or Pools
93. An institution shall have the necessary definitions, processes and criteria for
assigning exposures to grades or pools within a rating system. They shall meet at least the
following requirements:
93.1. the grade or pool definitions and criteria shall be sufficiently detailed to allow
those employees of an institution who are charged with assigning ratings to exposures to
19
consistently assign obligors or facilities with a similar risk to the same grade or pool. This
consistency shall exist across lines of business, structural units and geographic locations;
93.2. the documentation of the rating process shall allow third parties to understand
the assignment of exposures to grades or pools, to replicate grade and pool assignments and to
evaluate the appropriateness of the assignments to a grade or a pool;
93.3. these criteria shall also be consistent with the institution's internal lending
standards and its policies for handling troubled obligors and facilities.
94. When assigning obligors or facilities to grades or pools, an institution shall take all
relevant information into account. Information shall be current and shall enable the institution
to forecast the future performance of the exposure. The less information an institution has, the
more conservative shall be its assignments of exposures to obligor and facility grades or
pools. Where an institution uses an external rating as a primary factor determining an internal
rating assignment, it shall ensure that it considers other relevant information.
1.3. Assigning of Ratings to Exposures
1.3.1. Exposures to Corporates, Institutions, Central Governments and Central
Banks
95. Each obligor shall be assigned to an obligor grade as part of the credit approval
process.
96. Where an institution is permitted to use its own estimates of LGD or conversion
factors, it shall also assign each exposure to a facility grade as part of the credit approval
process.
97. Where an institution uses the methods set out in Paragraph 6 of Section 1 for
determining risk weights for specialised lending exposures, it shall assign each of these
exposures to a grade in accordance with Paragraph 88.
98. Each legal entity to which an institution is exposed to shall be separately rated. An
institution shall demonstrate to the Commission that it has acceptable policies regarding the
treatment of individual obligor customers and groups of connected customers.
99. Exposures to the same obligor shall be assigned to the same obligor grade
irrespective of any differences in the nature of each specific transaction. Exceptions when
separate exposures of the same obligor are allowed to be grouped in multiple grades are as
follows:
99.1. country transfer risk that is dependent on whether the exposure is denominated in
local or foreign currency;
99.2. where the guarantees associated with an exposure may be reflected in an
adjusted assignment of an obligor to the respective grade;
99.3. where consumer protection, institution's secrecy or other regulatory requirements
prohibit the exchange of customer data with third parties.
1.3.2. Portfolio of Retail Exposures
20
100. Each exposure shall be assigned to a grade or a pool as part of the credit approval
process.
1.3.3. Overrides
101. For grade and pool assignments an institution shall document the situations in
which, as an exception, human judgement may override the inputs or outputs of the
assignment process and the personnel responsible for approving these overrides. The
appropriately authorised staff shall approve these overrides. An institution shall document
these overrides and the responsible personnel. An institution shall analyse the performance of
the exposures whose assignments have been overridden, i. e., overriding the inputs or outputs.
This analysis shall include assessment of the effective performance of exposures whose rating
has been overridden by a particular person, accounting for all the responsible personnel who
have approved overriding outside the normal order of assignment.
1.4. Integrity of the Assignment Process
1.4.1. Exposures to Corporates, Institutions, Central Governments and Central
Banks
102. Assignments of ratings and periodic reviews of assignments shall be completed
or approved by an independent party that does not directly benefit from decisions to extend
the credit.
103. An institution shall update rating assignments at least annually. In respect of high
risk obligors and problem exposures the review shall be more frequent. An institution shall
assign a new rating where material information on the obligor or exposure becomes available
to it.
104. An institution shall have an effective process to obtain and update relevant
information on obligor characteristics that affect PD and on transaction characteristics that
affect LGD and conversion factors.
1.4.2. Portfolio of Retail Exposures
105. An institution shall at least annually revise obligor and facility assignments to
grades and pools or review the loss characteristics and delinquency status of each identified
risk portfolio, where applicable. At least annually an institution shall also review in a
representative sample the status of individual exposures within each portfolio as a means of
ensuring that exposures continue to be assigned to the correct portfolio.
1.5. Use of Models
106. Where an institution uses statistical models and other mechanical methods to
assign exposures to obligor or facility grades or pools, then:
106.1. an institution shall demonstrate to the Commission that it is possible to derive
reliable predictions and that capital requirements for credit risk are not distorted as a result of
the use of models. The input variables shall form a reasonable and effective basis for the
resulting predictions. The model shall not have material biases;
21
106.2. an institution shall have a process for vetting data inputs into the model, which
includes an assessment of the accuracy, completeness and appropriateness of the data;
106.3. an institution shall demonstrate that the data used to build the model are
representative of the institution's actual obligors or exposures;
106.4. an institution shall have a regular cycle of model validation that includes
monitoring model performance and stability, reviewing model specification, and testing
model outputs against outcomes;
106.5. an institution shall complement the statistical model by a human judgement and
human oversight to review model–based assignments and to ensure that the models are used
appropriately. Review procedures shall aim at finding and limiting errors associated with
model weaknesses. Human judgements shall take into account all relevant information not
considered by the model. An institution shall document how human judgement and model
results are combined.
