Charting the course of default definition
The Basel Committee on Banking Supervision, under the Basel regulations, provides two main approaches for calculating banks’ regulatory capital requirement for credit risk - the internal ratings-based (IRB) and standardized approach (SA).
The capital requirement regulations (CRR), which incorporate Basel regulations into European Union (EU) law, provides the ‘definition of default’ (DoD) of an obligor. DoD represents the starting point of both approaches.
Currently, banks across the EU have the freedom to tweak the default definition according to their internal requirement, leading to inconsistencies in regulatory capital calculation. This, in turn, makes revision of the existing approaches confusing and difficult. Thus, in the absence of specific criteria for default definition, the European Banking Authority (EBA) has followed the CRR mandate to provide guidelines on the application of default definition. This would increase transparency in estimates and reduce non-risk related variability in regulatory capital.
On September 28, 2016, the EBA issued guidelines1 on the application of a new DoD across the EU prudential framework. It also released its final draft of the regulatory technical standards (RTS) on the ‘materiality threshold’ of past due credit obligations. The implementation of both the guidelines and RTS in the EU is expected to harmonize the DoD. This, in turn, is bound to lead to consistency and comparability in regulatory capital calculations based on SA and IRB methods.
The guidelines cover all aspects of DoD such as days past due (DPD) criterion for default identification, indicators of unlikeliness to pay (UTP), circumstances enabling return to non-defaulted status, and handling of external data for default identification. The RTS lists the criteria used to set the materiality threshold (absolute and relative component) for credit obligations that are past due, to harmonize its structure and application.
In addition to the guidelines and RTS, the EBA issued a quantitative analysis and qualitative impact study (QIS) for assessing the impact of select policy scenarios on the regulatory capital requirement. The QIS provides a detailed analysis of the current approaches of institutions, including the primary drivers used for setting DoD.
Finally, on December 22, 2017, the EBA published its opinion on the use of 180 DPD criterion, recommending its removal and return to the 90 DPD criterion.
The implementation of DoD guidelines are expected to kick-off from January 1, 2021. Institutions are expected to cooperate with the competent authorities for smooth implementation by modifying their internal procedures. This would include adjusting historical data and assessing the materiality of impact on the risk parameters, including the margin of conservatism (MoC) as well as recalibrating information technology systems over time.
1 under Article 178 of Regulation (EU) no 575/2013 (known as CRR)