Financial Services Authority

To: From:

Members of the EAD Expert Group Kevin Ryan FSA

Date: cc:

14 February 2007

Subject: Own estimates of Exposure at Default under IRB

Summary 1. This note is an amended version of a paper considered within the FSA, and which it has been agreed should be put forward to the Expert Group for discussion in the first instance, with a view to putting a final version to the full CRSG. Accordingly this version of the paper contains a level of background detail which is not strictly necessary for this group, but is likely to be appropriate for the less specialised membership within the CRSG. In response mainly to last year's industry note, but also to other emerging issues around the estimation of EAD, this paper makes proposals on interpretations in a number of specific areas. EADs has been the subject of relatively little consideration across the piece. Accordingly it is acknowledged that firms will have made their preparations without access to much thinking beyond the relatively high-level provisions contained in the Basel Revised Capital Framework, the CRD and BIPRU. Accordingly the main purposes of the thinking set out in this note should not be considered to constrain firms beyond what is contained in BIPRU for the purposes of their IRB applications. It does however set out what we consider to be the best interpretation of what is there contained, we think is unlikely to come as a surprise to most firms, and should be used as the basis against which we would wish to see firms develop their systems further over the coming years. Note, the previous paragraph should not be taken as meaning that firms will not be expected to meet good fit-for-purpose standards in respect of their EAD estimates for the purposes of IRB approval. It simply means that it will not be required that firms will necessarily comply with the specifics of what is contained in this note in the first instance. In addition to the specific issues with proposed ways forward covered by this note:-

2.

3.

4.

5.

6.

1 of 16

a)

We observe that the production in practice of IRB-compliant estimates of EAD has a number of similar challenges to those affecting LGD, and which was the subject of a note to the January CRSG. Examples of these are firms' ability to produce anything other than high level broad averages, the lack of data to support even these in a large number of cases (issues of both historic data storage and low default portfolio-type issues), and the applicability of even good quality external data to a parameter in which the behaviour of individual lenders is important. The conclusions from that work will have a read-across into EAD and will be the subject of a subsequent note; Further work is also required on some additional specific EAD issues, and these will also be the subject of further notes in due course.

b) Background 7.

Exposure at Default (EAD) is the third parameter to be input into IRB capital calculations, and firms wishing to use the Retail or Advanced IRB approach are required to use their own estimates for this parameter. However, relatively little attention has historically been paid to EAD on banking book assets - by academics/consultants, banks or supervisors. At a high level, the question addressed by EAD estimation is how the exposure to a borrower when default takes place will differ from the currently drawn balances. The materiality of these differences will vary greatly most markedly by type of facility, but other important influences are a firms willingness and ability to anticipate and react to deteriorating borrower circumstances; and the length and nature of the time period up to when default takes place. Banking book exposures will change over time for a number of reasons additional drawings under existing facilities; or under new facilities to existing or even new borrowers; repayments (whether scheduled, voluntary or lender-induced) under facilities; or accrual/payment of interest and charges, In addition to lending facilities, there is also another broad category of facilities, which are guarantee-like in nature, for which the EAD depends on a combination of a guarantee being issued under that facility, and on a claim being made under that guarantee. It is important to emphasise that a basic decision underpinning any approach to exposure measurement that extends beyond simply assuming that current balances remain unchanged is to decide which of the changes in exposures up to the time of default are to be covered. An important element of this is the extent to which the focus is on movements in individual facilities as opposed to in a firm's overall portfolio. There has been supervisory concern for 20 years or more over potential understatement of capital requirements on facilities where balances were not fully drawn. Hence the direct focus has been on increased drawings under existing facilities. Some simple rules were incorporated into Basel 1 as an important element of that package. Since that time these rules themselves, especially the nil capital requirement for an under one year commitment, and the boundaries around them, have been seen as key issues in capital arbitrage. The Basel 2 changes were intended to address these. However neither the objectives of EAD estimation nor the

8.

9.

10.

