Credit Risk & Output floor

Background

The revisions to the credit risk framework under CRR III are part of the European Union's latest effort to implement the outstanding components of the Basel III standards. 

Under the existing rules, institutions have two alternative approaches for calculating risk-weighted exposure amounts for credit risk. The Standardised Approach (SA-CR) enables institutions to adopt prescribed risk weights which are linked, where relevant, to external credit rating assessments, and the Internal Ratings-based (IRB) Approach permits institutions to use their internal models to estimate the credit risk arising from their exposures.

Both approaches will be subject to extensive amendments under CRR III. Although the changes are not expected to result in a substantial immediate increase in capital requirements for institutions (at least not during the transitional phase of the legislation), the existing calculation methodologies and conditions relied upon by institutions for assessing credit risk will inevitably need to be updated.

Key changes

 

We explore some of these changes below in further detail.

Requirements under CRR III - Output floor

One of the flagship reforms introduced under the Basel III standards is the output floor. The proposal was instigated by a concern that institutions using internal models are prone to underestimate risks (not just limited to credit risk). This has led to excessive variability of own funds requirements across the sector.

Under CRR III, the total risk exposure amount for the purposes of determining an institution's own funds requirement will be calculated as the higher of:

(a)  the "un-floored total risk exposure amount" (i.e. where it is possible to apply internal models under the IRB Approach); and

(b)  the product of the "standardised total risk exposure amount" (i.e. without applying the IRB Approach) multiplied by 72.5%.

The output floor is subject to a transitional arrangement so that the 72.5% multiplier will only apply in 2030. The output floor will begin at 50% in 2025 and then it will gradually increase over a five-year phase-in period.

In conjunction, the own funds requirement will also be subject to a "ceiling" of 125% of the "un-floored total risk exposure amount" until the end of 2029. Therefore, any initial jumps in the regulatory capital requirements following CRR III will be controlled during the transitional period.

The level of application of the output floor has been an area of contention as the package moved through the legislative process. The final text of CRR III now requires the output floor to be applied at all levels of consolidation (though Member States have an option to derogate from solo/individual application for banking group entities established in their territories).

Requirements under CRR III – Standardised approach

The Standardised Approach / SA-CR is the most common approach to credit risk adopted by institutions in the EU. While the approach is more straightforward to apply compared to the IRB Approach, it lacks the sensitivity and granularity to ensure that credit risks are appropriately captured and covered by the risk-weighted exposure amounts.

We have highlighted some of the key amendments which will be introduced by CRR III with respect to SA-CR below.

a) Off-balance sheet items

The list of off-balance sheet items at Annex I of the CRR will be replaced in its entirety, and each item will be allocated to one of five "buckets". New credit conversion factors (CCFs) of 40% and 10% will be introduced and the existing CCF of 0% will be removed.

A new definition of "commitment" has been created to capture any contractual arrangement which an institution offers to a client (and is accepted by that client) to extend credit, purchase assets or issue credit substitutes. Contractual arrangements offered by an institution but not yet accepted by the client, that would become commitments if accepted, will also be treated as a commitment.

Commitments regardless of the maturity of the underlying facility will typically be assigned to Bucket 3 and with a 40% CCF. "Unconditionally cancellable commitments" will also be treated as a form of off-balance sheet item but it is assigned to Bucket 5 with a 10% CCF. However, "unconditionally cancellable commitment" will benefit from a transitional arrangement which will apply a 0% multiplier until 2029 and then gradually scaling-up over a three-year period.

Although the definition of "commitment" is wide, a contractual arrangement whereby the institution does not receive fees or commission to establish or maintain the arrangement, and it has full authority over each drawdown request by the client, would not be a "commitment" provided various conditions are met. To the extent that such arrangements constitute other forms of off-balance sheet items, they will benefit from a 0% CCF. Nevertheless, the institution must still monitor and document these "non-commitment" contractual arrangements on an ongoing basis.

b) Exposure to institutions

Exposures to rated institutions are currently risk-weighted using the External Credit Risk Assessment Approach (ECRA), whereby applicable risk weights are determined in accordance with the credit ratings provided by eligible credit assessment institutions (ECAI).
 
Such exposures will continue to be risk-weighted using external credit ratings, however the risk weight for institutions subject to credit quality step 2 credit assessment by a nominated ECAI will be reduced from 50% to 30%. Under the current rules, rated exposures to institutions with a residual maturity of three months or less can also be risk-weighted in accordance with the prescribed mapping table. This will be amended so that only rated exposures with an original maturity of three months or less, or rated exposures which arise from the movement of goods across national borders with an original maturity of six months or less, could be risk-weighted using the relevant mapping table.
 