1.6. Documentation of Rating Systems
107. An institution shall document the design and operation of its rating systems. The
documentation shall evidence compliance with the minimum requirements in this Section and
address topics including portfolio differentiation, rating criteria, responsibilities of parties that
rate obligors and exposures, frequency of assignment reviews, and management oversight of
the rating process.
108. An institution shall document the rationale and analysis methods supporting its
choice of rating criteria. An institution shall document all major changes in the risk rating
assignment process and such documentation shall support identification of the changes made
to the risk rating assignment process subsequent to the last review by the Commission. The
organisation of rating assignment including the rating assignment process and the internal
control structure shall also be documented.
109. An institution shall document the specific definitions of default and loss as used
internally and demonstrate consistency with the definitions set out in these Regulations
110. Where an institution employs statistical models in the rating process, it shall
document its methodologies. This material shall:
110.1. provide a detailed outline of the theory, assumptions or mathematical and
empirical basis for the estimates in respect of the assignment to grades, individual obligors,
exposures, or pools, and the data source(s) used to estimate the model;
110.2. establish a rigorous statistical process (including out–of–time and out–of–
sample performance tests) for validating the model;
110.3. indicate any circumstances under which the model does not work effectively.
111. Where a model obtained from a third party vendor that claims proprietary
technology is used, it is not a justification for an exemption from the documentation of the
model or from any other requirements for rating systems. An institution shall satisfy the
Commission that the model meets the requirements of the Regulations.
1.7. Data Maintenance
22
112. An institution shall collect and store data on its internal ratings to ensure, as a
minimum, disclosure of information as required under the Commission’s Regulations No. 61
“Regulations on Information Disclosure” of 2 May 2007.
1.7.1. Exposures to Corporates, Institutions, Central Governments and Central
Banks
113. An institution shall collect and store the following data:
113.1. complete rating histories on obligors and recognised guarantors;
113.2. the dates on which the ratings were assigned;
113.3. the key data and methodology used to derive the rating;
113.4. the identity of the person responsible for the rating assignment;
113.5. the identity of obligors and exposures that defaulted;
113.6. the date and circumstances of such defaults;
113.7. data on the PD and realised default rates associated with rating grades and
ratings migration across grades;
113.8. where an institution does not use own estimates of LGD or conversion factors,
it shall collect and store data on comparisons of realised LGD to the values as set out in
Paragraph 44 of Section 2, and the realised conversion factors to the values as set out in
Paragraph 72 of Section 3.
114. Where an institution uses own estimates of LGD or conversion factors, it shall
collect and store the following data:
114.1. complete histories of data on the facility ratings, LGD and conversion factor
estimates associated with each rating scale;
114.2. the dates on which the ratings were assigned and the estimates were made;
114.3. the key data and the methodology used to derive the facility ratings, LGD and
conversion factor estimates;
114.4. information on the person who assigned the facility rating and the person who
provided LGD and conversion factor estimates;
114.5. data on the own estimated and effective LGD and conversion factors associated
with each defaulted exposure;
114.6. data on the LGD of the exposure before and after evaluation of the effects of a
guarantee or credit derivative instrument where an institution reflects the credit risk mitigating
effects of guarantees or credit derivative instruments through LGD estimates;
114.7. data on the components of loss for each defaulted exposure.
1.7.2. Portfolio of Retail Exposures
115. An institution shall collect and store the following data:
115.1. data used in the process of allocating exposures to grades or pools;
115.2. data on the own estimated PD, LGD and conversion factors associated with
grades or pools of exposures;
115.3. the identity of obligors and exposures that defaulted;
115.4. for defaulted exposures, data on the grades or pools to which the exposure was
assigned during the year prior to default and the effective outcomes on LGD and conversion
factors;
115.5. data on loss rates for qualifying revolving retail exposures of the portfolio of
retail exposures.
23
1.8. Stress Tests for Establishing Capital Adequacy
116. An institution shall have and it shall apply sound stress testing processes for use
in the assessment of its capital adequacy. Stress testing shall involve identifying possible
events or probable changes in economic conditions that could have adverse effects on an
institution's credit exposures and assessment of the institution's ability to withstand such
changes.
117. An institution shall regularly perform a credit risk stress test to assess the effect
of certain specific conditions on its total capital requirements for credit risk. The test shall be
chosen by the institution, it shall be meaningful and reasonably conservative and it shall
consider at least the effect of mild recession scenarios. An institution shall assess migration in
its ratings under the stress test scenarios. Stressed portfolios shall contain the vast majority of
an institution's total exposure.
118. Where an institution uses the adjustments set out in Paragraph 4 of Section 1 to
calculate the risk–weighted exposure amounts, it shall consider, as part of its stress testing
framework, the impact of deterioration in the credit quality of the protection provider, in
particular the impact of a protection provider falling outside the eligibility criteria.
2. Risk Quantification
119. When determining the risk parameters associated with rating grades or pools, an
institution shall apply the following requirements.
2.1. Definition of Default
120. A default by a particular obligor shall be considered to have occurred when either
or both of the two following events have taken place:
120.1. an institution considers that the obligor is unlikely to pay its credit obligations
to the institution, its parent undertaking, subsidiary undertakings or subsidiary undertakings of
the parent undertaking in full, without recourse by the institution to actions such as realising
security (if held);
120.2. the obligor is past due more than 90 days on any material credit obligation to
the institution, its parent undertaking, subsidiary undertakings or subsidiary undertakings of
the parent undertaking.
