Developments in the Credit Risk Mitigation Framework in the European Union

The financial crisis of 2008 revealed shortcomings in the way financial institutions evaluated risk exposure. These shortcomings led to insufficient regulatory capital in times it was most needed. In the aftermath of the crisis, criticism was directed at poor risk management practices, specifically at the failure of internal model-based approaches to accurately measure risk. In response, regulators, specifically the Basel Committee on Banking Supervision, commenced reviews and revisions of internal model-based methodologies to reduce excessive variability of risk-weighted assets (“RWAs”) across institutions. While Basel III introduced changes to calculating risk-weighted assets for credit risk, using the Standardized approach and the Internal-Ratings Based (IRB) approach, rules regarding credit risk mitigation (“CRM”) remained largely unchanged.

In 2013, the European Union (“EU”) introduced the Capital Requirements Regulation (“CRR”) which implements the Basel III framework in Europe and serves as a “Single Rulebook,” providing a set of harmonized prudential requirements for the EU banking sector. The CRR specifies the CRM techniques available to financial institutions and eligibility requirements for each technique. The regulation also mandates that the European Banking Authority (“EBA”) develops regulatory technical standards (“RTS”) on select issues in this area, including three mandates pertaining to the application of CRM. The mandates by the CRR, as well as the EBA’s own assessment of the need to conduct a review of the CRM framework, laid the groundwork for the EBA’s IRB Review program.

The IRB review program is in four phases:

  1. reviewing supervisory practices used by authorities in assessing an institution’s compliance with IRB requirements,
  2. harmonizing the definition of default,
  3. providing more clarity on modelling approaches in the areas of risk parameter estimation and treatment of defaulted assets, and
  4. reviewing the credit risk mitigation framework. The March 2018 report on the CRM framework was a product of this final phase (see below).

While the report provided clarification on technical aspects of using CRM techniques, the EBA highlighted the necessity for regulators to undertake an analysis of the overall CRM framework to determine whether reform would be beneficial. The EBA’s report relied on feedback received from stakeholders; this feedback underlined the need for more clarity in the CRM framework. Regulators are continuously improving the consistency of RWAs across institutions, and these improvements will lead to future changes to the CRM framework.

Primer on the EBA’s Report Assessing the Current Credit Risk Mitigation Framework

Part I: Overview of the current design of the CRM framework in the CRR

There are several factors to consider in CRM rule implementation. CRM rules are implemented differently depending on:

  • whether the institution is using the Standardized Approach or the IRB Approach. The EBA’s review covered the use of CRM techniques under all approaches. The report maps relevant provisions to the corresponding credit risk approach;
  • whether an institution, under IRB, is permitted to use their own estimates of loss given default (LGD) and credit conversion factors (this is known as Advanced IRB, or A-IRB) versus supervisory inputs (this is known as Foundation IRB, or F-IRB). The EBA pointed out the limited guidance on the use of CRM for exposures under A-IRB and indicated it would start work on this topic in the future.

Part II: Data collected about the use of the CRM framework in the EU

The report includes a quantitative overview of the collateral types and CRM techniques used by institutions to calculate capital requirements for credit risk:

  • Findings show that the use of techniques varies significantly across jurisdictions, as the choice of technique varies by institution’s type of approach and business model.

Part III: Policy Issues related to CRM

  • The EBA recommends amendments to the CRR, with the aim of reducing variability in the application of CRM provisions.
  • The EBA presents arguments reinforcing its negative opinion of the development of RTS on recognition of conditional guarantees, on liquid assets and on master netting agreements. The EBA emphasizes that the mandates cover select aspects of the CRM framework that are not expected to have a significant impact on the regulatory capital and rating systems of financial institutions. According to the report, “pursuing work on these three mandates…would create the risk of disproportionate regulation given the limited benefit of such additional provisions.”
  • The EBA further recommends deleting the mandate for RTS on liquid assets. The CRR already covers the requirements for the liquidity of assets usable for CRM purposes and the stability of the value of these assets.
  • The EBA communicated it does not intend to deliver on these mandates until further notice.