What do the PRA’s changing credit risk rules mean for firms?
06 December 2019
Efforts to reduce the unwarranted variability in credit risk-weighted assets (RWAs), stemming from differences in modelling practices across firms, continue to be high on the regulatory agenda in the EU. Despite the political uncertainty surrounding Brexit, the Prudential Regulation Authority (PRA) continues to apply the European Banking Authority’s (EBA) roadmap of regulatory products with respect to the credit risk framework.
This blog reviews the PRA’s changing credit risk rules, analyses what these mean for firms and discusses what they should do to remain compliant.
Following the first phase related to the adoption of the EBA’s changes aimed at harmonising the definition of default in July 2018, the PRA launched a new consultation. The new consultation, which runs until 18 December 2019, proposes a number of important changes to Supervisory Statement SS11/13 Internal Ratings Based (IRB) approaches to implement the following EBA regulatory products:
- guidelines on Probability of Default (PD) estimation, Loss Given Default (LGD) estimation, and the treatment of defaulted exposures
- final draft regulatory technical standards on the specification of the nature, severity and duration of an economic downturn
- guidelines for the estimation of LGD appropriate for an economic downturn
The proposed changes are set to create additional challenges for firms that have already been grappling with clarifications over the definition of default and hybrid PD implementation. A key challenge will be the compressed implementation timescales. While the EBA’s July 2019 IRB roadmap progress report maintained an end-2020 implementation deadline for changes relating specifically to the definition of default, it delayed the final deadline for implementation of wider changes to the rating systems by one year until end-2021.
Aiming to align with the deadline for the hybrid approach for modelling PD for residential mortgages, the PRA is currently consulting on updating the deadline for IRB firms to implement all changes from the EBA roadmap, including those relating to the wider changes to the rating systems, to 31 December 2020 for residential mortgage portfolios. For all other exposure classes, the proposed deadline for IRB firms to implement the EBA roadmap requirements is 1 January 2022.
While this should minimise the need to build multiple iterations of models, it is likely to result in significant timing pressure for firms to redevelop models and undertake validation, audit and monitoring ahead of submission to the PRA for approval in early-to-mid 2020. Given the temporary nature of the provisions in CRR Article 146, it remains to be seen whether firms are able to rely on this to push the implementation timelines back, but this seems unlikely.
So firms should review the proposed changes, assess their potential impact and respond to the consultation should they have any concerns. In the meantime, they would also be well advised to engage with their supervisors to discuss implementation approach for those exposures for which Basel III removes the use of the Advanced IRB approach.
We expect that for some firms the impact on their RWA calculations will be material particularly due to issues with identifying an appropriate downturn, as well as the availability of data to calibrate their LGD estimates to the downturn period.
But the most material impact is likely to be on firms that are currently undertaking an IRB application. This will require firms to re-plan their IRB programmes to ensure they have compliant models by the date of the application decision, or December 2020, whichever is later.
While the evolving credit risk regime introduces challenges, PwC has developed a suite of enablers and tools that can be used to support firms in the end-to-end implementation of these regulatory changes, particularly in defining economic downturn for LGD modelling.
Both current and aspirant IRB firms should review their modelling practices and preparedness for compliance with these requirements. The extent of remediation work required in the near term may be substantial, so firms are advised to start as soon as possible.