Moreover, CRR III will transpose the Standardised Credit Risk Assessment Approach (SCRA) under the Basel III standards for exposures to institution where there is no credit assessment by a nominated ECAI available. This approach classifies such exposures into one of three grades based on various qualitative and quantitative criteria, without assuming that an unrated institution's credit risk can be tied to that of the central government in the jurisdiction in which it is incorporated. This is a marked departure from the current rules which are less granular and allow for a mechanistic application of risk weights based on the assumption that there is implicit government support for these unrated institutions.

c)  Exposures to corporates

Exposures to corporates for which a credit quality step 3 credit assessment by a nominated ECAI is available will be assigned a risk weight of 75% (reduced from the current 100%). Where the exposure is to an unrated corporate, the risk weight will be 100% without reference to the risk weight assigned to the central government of the relevant jurisdiction.

With the advent of the output floor, institutions that currently use internal models to calculate own funds requirements for exposures to corporates would also need to calculate their requirements under the Standardised Approach. Coupled with the fact that most EU corporates do not have external credit ratings (i.e. the 100% risk weight for unrated corporate exposures would apply), there was a concern that this could cause a substantial increase in own funds requirements for institutions that use internal models and, as a result, hamper bank-lending to unrated companies. Accordingly, a transitional arrangement has been introduced to enable institutions to apply a risk-weight of 65% to exposures to unrated corporates until the end of 2032, provided that the "probability of default" / PD for the obligor is not higher than 0.5%.

d)  Specialised lending exposures

In the effort to promote infrastructure projects and other specialised projects across the EU, CRR III will introduce a new exposure class for specialised lending activities within the corporate exposure class. The applicable risk weights will be determined by one of two approaches: one for externally rated exposures, and the other for exposures which are not externally rated.

Unrated exposures are further sub-divided into categories of object finance exposures, commodities finance exposures, and project finance exposures (which reflects the sub-categories under the IRB Approach). Additional granularity is provided for each of these sub-categories in order to ascertain the relevant risk weights for the exposures.

For example, object finance exposures are defined to mean specialised lending exposures the purpose of which is to finance the acquisition of physical assets (e.g. ships, aircrafts, satellites, railcars, and fleets) and the income to be generated by those assets comes in the form of cash flows generated by the specific physical assets that have been financed and pledged or assigned to the lender. Whereas project finance exposures are those with the purpose of financing an individual project (either in the form of construction of a new capital installation or refinancing of an existing installation), with or without improvements for the development or acquisition of large, complex and expensive installations (e.g. power plants, chemical processing plants, mines, transportation infrastructure, environment, and telecommunications infrastructure), in which the lending institution looks primarily to the revenues generated by the financed project, both as the source of repayment and as security for the loan.

Further, unrated object finance exposures will benefit from a transitional arrangement whereby a risk-weight of 80% can be applied until the end of 2032, provided the exposure is deemed to be a "high quality" investment. However, this preferential treatment cannot be relied upon if the institution is already using the infrastructure supporting factor (i.e. 0.75) in accordance with Article 501a of the CRR.

e) Retail exposures

The provisions concerning exposures to natural persons or "small or medium-sized enterprises" (now defined) will be replaced with a new Article 123 in the CRR.

The 75% risk weight for retail exposures has been maintained, however revolving retail exposures that meet a set of repayment or usage conditions capable of lowering their risk profile (i.e. what have been termed "transactor exposures") would benefit from a risk weight of 45%.

Exposures to natural persons that do not meet the criteria are to be treated as a retail exposure would be assigned a risk weight of 100%.

f) Exposures with a currency mismatch

Exposures to natural persons (either categorised as a retail exposure, or as an exposure secured by mortgages on residential property) may be subject to a currency mismatch multiplier.

Specifically, where the exposure is denominated in a currency that is different from the currency of the obligor's source of income and the obligor does not have a hedge for their payment risk due to currency mismatch, then the risk weight must be multiplied by 1.5 (subject to a cap that the resulting risk weight cannot be higher than 150%).

If an institution is unable to single out exposures with a currency mismatch, then the 1.5 multiplier will apply to all unhedged exposures where the currency of the exposures is different from the domestic currency of the obligor's country of residence.

The only derogation is where the currency pair includes the Euro and the currency of a Member State participating in the second stage of the Economic and Monetary Union.

g) Exposures secured by real estate

The treatment of real estate exposure will be aligned with the Basel III standards in order to provider greater granularity that is sensitive to the different risks inherent in the various types of real estate transactions and loans.

The relevant exposure class will be expanded and renamed as "exposures secured by mortgage on immovable property and ADC exposures". These changes are accompanied by a series of new definitions. In particular, the concepts of "land acquisition, development and construction exposures" (ADC exposures) and "income producing real estate exposures" (IPRE exposures) have been introduced.