121. Days past due for credit obligations shall be determined as follows:
121.1. for overdrafts, days past due commence once an obligor has breached an
advised limit (the limit notified to the obligor when signing the contract or in any other form),
has been advised a limit smaller than current outstanding balance, or has drawn credit without
authorisation and the overdraft amount is material.;
121.2. for credit cards, days past due commence on the minimum payment due date,
but the payment is not made;
121.3. for other credit obligations, days past due commence on the next day after the
established repayment date of the principal, the interest or any other liabilities set out in the
contract, where the risk arising thereof is material.
24
122. In the case of retail exposures an institution shall be entitled to apply the
definition of default at a facility rating level.
123. The following indicators evidence probable inability to pay:
123.1. an institution puts the credit obligation on non–accrued status and assigns to it
the status of a non–interest bearing debt;
123.2. an institution makes a value adjustment of a debt as there is a significant
decline in credit quality;
123.3. an institution sells the debt at a material economic loss;
123.4. an institution consents to restructuring the debt of the distressed obligor where
this is likely to result in a diminished financial obligation caused by the material forgiveness,
or postponement, of principal, interest or (where relevant) fees. In the case of equity securities
assessed under a PD/LGD Approach, the issuer’s equity is restructured;
123.5. an institution has made a request to recognise the obligor's insolvency or a
similar request in respect of an obligor's obligations to the institution, its parent undertaking,
its subsidiary undertaking or the subsidiary undertakings of the parent undertaking;
123.6. the obligor has sought to be recognised as insolvent or has been placed in a
bankruptcy or a similar protection where this would avoid or delay repayment of a credit
obligation to the institution, its parent undertaking, its subsidiary undertaking or the
subsidiary undertakings of the parent undertaking.
124. Where an institution uses external data that are not consistent with the definition
of default, it shall demonstrate to the Commission that it has made appropriate adjustments to
achieve broad equivalence with the definition of default.
125. Where an institution considers that no case of the definition of default can apply
to a previously defaulted exposure, it shall rate the obligor or the facility as if there has been
no default. Should the definition of default subsequently be triggered, another default not
related to the previous would be deemed to have occurred.
2.2. Overall Requirements for Estimates
126. An institution's own estimates of the risk parameters PD, LGD, conversion factor
and EL shall incorporate all relevant data, information and methods. The estimates shall be
derived using both historical experience and empirical evidence and not be based purely on
judgement. The estimates shall be plausible and reasonable and shall be based on the material
drivers of the respective risk parameters. The less data an institution has, the more
conservative its estimates shall be.
127. An institution shall be able to provide a breakdown of its historical loss by the
factors it sees as the drivers of the respective risk parameters. The institution shall
demonstrate that its estimates are representative in the long run.
128. Any changes in the lending practice or the process for pursuing recoveries over
the observation periods referred to in Paragraphs 143, 148, 159, 163, 170 and 172 shall be
taken into account. An institution's estimates shall reflect the implications of technical
advances, new data and other information as they become available. An institution shall
review its estimates when new information emerges, but at least annually.
25
129. The set of exposures represented in the data used for estimation, the lending
standards used when the data were generated and other relevant characteristics shall be
comparable with those of the institution's exposures and standards. An institution shall also
demonstrate that the economic or market conditions that underlie the data are relevant to the
current and foreseeable conditions. The number of exposures in the sample and the data
period used for quantification shall be sufficient to provide the institution with confidence in
the accuracy and reliability of its estimates.
130. For the purchased receivables the estimates shall reflect all relevant information
available to the purchasing institution regarding the quality of the underlying receivables,
including data for similar pools provided by the seller or by other external sources. The
purchasing institution shall evaluate the compliance of the data provided by the seller to its
requirements.
131. An institution shall estimate a margin of conservatism that depends on the
expected range of estimation errors. Where methods and data are insufficiently satisfactory
and the expected range of errors is large, the margin of conservatism shall be large.
132. Where an institution uses different estimates for the calculation of risk weights
and for internal purposes, it shall document them and their reasonableness shall be
demonstrated to the Commission.
133. Where an institution can demonstrate to the Commission that for the data that
have been collected prior to the date of implementation of these Regulations appropriate
adjustments have been made to achieve broad equivalence with the definitions of default or
loss, the Commission may permit the institution some flexibility in the application of the
required standards for data.
134. Where an institution uses data that are portfolioed across institutions it shall
demonstrate that:
134.1. the rating systems and criteria of other institutions in the portfolio are similar
with its own;
134.2. the portfolioed data are representative of the portfolio for which they are used;
134.3. the institution uses the portfolioed data consistently all the time for its
estimates.
135. Where an institution uses data that are portfolioed across institutions, it shall
remain responsible for the integrity of its rating systems. The institution shall demonstrate to
the Commission that it has sufficient in–house understanding of its rating systems, including
effective ability to monitor and audit the rating process.
2.2.1. Requirements Specific to PD Estimates
Exposures to Corporates, Institutions, Central Governments and Central Banks
136. An institution shall estimate PD by obligor grade or pool from long–run averages
of one–year default rates.
26
137. In respect of the purchased receivables of entities an institution shall be entitled
to derive PD estimates for obligor grades on the basis of long–run averages of realised default
during a one year period.