2 of 16

mechanisms to achieve these are explicitly articulated in any level of detail either in the Basel text or the CRD. 11. Nevertheless it does seem clear that the "own estimates of EAD" regime, with its direct focus on movement in exposures over a future period has resulted in at least an implicit consideration of the facilities/overall portfolio balance. More specifically, the IRB standards do not allow firms to anticipate reductions in exposures between the observation date and the default date, even if there is good reason to believe these will take place. This is because not allowing reductions is considered to be a sufficient proxy for the lack of a capital requirement on the new facilities assumed to come onto a firm's balance sheet over the run-off period of the existing ones. Partially as a consequence of this, EAD is not explicitly affected by the maturity of facilities 1 , which impacts only upon the PD parameter. The industrys active interest in exposure measurement seems to have been more on varying mark to market exposure given possible changes in market prices (with an important element being the position net of financial collateral2 ) in trading books. For these the underlying models generally do not have an explicit focus on what the exposure will be when defaults take place in terms of either additional drawings that might take place in advance of defaults or the greater market volatility that might be associated with a high level of defaults. In the regulatory internal models regime the alpha factor does however provide a means of conditioning exposure on when default take place and in the downturn period in the economy, and accounting for the replacement of existing exposures to a counterparty. However, even in that regime, the estimation of alpha is not its primary aim, and it is hard to see how it takes account of additional drawings under lines made available to the counterparty. In most banks, prior to Basel 2, the supervisory rules seem to have been seen as sufficient in many, if not all, applications for banking book exposures. Although a large majority of IRB candidates need to use own estimates of EAD for at least some of their exposures, development of EAD modelling has generally lagged well behind that of PD and LGD. One result of the lack of academic/consultant involvement is the absence of external measures or models, as well as thinking, that might assist firms and supervisors in coming up with reliable measures of EAD. Although it should be noted that the particularly strong influence of lender, as opposed to merely borrower, behaviour on EAD outcomes means that reliance on averages of industry experience is particularly inappropriate in most instances for this parameter. In conclusion, the relative lack of attention given to EAD has some justification as, in many but not all cases, the consequences of misstatement are less material than for PD or LGD. However it does not follow that it is an easy parameter to estimate as there are a number of non-obvious conceptual questions and CRD-related requirements that add to its complexity. A number of the key issues are listed below:-

12.

13.

14.

15.

Albeit, to the extent that shorter maturities do have some mitigating influence in practice, they can limit the extent to which any capital need be held against undrawn lines. IRB treats collateral as an adjustment to LGD, and not EAD, where own estimates are being used.

3 of 16

Exposures will change between the observation date and date of default. Over what time horizon should changes in exposure be taken into account? The acceptability of approaches which seek to estimate EAD directly, as opposed to just the additional exposures under facilities that are not fully drawn We need to be clear on which are the exposures that need an EAD estimate for Pillar 1 purposes. At what stage in its life is a facility sufficiently certain that it requires an EAD estimate to reflect the possibility of drawdown? When is it necessary to use a downturn EAD estimate as opposed to a default weighted average? The complications caused by fluctuating accrued interest. However, the basic formulation set out in this note is that the EAD required for IRB purposes is the exposure(s) expected to be outstanding under a borrower's current facilities should it go into default in the next year, but assuming that economic downturn conditions occur in the next year; and assuming also that, other than any changes resulting from the economic downturn conditions, a firm's policies and practices for controlling exposures remain unchanged from what they are at present. As with other aspects of the IRB framework, the EAD estimates to be used for capital purposes are based on the realised EADs in the reference data set of exposures that have gone into default in the past. This basic historic data needs to be adjusted to take account of, inter alia, changes in policies and practices and to produce an orientation towards an economic downturn. Estimated EAD cannot be less than current drawings.

16.

Time horizon over which default may occur 17. Although this is not immediately obvious, a critical issue in estimating an EAD on a firm's performing exposures is to determine when the default in question is going to occur; so, for example, the EAD would be expected to be different if a borrower defaults in 2 years time, than if it defaults in 1 years time. We are aware of at least one firm that has identified the possibility of creating a term structure of EADs. To obtain a clear view of this issue, consider this. A firm will have a number of defaults in its database. These should be classified according to identified material drivers of the amount of exposure to be expected at default. From these defaults it is necessary to work backwards to see how the exposure amount changed during the period preceding default. The question is what should this period be. For example, should it be considered what the exposure was 1 day before default, 1 month, 6 months, 1 year or 2 years. The answer to this question is obviously key. Any of them is possible. The answers will be different depending upon the time chosen. It is important to have a unitary answer in the same way as it is important to have a unitary (though arbitrary) answer to the time period for probability of default (e.g. annual v semi-annual or bi-annual default rates). It should however be stressed that the impact of choosing different time horizons is not easily predictable. As a generalisation, a firm's exposure to an ultimately defaulting borrower may be expected to rise over the period in which the borrower's

18.