138. Where an institution derives long–run average estimates of PD and LGD for the
purchased receivables of corporates from an estimate of EL and an appropriate estimate of PD
or LGD, the process for estimating total losses shall meet the overall standards for estimation
of PD and LGD set out in this Section and the outcome shall be consistent with the concept of
LGD as set out in Paragraph 150.
139. An institution shall use the methods for estimating PD only together with an
analysis supporting compliance of these methods with the requirements of this Annex. An
institution shall recognise the meaning of judgemental considerations when combining the
results of different methods and making adjustments in respect of limitation for methods and
information.
140. To the extent that an institution uses data on internal default experience in the
long run for the estimation of PDs, it shall demonstrate in its analysis that the estimates reflect
the underwriting standards and any differences in the rating system that generated the data
and the current rating system. Where underwriting standards or rating systems have changed,
the institution shall add a greater margin to its estimate of PD.
141. To the extent that an institution associates or maps its internal grades to the scale
used by an ECAI or similar organisations and then attributes the default rate for the ECAI
grades to the institution's grades, mappings shall be based on a comparison of internal rating
criteria to the criteria used by the external organisation and on a comparison of the internal
and external ratings of all common obligors. Biases or inconsistencies in the mapping
approach or underlying data shall be avoided. ECAI criteria underlying the data used for
assigning the rating shall be oriented to default risk only and not reflect transaction
characteristics. The institution's analysis shall include a comparison of the default definitions
used, subject to the requirements of Paragraphs 120–125. The institution shall document the
rating and the basis for mapping the criteria.
142. To the extent that an institution uses statistical default prediction models, it shall
be entitled to estimate PD as the simple average of default–probability estimates for
individual obligors in a given grade. For this purpose the institution shall use default
probability models in accordance with the standards specified in Paragraph106.
143. Irrespective of whether an institution uses external, internal, or pooled data
sources, or a combination of the three, for PD estimation the length of the underlying
historical observation period shall be at least five years for at least one source. Where the
available observation period spans over a longer period for any source and this data are
relevant to the matter under consideration, this longer period shall be used. This point shall
also apply to the PD/LGD Approach to equity securities. Where an institution is not permitted
to use own estimates of LGD or of conversion factors when implementing the IRB Approach,
it shall be entitled to reduce the relevant period to two years. The period to be covered shall
be increased gradually by one year until it covers a period of five years.
Portfolio of Retail Exposures
27
144. An institution shall estimate PD by obligor grade or pool from long–run averages
of one–year default rates.
145. Notwithstanding the requirements of Paragraph 144, PD estimates may also be
derived from effective losses and appropriate estimates of LGD.
146. An institution shall regard internal data for assigning exposures to grades or pools
as the primary source of information for estimating loss characteristics. For quantification an
institution shall be entitled to use external data (including pooled data) or statistical models
provided that a strong link can be demonstrated between the institution's process of assigning
exposures to grades or pools and the process used by the external data source and the
institution's internal risk profile and the composition of the external data. For the purchased
retail receivables an institution shall be entitled to use external and internal reference data. In
such case an institution shall use all relevant data sources as points of comparison.
147. Where an institution derives long–run average estimates of PD and LGD for the
portfolio of retail exposures from an estimate of total losses and an appropriate estimate of PD
or LGD, the process for estimating total losses shall meet the overall standards for estimation
of PD and LGD set out in this Section and the outcome shall be consistent with the concept of
LGD as set out in Paragraph 150.
148. Irrespective of whether an institution uses external, internal or pooled data
sources or a combination of the three, for the estimation of loss characteristics the length of
the underlying historical observation period used shall be at least five years for at least one
source. Where the available observation spans over a longer period for any source and these
data are relevant to the matter under consideration, this longer period shall be used. An
institution needs not give equal importance to historic data where it can convince the
Commission that more recent data is a better predictor of loss rates. When an institution
implements the IRB Approach, it shall be entitled to reduce the relevant period to two years.
The period to be covered shall be increased by one year until it covers a period of five years.
149. An institution shall identify and analyse the expected changes of risk parameters
over the life of credit exposures (seasoning effects).
2.2.2. Requirements Specific to Own LGD Estimates
150. An institution shall estimate LGD by facility grade or pool on the basis of the
average realised LGD by facility grade or pool using all observed defaults within the data
sources (default weighted average).
151. An institution shall use LGD estimates that are appropriate for an economic
downturn if those are more conservative than the long–run average. To the extent that a rating
system is expected to deliver realised LGD at a constant level by grade or pool over time, an
institution shall make adjustments to the estimates of risk parameters by grade or pool to limit
the capital impact of an economic downturn.
28
152. An institution shall consider the extent of dependence between the risk of the
obligor and of the collateral or of the collateral provider. Cases where there is a significant
degree of dependence shall be addressed in a conservative manner.
153. Where the obligation and the collateral are denominated in different currencies,
an institution shall treat them conservatively when assessing LGD.
154. Where LGD estimates take into account the existence of collateral, these
estimates shall not be based solely on the collateral's estimated market value. LGD estimates
shall take into account the effect of the potential inability of an institution to expeditiously
gain control of the collateral and liquidate it.
155. To the extent that LGD estimates take into account collateral, an institution shall
establish internal requirements for collateral management, legal certainty and risk
management that are generally consistent with the minimum requirements for collateral set
out in Annex 3.