19.

4 of 16

needs are rising and the lender sees the borrower as healthy customer; it may then be expected to decline once the lender's view changes. In such a stylised example, the lowest EADs are achieved if it assumed that a firm is at the point at which exposure will start to reduce, and the highest EADs if it is assumed that we are at the start of the rise in exposure. But the magnitude and timing of these stylised trends will vary from case to case. 20. It is proposed that the time horizon should be one year, unless a firm can demonstrate that another period would be more conservative. The decision on the time horizon is a key calibration issue for EAD. This proposal is in line with CEBS GL10. It was moreover explicitly stated in the CEBS response to industry comments on this issue, that the CRD does require a one year time horizon for EAD. After a basic time horizon is identified, a secondary question is whether estimation is on the basis that default occurs at any time during that period, or at the end of that period. These are sometimes referred to as the cohort approach and fixed horizon approach respectively. The fixed horizon method means that you take your default data and observe what the position was one year (or other relevant period) before default. The cohort method means that you observe a cohort of transactions as of a particular date and observe what happens to them in the course of the following year. CEBS agreed that both approaches can be used. The most obvious implication of allowing both approaches is that they have effectively different time horizons while that of the fixed horizon approach is unambiguously 12 months, that of the cohort approach is closer to 6 months. It is proposed that both approaches should be allowed, in line with CEBS. There are also two consequential questions which have arisen. The first is whether a 6 month fixed horizon may be used, given that this is the effective time horizon of the cohort approach. It is proposed that this is not allowed. We are not aware of any firm which is using such an approach. The second is whether any special status should be given to the "variable time approach". This is considered to be a generalisation of the fixed time approach in which several reference points (eg monthly observations) in advance of default are used instead of just one. As such it is considered to be capable of producing more stable and accurate estimates, and if the observations are limited to those within one year of default, it is consistent with the one-year horizon. It is proposed that we say nothing on this point at this stage, but consider it as an area for future enhancement. As far as we are aware it is not used by the UK industry, and we need to better understand how estimates of EAD should be derived from this data. An important issue is the inter-relationship between the basic time horizon over which default may occur, and the period over which additional drawings may occur under undrawn facilities. It should be noted that the current regime, with its under one year/over one year split, is implicitly more concerned about additional drawings that may occur in the medium term, whereas the own estimates approach explicitly has a short term horizon.

21.

22.

23. 24.

25.

26.

5 of 16

27.

It is proposed that we clarify that, where own estimates are used, the time horizon for additional drawings should be the same as the time horizon for defaults. In effect this means that EAD estimation need cover only additional drawings that might take place in the next year, such that:a) b) No capital requirement need be held against facilities, or proportions of facilities that CAN NOT be drawn down within the next year; and Where facilities can be drawn down within the next year, firms may in principle reduce their estimates to the extent that they can demonstrate that they are able and willing, based on a combination of empirical evidence, current policies, and documentary protection to prevent further drawings.

28.

If we are to adopt the approach suggested above, a consequential question is whether similar provisions may be adopted for the Standardised and Foundation approaches. However there is no read across as the CRD does not contain any provisions on Standardised and Foundation which provides alleviation where drawings are restricted. A firm needs to be using an own estimates approach in order to take account of these. A future piece of work will be to look at whether any decisions on interpretation of the own estimates regime can be read across into Standardised and Foundation. Outside of the direct Expert Group process, a question that has arisen is how the estimation of LGD and EAD should be aligned. We have previously been of the opinion that these were two separate processes and, for example, although a time horizon is necessary to estimate EAD, LGD estimation was based on the concept that default occurs immediately (albeit that the calculation of losses is oriented towards what will be experienced in a downturn period). However it has become clear that some firms are building LGD models that include data that is observed in advance of default thus implying a time horizon. There has also been some discussion in the AIG regarding whether firms may be allowed to take account of improvements in their collateral position (or reductions in exposure with collateral unchanged). Consideration of this issue has raised some awkward points, for example on whether this amounts to ignoring the requirement that EAD cannot be less than current exposure, and which is necessary to protect the principle that the regime incorporates a proxy for new facilities. It is suggested that one way of progressing in this regard is to accept that the underlying purpose of the process is to produce estimates of LGD, as opposed to separately %LGD and EAD. This would allow us to take a holistic interpretation of how any element that affects losses should be properly reflected. For example, we might be able to produce a principles-based distinction between actions ahead of default to reduce losses for which firms should properly be rewarded, and those reductions which limit the capital regime to one which covers run-off of existing facilities, i.e. ignoring the need for a proxy for replacement facilities. Other consequences might include the same time horizon being used for LGD and EAD; and that the process for choosing between downturn and default weighted averages should look at LGD and EAD together.

29.

30.

6 of 16

31.

However, this idea has not previously been raised with industry; nor have we investigated what constraints might be imposed by the CRD. Accordingly such a concept would certainly need further discussion (if not formal consultation) and, if adopted, time to move to such an approach. The implications would also need further fleshing out. Accordingly, this is seen as an area for future work, as opposed to being something that might be resolved at this time

Direct estimates of EAD v additional exposures under undrawn facilities 32. Although this note has tended to describe the objective as the estimation of Exposure at Default, the CRD regime is one in which EAD is formulated as the sum of current drawings and additional drawdowns made under the limit applied to a facility. Hence what a firm is actually required to estimate is the percentage of the currently undrawn limit, i.e. the Conversion Factor, that will be drawn down at the time of default. Many approaches to EAD estimation are indeed formulated in this way. However, there is also a range of approaches with varying degrees of sophistication which do not focus on the undrawn amount of a facility, but rather on the total amount that will be drawn down at the time of default. Typically, but not in all cases, these will estimate EAD as a percentage of the Total Limit. In the CEBS GL10, these were described collectively as the Momentum Approach. GL10 said this should be available only as a transitory solution, subject to reconsideration by the supervisory authorities. This note now seeks to confirm the FSA's approach in this regard. A momentum approach can be used either:a) b) 36. By using the drawings/limit percentage to formulaicly derive a Conversion Factor on the undrawn portion of the limit; or Using the higher of percentage of the limit and the current balance as the EAD.

33.

34.

35.

Momentum approaches will produce different answers to those produced by estimation of Conversion Factors on undrawn lines, but there is no particular reason to believe that they are less valid. Moreover they do not have the weaknesses of Conversion Factor approaches, as described below, in coping with situations where the undrawn limit is at or close to zero. Accordingly we propose that the use of momentum approaches in both of the ways outlined in para 35 should be allowed, and without any suggestion that this will be withdrawn in the foreseeable future. As noted above, the Conversion Factor approach produces distorted answers in some cases. To illustrate this point take an example in which a line of 100 had a utilisation of 105 at the time of default, and a utilisation of 99 at the observation date prior to default. This would produce a CF of 600%. (If the line had been fully drawn at the observation date, the CF would be infinity!). Typically, firms seek to estimate CFs by using an average of realised observations. A significant number of such cases in a

37.

38.

7 of 16

reference data set would produce an unrealistically high CF to be applied to the generality of exposures in the performing book. 39. We propose that where a reference data set includes a significant number of high CFs as a result of very low undrawn limits at the observation date, firms should:a) b) Investigate the distribution of realised CFs in the reference data set; and Base the estimated CF on an appropriate point along that distribution that results in the choice of a CF appropriate for the exposures to which it is being applied. A starting point might be the median, while selection of a higher point along the distribution would deliver more conservatism; Firms should not however assume without analysis that the median does represent a reasonable unbiased estimate; and should also consider whether the pattern of distribution in realised CFs means that some further segmentation is needed, (e.g. treating differently those facilities that are close to full utilisation).

c)

40.

It should be recognised that, in such situations, the median is likely to be lower than the average (or mean). The alternative would be to allow firms manipulate the data in the reference data set itself, perhaps by excluding CFs above a certain figure or capping them. However this is considered less desirable in principle as it is better to work with the actual data than to ignore it, and ignoring data requires some arbitrary decisions. For example excluding CFs above 100% would ignore the fact that in the case described above, the exposure at default was in excess of the limit.