156. To the extent and manner that an institution recognises collateral for determining
the exposure value for calculating capital requirement for counterparty's credit risk in
accordance with Sections 5 and 6 of Annex 1, any part of the exposure value expected to be
recovered from the collateral shall not be taken into account in the LGD estimates.
157. In respect of the specific cases of exposures already in default, the institution
shall use the sum of its best estimate of EL for each exposure given the current economic
circumstances and exposure status and the possibility of additional unexpected losses during
the recovery period.
158. To the extent that unpaid late fees have been capitalised in an institution's profit
and loss statement, they shall be added to measure the institution's exposure and loss.
Exposures to Corporates, Institutions, Central Governments and Central Banks
159. The estimates of LGD shall be based on the data over at least five years,
increasing the period by one year after implementation until it reaches seven years for at least
one data source. Where the available observation period spans over a longer period for any
source, and the data is relevant to the matter under consideration, this longer period shall be
used.
Portfolio of Retail Exposures
160. Notwithstanding the requirements of Paragraph 150, LGD estimates may be
derived from realised losses and appropriate estimates of PD.
161. Notwithstanding the requirements of Paragraph 166, an institution shall be
entitled to reflect future drawings of the customer within the limits of contingent liabilities
either in its conversion factors or in its own LGD estimates.
162. To estimate LDG for the purchased retail receivables, an institution shall be
entitled to use external and internal reference data.
29
163. The estimates of LGD shall be based on the data of at least five years.
Notwithstanding the requirements of Paragraph 150, an institution needs not give equal
importance to historic data where it can demonstrate to the Commission that more recent data
is a better predictor of loss rates. When an institution implements the IRB Approach, it shall
be entitled to reduce the relevant period to two years. The period to be covered shall be
increased gradually by one year until it covers a period of five years.
2.2.3. Requirements Specific to Own Conversion Factor Estimates
164. An institution shall estimate conversion factors by facility grade or pool on the
basis of the average effective conversion factors by facility grade or pool using all observed
defaults within the data sources (default weighted average).
165. An institution shall use conversion factor estimates that are appropriate for an
economic downturn if those are more conservative than the long–run average. To the extent a
rating system is expected to deliver effective conversion factors at a constant level by grade or
pool all the time, an institution shall make adjustments to the estimates of risk parameters by
grade or pool to limit the capital impact of an economic downturn.
166. An institutions' estimates of conversion factors shall reflect the possibility of
additional drawings by the obligor up to the time a default event is triggered and after that
time. The conversion factor estimate shall incorporate a larger margin of conservatism where
a stronger positive correlation can reasonably be expected between the default frequency and
the magnitude of the conversion factor.
167. When starting the estimates of conversion factors, an institution shall consider its
specific policies and strategies adopted in respect of account monitoring and payment
processing. An institution shall also consider its ability and willingness to prevent further
drawings in circumstances short of payment default, such as contract violations or other
technical default events.
168. An institution shall have adequate systems and procedures to monitor crediting
amounts, the current drawn and outstanding amounts from credit lines and outstanding
amounts per obligor and/or per facility grade. An institution shall be able to monitor
outstanding balances on a daily basis.
169. Where an institution uses different estimates of conversion factors for the
calculation of risk weighted exposure amounts and for internal purposes, they shall be
documented and their reasonableness shall be demonstrated to the Commission.
Exposures to Corporates, Institutions, Central Governments and Central Banks
170. Estimates of conversion factors shall be based on the data of at least five years,
increasing this period by one year each year after implementation of the IRB Approach until a
minimum of seven years is reached for at least one data source. Where the available
observation period spans over a longer period for any source, and the data is relevant to the
matter under consideration, this longer period shall be used.
30
Portfolio of Retail Exposures
171. Notwithstanding the requirements of Paragraph 166, an institution shall be
entitled to reflect future drawings by customers either in its own conversion factors or in LGD
estimates.
172. Estimates of conversion factors shall be based on the data of at least five years.
Notwithstanding the requirements of Paragraph 164, an institution needs not give equal
importance to historic data where it can demonstrate to the Commission that more recent data
are a better predictor of credit draw downs. Where an institution implements the IRB
Approach to calculating capital requirement for credit risk, it shall be entitled to reduce the
relevant period to two years. The period to be covered shall be increased gradually by one
year until it reaches a period of five years.
2.2.4. Minimum Requirements for Assessing the Effect of Guarantees and Credit
Derivative Instruments
Exposures to Corporates, Institutions, Central Governments and Central Banks where
an Institution Uses Own Estimates of LGD and a Portfolio of Retail Exposures
173. The requirements set out in Paragraphs 174–181 shall not apply for guarantees
provided by institutions, central governments and central banks where an institution has
received approval to apply the SA to calculate capital requirement for credit risk for
exposures to such counterparties. In this case the requirements of Section 4 of Chapter 2 of
Title II shall apply.
174. For guarantees of a portfolio of retail exposures, the requirements of Paragraphs
175–181 shall also apply to the assignment of exposures to grades or pools, and the estimation
of PD.
Eligible Guarantors and Guarantees
175. An institution shall have clearly specified criteria for those guarantors it
recognises for the calculation of the risk–weighted exposure amounts.
176. For eligible guarantors the same rules as for obligors set out in Paragraphs 93–
105 shall apply.