Which exposures need an EAD estimate for Pillar 1 purposes? 41. Under the current capital regime, a facility needs to be both committed and with a drawdown period of one year or more in order to attract a capital requirement. Both these distinctions remain to some degree in the Standardised approach, while the main distinction in the Foundation approach is between committed and uncommitted facilities. Where own estimates of EAD are being used:a) b) As explained above, the focus is on defaults that may occur within the next year; and The fact that a facility is uncommitted does not remove the need for an EAD/CF to be estimated against it. This is because the own estimates approach is based upon what happens in practice, as opposed to a legalistic distinction, and in practice drawings do indeed often increase prior to default even for facilities that are uncommitted. Rather the fact that an exposure is uncommitted can result in a lower EAD than a committed facility, to the extent that a firm can demonstrate that drawdown experience is different between the two; i.e. that the existence of a commitment is a driver of EAD.

42.

43.

In summary, all current facilities at a given observation/reporting date in the banking book that may result in an exposure should a default occur require an EAD/CF. On

8 of 16

the other hand, the framework does not seek to apply an EAD where exposures outstanding at default result from new facilities or from increases in facilities subsequent to the observation date, even though these will also contribute to losses should the borrower default in the next year. This is part of the quid pro quo for using the current drawings floors as a proxy for replacement facilities in the portfolio. 44. However, even within these constraints, it should be recognised that there is a need for some clarity on:a) When the availability of a facility is sufficiently certain that an EAD/CF does need to be applied against it. The issue here is getting the balance right between, on the one hand, not wanting to apply a capital requirement too early in the facility negotiation approach and where the prospects of its being completed may be quite low; and on the other of allowing too much liberalism such that the existence of conditions precedent - a material adverse change clause, for example, means that there may be no CF/EAD until the time that a drawing is virtually certain; as well as The distinction between an increase in a facility (or a new facility) and a facility that has been extended but not yet taken up by the borrower.

b) 45.

In some ways it is regrettable that we need to provide further clarity in this area. However it must be borne in mind that measurement of undrawn exposures has to date been an area in which risk has been seen as under-recorded and that gaming of the rules has taken place. Moreover, a purer principles-based approach, such as might be based on all drawings; i.e. under both existing and new facilities, over the next year is not available in the way the IRB framework has been formulated. We have to date included in BIPRU (4.3.126(2)) guidance to the effect that a firm should treat a facility as an exposure from the earliest date at which a customer is able to make drawings under it. This was drafted with a view to avoiding inclusion of facilities at too early a stage. However a literal reading may suggest the wording may be capable of too liberal an interpretation; e.g. not until all conditions precedent have been satisfied. However we are not aware of firms in practice adopting its most liberal interpretation. While it might be preferable to step back entirely from the existing guidance for example requiring an EAD/CF to be applied as soon as the provision of a facility has been given the necessary credit approval within the firm, this would not seem practicable at this time given the language in BIPRU. Accordingly we propose to adopt the following approach:a) An EAD/CF is required on a facility from the time that a borrower is advised by the firm that it has agreed the facility is to be made available. The possibility that a facility will not eventually be taken up by the borrower, or that the formalities necessary to allow drawings to take place are not completed, subsequent to advice of the facility to the borrower, should be reflected in the EAD/CF applied to that facility;

46.

47.

48.

9 of 16

b)

Where the facility is of the type that it is customary not to advise the borrower details of its availability, an EAD/CF is required from the time that the existence of the facility is recorded on the firm's systems in a way that would allow the borrower to make a drawing; If the availability of a facility is subject to a further credit assessment by the firm, this may remove the requirement to apply an EAD/CF. However this will be the case only if the subsequent credit assessment is of substantially equivalent rigour to that of the initial credit approval, and that this includes a re-rating or a confirmation of the rating of the borrower; Internal indications of willingness to provide facilities in the future, such as by means of expression of a risk appetite for a customer, which have not been advised to the customer and the provision of which will be subject to the process described in the previous paragraph, do not require an EAD/CF; Firms are not expected to include in their EAD/CF estimates the possibility of increases in limits between observation and default date. If the reference data set includes the impact of such increases, firms may adjust their estimates accordingly with the aim of assessing what the exposure would have been at default if the limit had not been increased.

c)

d)

e)

49.