177. The guarantee shall be made in writing, it shall be non–cancellable on the part of
the guarantor, in force until the obligation is satisfied in full (to the extent of the amount and
tenor of the guarantee) and legally enforceable against the guarantor in a jurisdiction where
the guarantor has assets to attach and enforce a judgement. A guarantee prescribing conditions
under which the guarantor may not be obliged to perform (a conditional guarantee) may be
recognised as eligible subject to the Commission's approval. In that case an institution shall
demonstrate that the assignment criteria adequately address any potential reduction in the risk
mitigation effect.
Adjustment Criteria
31
178. An institution shall have clearly specified criteria for adjusting grades, pools or
LGD estimates to reflect the impact of guarantees when calculating the risk–weighted
exposure amount. In the case of a portfolio of retail exposures and eligible purchased
receivables an institution shall have clearly specified criteria for adjusting the process of
allocating exposures to grades or pools to reflect the impact of guarantees. These criteria shall
comply with the minimum requirements set out in Paragraphs 93–105.
179. The criteria shall be plausible and reasonable. They shall address the guarantor's
ability and willingness to perform under the guarantee, the likely timing of any payments
from the guarantor, the degree to which the guarantor's ability to perform under the guarantee
is correlated with the obligor's ability to repay, and the extent to which residual risk to the
obligor remains.
Credit Derivative Instruments
180. The minimum requirements for guarantees set out in this Section shall apply also
for single–name credit derivative instruments. In relation to a mismatch between the
underlying obligation and the reference obligation of the credit derivative instrument or the
obligation used for determining whether a credit event has occurred, the requirements set out
in Paragraph 39 of Section 2 of Annex 3 shall apply. For a portfolio of retail exposures and
eligible purchased receivables, this Paragraph shall apply to the process of allocating
exposures to grades or pools.
181. The criteria shall address the payment structure of the credit derivative instrument
and conservatively assess its impact on the level and timing of recoveries. An institution shall
consider the extent to which other forms of residual risk remain.
2.2.5. Minimum Requirements for the Purchased Receivables
Legal Certainty
182. The structure of the transaction shall ensure that under all foreseeable
circumstances an institution has effective ownership and control of all cash remittances from
the receivables. Where the obligor makes payments directly to a seller of commodities or
services or a corporate servicing the obligation, the institution shall verify regularly that
payments are forwarded completely and within the contractually agreed terms. A corporate
servicing the obligation (the servicer) is an entity that manages a portfolio of purchased
receivables or the underlying credit exposures on a day–to–day basis. An institution shall
have procedures to ensure that ownership over the receivables and cash receipts is protected
against delays due to bankruptcy or legal challenges that could materially delay the lender's
ability to realise or assign to a third party the receivables or retain control over cash receipts.
Effectiveness of Monitoring Systems
183. An institution shall monitor both the quality of the purchased receivables and the
financial condition of the seller and servicer. In particular:
183.1. an institution shall assess the correlation among the quality of the purchased
receivables and the financial condition of both the seller and the servicer and have internal
32
policies and procedures that provide adequate safeguards to protect against any contingencies,
including the assignment of an internal risk rating for each seller and servicer;
183.2. an institution shall have clear and effective policies and procedures for
determining eligibility of the seller and the servicer. An institution or its representative shall
conduct regular reviews of sellers and servicers in order to verify the accuracy of reports from
the seller or servicer, detect fraud or operational weaknesses, and verify the quality of the
seller's credit policies and servicer's collection policies and procedures. The findings of these
reviews shall be documented;
183.3. an institution shall assess the characteristics of the portfolios of purchased
receivables, including over–advances, history of the seller's arrears, bad debts and provisions
for impaired loans, payment terms, and conditions and potential correspondent accounts;
183.4. an institution shall have effective policies and procedures for monitoring on an
aggregate basis single–obligor concentrations both within and across the portfolios of
purchased receivables;
183.5. an institution shall ensure that it receives from the servicer timely and
sufficiently detailed reports on the receivables ageings and dilutions of recoverable amounts
to ensure compliance with the institution's eligibility criteria and advancing policies
governing the purchased receivables. An institution shall provide an effective means for
monitoring and confirming the seller's terms of sale and dilution of the recoverable amount.
Effectiveness of Work–out Systems
184. An institution shall have systems and procedures for detecting deteriorations in
the seller's financial condition and the quality of the purchased receivables at an early stage,
and for addressing emerging problems proactively. In particular, an institution shall have clear
and effective policies, procedures, and information systems to monitor violations of a
contract, and clear and effective policies and procedures for initiating legal actions and
dealing with problem purchased receivables.
Effectiveness of the Systems for Controlling Collateral, Credit Availability and Cash
185. An institution shall have clear and effective policies and procedures governing
the control of the purchased receivables, credit and cash. Written internal policies shall
specify all material elements of the receivables purchase programme, including the advancing
rates, eligible collateral, necessary documentation, concentration limits, and the way cash
receipts are to be handled. These elements shall take appropriate account of all relevant and
material factors, including the seller and the servicer's financial condition, risk concentrations,
and trends in the quality of the purchased receivables and the seller's customer base, and
internal systems shall ensure that funds are advanced only against specified supporting
collateral and documentation.