To summarise, the usual application of the framework will result in no CF being applied in the following cases:a) Exposures at Default which will result from new limits or increases in limits subsequent to the observation/reporting date, or whose availability is not yet sufficiently firm; Exposures at Default which result from drawings that take place outside the firms one year time horizon; Exposures at Default which result from products/relationships which are not meant to result in credit exposures; Exposures at Default which, although representing credit exposures that can result in losses, are intended to be excluded from the regulatory capital regime. The key area for consideration here appears to be settlement risk. The current regime has a range of different treatments for exposures associated with settlement risk. Some have explicit treatments (e.g. securities-related exposures which focus on failed settlements as opposed to credit risk in the event of counterparty defaults); others have normal Pillar 1 treatments (e.g. items in the course of collection); while settlement-related guarantees have no explicitly different treatments from other guarantees given. We would prefer to ensure that these exposures are coherently treated under the own estimates regime. However this is a complicated area, and further thought and dialogue with the industry is needed to come up with well-founded proposals. We do not have any preconceived outcome at this stage;

b) c) d)

10 of 16

e)

Anticipated increases in Exposure at Default which may legitimately be set off against anticipated reductions in other Exposures at Default, as part of the aggregation that occurs in the overall estimation process; Further increases in Exposures at Default from facilities which are already in excess of limit at the observation date. (This is because there is no undrawn limit to which a CF may be applied);

f)

50.

Of the above, items c) and f) deserve further consideration as these are not exclusions that can be said to be explicitly intended by the framework. Rather there are gaps that might be said to arise from the inability of firms to restrict exposures in practice to those allowed by their formal limits. However the materiality of such items may not be very large and by definition will vary from firm to firm. Our proposed approach is as follows:a) Firms should investigate the incidence of exposures existing at default that arise from products or relationships that are not intended to result in a credit exposure and, consequently, have no credit limit established against them and are not reflected in their estimates of EAD. Unless these are immaterial, firms should estimate a Pillar 1 capital charge on a portfolio basis to be applied against such exposures; Firms should also investigate how their EAD estimates are impacted by exposures that are in excess of limits at either the observation date (if in the reference data set) or at the current reporting date (for the existing book to which estimates need to be applied). Exposures in excess of limit should be excluded from the reference data set (as the undrawn limit is negative and nonsensical answers would result from their inclusion). Unless current exposures in excess of limit are immaterial, firms should estimate a Pillar 1 capital charge on a portfolio basis to be applied against possible future increases in such exposures. 3

51.

b)

Use of downturn and default weighted averages 52. As with LGD, estimation of EAD is intended to be oriented towards what happens in a downturn, and not just short term expectations; either by the expected default weighted average over a long run, or the direct use of estimates appropriate for a downturn if the conversion factors are expected to be higher in a downturn (BIPRU 4.3.127). However there has been no follow-up work on what this means in practice for EAD, to parallel that on downturn LGD. In part the lack of work on this subject reflects the fact that, unlike LGD where we can readily observe that, say, property values will fall in a downturn, it is not as obvious that realised EAD may be expected to increase in a downturn. Previous FSA

53.

Note that, for the amounts in excess of limit, the underlying purpose of the portfolio approach is to provide a means of estimating EAD. PD and LGD may be estimated in the usual way. However, for products which have no credit limit, a firm will frequently have no PD for the counterparties, so the entire calculation may need to be on an approximated portfolio basis.

11 of 16

work, adopted in the CEBS document, has pointed out that changes in exposure ahead of default will result from a combination of borrower demand for more funding, the willingness and ability of the firm as to provide/limit that funding, and the attitude of third party lenders who may either fill or add to (by cutting their lines) that funding need. 54. Estimation of this net effect in even normal times is generally beyond the scope of firms capabilities. However it does highlight the importance of lender behaviour in EAD which can itself of course vary over time, and also that a number of plausible stories can be put forward as to how EAD will vary in a downturn. For example, transactional lenders may argue that they will take action to cut their lines to corporate borrowers. On the other hand, if a borrowers funding requirement does not reduce, core relationship lenders will find their utilisations increasing. On the retail side, firms EADs will be affected by the strategies of themselves and other lenders. In both cases, decisions to be supportive will be aimed at reducing PD and LGD, but a higher EAD is likely to be an offsetting factor. It is proposed that we should remind firms of the requirement for EADs to be those appropriate for a downturn if these are more conservative than the long run average, and that this implicitly requires them to follow similar steps as for LGD, and in particular to identify dependencies between default rates and conversion factors for various products and markets. An important element of this will be how a firm expects its own policies as regards exposure management to evolve in a downturn. It needs to be accepted that this involves an element of pre-commitment. We do not think we can do much more than this at this stage. However, as experience evolves we can expect our general judgements to be influenced by the assumptions we see being made by individual firms; e.g. for which products are utilisations expected to be more or less likely to increase in a downturn; and (albeit more challenging) whether the assumptions being made by individual firms are, when combined, plausible for the market as a whole.