Compliance with the Institution's Internal Policies and Procedures
186. An institution shall have an effective internal process for assessing compliance
with all internal policies and procedures. The process shall include regular audits of all critical
phases of the institution's receivables purchase programme, verification of the separation of
duties between firstly the assessment of the staff of the seller and the servicer involved in the
assessment of the assessment of the obligor, and secondly between the assessment of the staff
of the seller and the servicer and the field audit of the seller and the servicer, evaluations of
33
back office operations, with a particular focus on qualifications, experience, staffing levels,
and supporting automation systems.
3. Validation of Internal Estimates
187. An institution shall have robust systems to validate the accuracy and consistency
of rating systems, processes, and the accuracy and consistency of estimation of all relevant
risk parameters. An institution shall demonstrate to the Commission that the internal
validation process enables it to assess the performance of internal rating and risk estimation
systems consistently and meaningfully.
188. An institution shall regularly compare effective default rates with estimated PDs
for each grade and, where effective default rates are outside the expected range for that grade,
the institution shall specifically analyse the reasons for the deviation. Where an institution
uses its own estimates of LGDs or conversion factors, it shall also perform analogous analysis
for these estimates. Such comparisons shall make use of historical data that cover as long a
period as possible. An institution shall document the methods and data used in such
comparisons. This analysis and documentation shall be updated at least annually.
189. An institution shall also use other quantitative assessment and validation tools
and comparisons with relevant external data sources. The analysis shall be based on the data
that are appropriate to the portfolio, are updated regularly, and cover a relevant observation
period. An institution's internal assessments of the performance of its rating systems shall be
based on as long a period as possible.
190. The methods and data used for quantitative validation shall be used consistently
all the time. Changes in estimation and validation methods and data (both data sources and
periods covered) shall be documented.
191. An institution shall have sound internal standards for situations where deviations
in realised PD, LGD, conversion factors and total losses, where EL is used, from expectations
become significant enough to call the validity of the estimates into question. These standards
shall take account of business cycles and similar systematic variability in default experience.
Where realised values continue to be higher than expected values, an institution shall revise
estimates upward to reflect its default and loss experience.
4. Calculation of the Risk–weighted Exposure Amounts for Equity Securities
under the Internal Models Approach
4.1. Capital Requirement and Risk Quantification
192. When calculating capital requirements, an institution shall meet the following
standards:
192.1. the estimate of potential loss shall be robust to adverse market movements
relevant to the long–term risk profile of an institution's specific portfolios. The data used to
derive return distributions shall reflect the longest sample period for which the data are
available and shall be meaningful in representing the risk profile of an institution’s equity
securities. The data used shall be sufficient to ensure conservative, statistically reliable and
34
robust loss estimates that are not based purely on subjective considerations. An institution
shall demonstrate to the Commission that the shock calculation employed provides a
conservative estimate of potential losses over a relevant long–term market or business cycle.
An institution shall combine empirical analysis of the available data with the adjustments
based on a variety of factors in order to attain model outputs that achieve appropriate realism
and conservatism. In constructing VaR models for estimating potential quarterly losses, an
institution shall be entitled to use quarterly data or extrapolate a shorter period data to a
quarterly equivalent using an analytically appropriate method supported by empirical
evidence and through a well–developed and documented thought process and analysis. Such
an approach shall be applied conservatively and consistently all the time. Where only limited
relevant data is available, an institution shall add appropriate margins of conservatism;
192.2. the models used shall be able to capture adequately all material risks embodied
in returns from equity securities including both the general market risk and specific risk
exposure of the institution's portfolio of equity securities. The internal models shall
adequately explain historical price variation, capture both the magnitude and changes in the
composition of potential concentrations, and be robust to adverse market environments. The
risk parameters represented in the data used for estimation shall be closely matched to or at
least comparable with those of the institution's equity securities;
192.3. the internal model shall be appropriate for the risk profile and complexity of an
institution's portfolio of equity securities. Where an institution has material portfolios whose
values are highly non–linear, the internal models shall be designed to capture appropriately
the risks associated with such securities;
192.4. mapping of individual positions to those of proxies, market indices, and risk
factors shall be plausible, reasonable, and conceptually sound;
192.5. an institution shall demonstrate through empirical analyses the appropriateness
of risk factors, including their ability to cover both general and specific risk;
192.6. the estimates of the return volatility of equity securities shall incorporate
relevant and available data, information, and methods. Independently reviewed internal data
or data from external sources (including pooled data) shall be used;
192.7. a rigorous and comprehensive stress–testing programme shall be in place.
4.2. Risk Management Process and Controls
193. In order to develop and use internal models for capital requirement calculation
purposes, an institution shall establish policies, procedures, and controls to ensure the
integrity of the model and the modelling process. These policies, procedures, and controls
shall include the following:
193.1. full integration of the internal model into the overall management information
systems of the institution and in the management of the portfolio of equity securities included
in the institution's portfolio. Internal models shall be fully integrated into the institution's risk
management infrastructure if they are particularly used for the following purposes: in
measuring and assessing portfolio of equity securities performance (including the risk–
adjusted performance), in allocating economic capital to equity securities and in evaluating
overall capital adequacy and the investment management process;
193.2. establishing management systems, procedures, and control functions for
ensuring the periodic and independent review of all elements of the internal modelling
process, including approval of model revisions, vetting of model inputs, and review of model
results, such as direct verification of risk computations. These reviews shall assess the
accuracy, completeness, and appropriateness of model inputs and results and focus on both
35
finding and limiting potential errors associated with known weaknesses and identifying
unknown model weaknesses. Such reviews may be conducted by an internal independent
structural unit, or by an independent external third party;
193.3. adequate systems and procedures for monitoring investment limits and the risk
exposures of equity securities;
193.4. the structural units responsible for the design and application of the model shall
be functionally independent from the units responsible for managing individual investments;
193.5. the persons responsible for any aspect of the modelling process shall be
adequately qualified. Management shall allocate sufficiently skilled and competent employees
to the modelling function.