55.

56.

Complications caused by accrued interest 57. As noted earlier, one of the factors that affects exposure to a borrower is the amount of interest owed, and this causes exposure to rise and fall in a saw-tooth effect as interest gradually accrues, and is then paid. Typically, however, when a default occurs, interest is no longer paid, although the debt continues to accrue interest in the books of the lender. At the time of default, and especially if the default is triggered by a non-payment, accrued interest will usually be higher than it is on average when an exposure is performing; e.g. with quarterly payments and a 3 month default definition, 6 months accrued interest may be expected to be outstanding at default. The CRD/BIPRU requires current drawings to include interest accrued to date, or an allowance for it to be built into the conversion factor. However the CRD is silent on the treatment of changes in accrued interest up to the time of default. As its framework is based on conversion factors on undrawn limits, this silence might be interpreted as implicitly requiring changes in interest accrued up to the time of default

58.

59.

12 of 16

to be treated as part of LGD instead of EAD. However, notwithstanding this, given that the parameter is Exposure At Default, it is more conventional to include all interest up to default in EAD and not LGD. This is consistent with the guidance we have given firms in the past. 60. It should however be noted that the inclusion of increases in accrued interest in EAD does allow these to be offset against reducing balances. Where the latter are significant, this frustrates the intention of the EAD floor. The treatment of post-default interest is problematic because IRB requires recoveries to be discounted at an economic loss discount rate. If interest were to be accrued as well, this would imply a double-hit. Accordingly inclusion of post default accrued interest is not necessary in either LGD or EAD. Where the exposures in question are term loans, increases in accrued interest should be the only factor that will result in EAD being higher than current drawings. Especially where we are considering downturn LGDs, this highlights the question of what interest rate to use, and how this should inter-relate with the rate currently charged on the exposure. We propose following the following approach:a) b) c) We would reiterate that accrued interest to date should be included in current exposure for performing exposures; Firms may choose whether estimated increases in accrued interest up to the time of default should be included in LGD or EAD; Pending any wider review of the need for compatible treatments of EAD and LGD, in the estimation of EAD increases in accrued interest may be offset against reductions in other outstandings; Estimation of changes in accrued interest needs to take account of changes in the contractual interest rate over the time horizon up to default, and in a way consistent with the scenario envisaged in the calculation of the downturn/ default weighted average; Inclusion of estimates of future post-default interest is not necessary in either EAD or LGD; Firms accounting policies will determine the extent to which interest accrued to date is reflected in current exposure as opposed to LGD for defaulted exposures.

61.

62.

63.

d)

e) f)

Other issues Netting 64. In the own estimates approaches, netting is relevant in two respects. First is the calculation of current exposure. The second, and the more relevant for the purposes of this paper, is the estimation of how the exposure might be larger in the event of default. It is suggested that the distinguishing feature of the own estimates approach

13 of 16

is its ability to look at each of these cases explicitly and separately, whereas the simpler approaches are limited to one measure, ostensibly of current exposure, but which also needs to provide an estimate of what exposure might be in the future. 65. Some of the issues that arise with netting are derived from the fact that firms may charge their customers interest on the basis of net amounts owed, even though they do not necessarily have the risk management structures in place to ensure that the amount they will lose in event of default is at that time, and/or in the future, no greater than that net amount. In the Expert Group paper two issues that are mentioned are the offsetting of credit accounts against mortgage lending, and the operation of a group of business accounts against a single net limit. As regards the operation of a group of business accounts, the issue is whether the EAD should be based on the net limit, or the sum of gross limits/gross exposures. In some respects this might be considered an unnecessary complication, given that an EAD of 100 on accounts with a net limit of 200 and a gross limit of 400 could justifiably be considered an EAD of 50% or 25% respectively, and that choice should not matter provided the treatment is transparent and consistent. However practical limitations to this conclusions arise from, inter alia, the existence of zero net limits (where no CF is possible), that gross limits are not always in existence where accounts are managed on a net basis, and the LDP nature of many such exposures which means that any estimates are hard to validate. It is proposed that we adopt the following approach:a) As regards current balances, netting may be applied in those cases where a firm meets the general conditions for on-balance sheet netting set out in BIPRU 5.3.3; 4 As regards the CF on undrawn limits, this may be applied on the basis of the net limit provided the conditions in 5.3.3 are met. However firms are reminded that the purpose of the measure is to estimate the amount that would be outstanding in the event of a default. This implies that their ability in practice to constrain the removal of credit balances will be particularly tested. Moreover the appropriate conversion factor should be higher as a percentage of a net limit than a gross limit; The lower the net limit as a percentage of gross limits or exposures, the greater will be the obligation on the part of the firm to ensure that it is restricting exposures below net limits in practice and that it will be able to continue to do so should borrowers encounter difficulties. The application of a zero net limit is acceptable in principle, but there is a consequently very high obligation on the firm to ensure that breaches of this are not tolerated.

66.

67.

b)

c)

Underwriting commitments

Legal enforceability, can measure exposure at any time, monitor and control on a net basis

14 of 16

68.

The issue here is that facilities are advised to the borrower as being available along the lines set out in the section on Which exposures need an EAD estimate for Pillar 1 purposes, but on the assumption that some or all of that exposure will be passed onto other firms. The broad choices available on this problem are to:a) Allow some alleviation on underwritings in the primary market, but risk some arbitrage with the transactions in the secondary market. These are very similar in economic substance, but it is more obviously unacceptable in principle to allow a firm to reduce its EAD on the basis that it might sell off its exposure; Notwithstanding the principle suggested above, to allow firms to take account of estimated reductions in undrawn commitments on both the primary and secondary markets; Not allow any alleviation for primary market underwritings on the basis that it will not prove feasible to maintain a distinction between the primary and secondary markets;

69.

b)

c)

70.

The proposed approach is in line with the first of these alternatives:a) The estimation of CFs on underwritten facilities in the course of primary market syndication may take account of anticipated sell down to other parties; Firms are reminded that the basis of EAD estimation is that default by the borrower is expected to take place in a one year time horizon and quite possibly in downturn conditions, and any reduction in their CF in anticipation of syndication needs to take account of this scenario.

b)

Use test 71. Given the early nature of EAD estimation, there is relatively little scope for differences between those used for internal and IRB purposes. However, the above discussion on syndications does highlight one issue namely that limits are set at an earlier stage than that at which firms want to recognise the existence of that exposure for regulatory capital purposes. Abstracting from this particular point it does need to be appreciated that the IRB own estimates version of EAD does make a number of conceptual choices e.g. downturn EAD, one year time horizon, constraining reductions in exposures as a proxy for replacement facilities, that may well be different from the choices a firm might make for itself. We propose the following approach:a) As with the other parameters firms are not required to use exactly the same EAD measures for regulatory and internal purposes, but must be able to demonstrate the reasonableness of any differences as set out in BIPRU 4.2.6;

72.

73.

15 of 16

b)

In general differences are expected to be confined to those arising from conceptual distinctions between internal measures and CRD-compliant estimates of EAD. As examples: i) As with LGD, a firm may use EAD estimates in its internal risk management processes that differs from downturn EADs used in the calculation of risk weighted assets; The starting date at which a CF must be recognised against an undrawn exposure for IRB purposes need not be the same as that at which an internal limit is recorded, where the firm has a different approach to the CRD regarding the balance in EAD measurement between exposures to individual counterparties or facilities and exposures of the book as a whole.

ii)

74.

Of these the second is the more controversial (albeit on the accommodating side to the industry) and the particular proposal there is linked to the proposal on that topic for syndicated facilities. If the proposal on syndicated facilities were not taken forward, then we might revisit how the use test should be applied in that case. It is also feasible to extend the list of acceptable differences, once the way forward on the other recommendations in this paper is settled, if there is a demand from the industry.

Important EAD issues not being covered in this paper 75. As explained at the start of this paper, the production in practice of EAD-compliant estimates has a number of similar challenges to those affecting LGD. Examples of these are firms' ability to produce anything other than high level broad averages, the lack of data to support even these in a large number of cases (issues of both historic data storage and low default portfolio-type issues), and the applicability of even good quality external data to a parameter in which the behaviour of individual lenders is important. The conclusions from that work will have a read-across into EAD and will be the subject of a subsequent note. To sum up from the body of the paper, the main technical issues for further work are:a) b) c) The treatment of settlement risk; Read across of decisions on Own Estimates of EAD into Foundation IRB and/or Standardised; and Alignment of EAD and LGD.

76.

16 of 16