4.3. Validation and Documentation
194. An institution shall have a robust system to validate the accuracy and consistency
of their internal models and modelling processes. All material elements of the internal models
and the modelling process and validation shall be documented.
195. An institution shall use the internal validation process to assess the performance
of its internal models and processes in a consistent and meaningful way.
196. The methods and the data used for quantitative validation shall be consistent all
the time. Changes in estimation and validation methods and data (both data sources and
periods covered) shall be documented.
197. An institution shall regularly compare actual equity securities returns (computed
using realised and unrealised gains and losses) with modelled forecasts. Such comparisons
shall make use of the historical data that cover as long a period as possible. An institution
shall document the methods and the data used in such comparisons. This analysis and
documentation shall be revised and updated at least annually.
198. An institution shall also make use of other quantitative validation tools and
comparisons with external data sources. The analysis shall be based on the data that are
appropriate to a particular portfolio, are revised and updated regularly. The data shall cover a
relevant observation period. An institutions' internal assessments of the performance of
models shall be based on as long a period as possible.
199. An institution shall have sound internal standards for situations where
comparison of actual equity securities returns with the modelled forecasts calls the validity of
the estimates or of the models as such into question. These standards shall take into account
business cycles and similar systematic variability in equity securities returns. All adjustments
made to internal models in response to model reviews shall be documented and consistent
with the institution's model review standards.
200. The internal models and the modelling process shall be documented, including
the responsibilities of the persons involved in the modelling, and the model approval and
model review processes.
5. Corporate Governance and Oversight
36
5.1. Corporate Governance
201. All material aspects of the rating and estimation processes shall be approved by
the institution's management body or a designated committee of auditors and the senior
management. The persons involved in the approval shall possess a general understanding of
the institution's rating systems and detailed comprehension of its associated management
reports.
202. The senior management of an institution shall provide notice to the management
body or a designated committee of auditors of material changes or exceptions from
established policies that will materially impact the operations of the institution's rating
systems.
203. Senior management shall have a good understanding of the rating systems
designs and operations. Senior management shall ensure, on an ongoing basis, that the rating
systems are operating properly. The structural unit carrying out the credit risk control function
shall notify senior management on a regular basis about the performance of the rating process,
the areas needing improvement, and the status of efforts to improve previously identified
deficiencies.
204. Internal ratings–based analysis of an institution's credit risk profile shall be an
essential part of the management reporting to senior management and management body or
committee. Management reporting shall include at least risk profile by grade, migration of
exposures across grades, estimation of the relevant parameters per grade, and comparison of
realised default rates and own estimates of LGD and of conversion factors against estimates
and stress–test results. Management reporting frequencies shall depend on the significance
and type of information and the level of the recipient.
5.2. Credit Risk Control
205. The structural unit that carries out the credit risk control function shall be
independent from the personnel and the management responsible for originating or renewing
exposures and shall report directly to senior management. The unit shall be responsible for the
design or selection, implementation, oversight and performance of the rating systems. It shall
regularly produce and analyse reports on the output of the rating systems.
206. The areas of responsibility for the structural unit that carries out credit risk
control shall include the following:
206.1. testing and monitoring grades and pools;
206.2. producing and analysing summary management reports from the institution's
rating systems;
206.3. implementing the procedures to verify that grade and pool definitions are
consistently applied across departments and geographic areas;
206.4. reviewing and documenting any changes to the rating process, including the
reasons for the changes;
206.5. reviewing the rating criteria to evaluate whether they remain predictive of risk.
Changes to the rating process, criteria or individual rating parameters shall be documented
and retained;
37
206.6. participating actively in the design or selection, implementation and validation
of models used in the rating process;
206.7. overseeing and supervising the models used in the rating process;
206.8. reviewing, on an ongoing basis, and making alterations to the models used in
the rating process.
207. Notwithstanding the provisions of Paragraph 206, where an institution uses
pooled data according to Paragraphs 134 and 135, it shall be entitled to outsource the
following tasks:
207.1. production of information relevant to testing and monitoring grades and pools;
207.2. production of summary management reports from the institution's rating
systems;
207.3. production of information relevant to review of the rating criteria to evaluate
whether they remain predictive of risk;
207.4. documentation of changes to the rating process, criteria or individual rating
parameters;
207.5. production of information relevant to ongoing review and alterations to models
used in the rating process.
Where an institution uses this Paragraph, it shall ensure that the Commission has
access to all relevant information that is necessary for examining compliance with the
minimum requirements and that the Commission may perform on–site examinations to the
same extent as within the institution.
5.3. Internal Audit
208. Internal audit or another comparable independent auditing unit shall review at
least annually the institution's rating systems and their operations, including of the credit
function and the estimation of PD, LGD, EL and conversion factors. The review shall capture
analysis of the adherence to all applicable minimum requirements.
38