ADC exposures

Loans financing land acquisition, development or construction (i.e. ADC) of any residential or commercial immovable properties incur a heightened risk. The current
treatment of speculative immovable property financing under the CRR is based solely on the borrower’s intention to resell the property for a profit, but the certainty of repayments is not taken into account.

CRR III inserts a new Article 126a that will allow a specific risk weight treatment of 150% in line with the Basel III standards for loans to companies / SPVs financing the ADC of any residential or commercial property. However, a risk weight of 100% can be assigned to residential ADC exposures provided that certain risk-mitigating conditions (e.g. underwriting standards, proportion of pre-sale or pre-lease contracts and equity-at-risk) are satisfied.

Non-ADC exposures

For general residential and commercial real estate exposures (i.e. non-ADC), the "loan-splitting" approach enshrined in Articles 124 – 126 of the CRR is largely retained. This approach divides the mortgage exposures into a secured part and an unsecured part, and assigns corresponding risk weights to each. However, CRR III will revise the corresponding risk weights in line with the Basel III standards whereby the secured part of the exposure up to 55% of the property value receives a risk weight of 20% and 60% (for residential and commercial properties, respectively), and the remainder is risk-weighted as an exposure to the counterparty that is not secured by the property.

Moreover, additional granularity has been introduced with respect to IPRE exposures (e.g. mortgage loans the repayment of which is materially dependent on the cash flows generated by the property securing those loans). The view is that IPRE exposures are riskier than mortgage loans, the repayment of which are materially dependent on the underlying capacity of the borrower to service the loan. Such exposures will be risk-weighed depending on their exposure-to-value (ETV) ratio, unless the so-called "hard test" is met in which case the non-IPRE treatment can be applied. The "hard test" refers to where the competent authority of the Member State where the property is located has published evidence showing that the property market is well-developed and long-established with yearly loss rates that do not exceed certain thresholds. The "hard test" has been extended in the final text of CRR III so that the competent authority of an equivalent third country may publish loss rates for exposures secured by properties situated in their territory (the EBA may publish such data if the third country does not).

The flowchart below is an overview of how the relevant provisions (i.e. Articles 124 – 126a of the CRR) are envisaged to apply. However, it is not intended to be comprehensive as there are a number of nuances in the rules which we have not included. In particular, designated authorities of Member States are mandated to the assess annually whether the prescribed risk weights are appropriate for exposures secured by immovable properties located in their territory. Designated authorities are empowered to amend the risk weights and related conditions as they consider appropriate.

Valuation of immovable property collateral

The obligation on institutions to monitor frequently the value of property pledged as collateral (and make adjustments accordingly) is preserved. However, the monitoring obligation has been bolstered under CRR III with requirements to ensure the monitoring or property values and the identification of properties in need of revaluation by means of advanced statistical or mathematical models. Further, a new requirement is that properties used as collateral must be adequately insured against the risk of damage and the insurance coverage is monitored.

The valuation principles for immovable property have also been revised. In particular, where the property has been re-valued, the new value cannot exceed the average value measured for that property, or for a comparable property, over the last six years for residential property or eight years for commercial immovable property or the value at origination (whichever is higher).

There are also specific amendments to exposures to covered bonds which are not summarised here.

Transitional arrangement

A transitional arrangement will be provided for low-risk exposures secured by mortgages on residential property when calculating the output floor. During the transitional period Member States may allow institutions to apply a preferential risk weight of 10% to the secured part of the exposure up to 55% of the property value, and a risk weight of 45% to the remaining part of the exposure up to 80% of the property value, provided certain conditions are met.

h)  Subordinated debt exposures

Article 128 of the CRR (i.e. items associated with particular high risk) will be replaced to implement the Basel III standards for exposures to subordinated debt. Such exposures will be given a risk weight of 150%.

i)  Equity exposures

The scope of the equity exposure class in Article 133 of the CRR is substantially clarified. Unless required to be deducted or risk-weighted under the own funds provisions, equity exposures should generally be assigned a 250% risk weight, except:

(i) certain short-term / speculative exposures to unlisted companies must be assigned a 400% risk weight;

(ii) certain equity exposures incurred under legislative programmes to promote specified sectors of the economy can be assigned a 100% risk weight, provided prior permission from the competent authority is obtained and the risk weight can only be applied up to the part of such equity exposures that in aggregate does not exceed 10% of the institution's own funds;

(iii) exposures to central banks are still subject to a 0% risk weight; and

(iv) an equity holding that is recorded as a loan but that has arisen from a debt / equity swap made as part of the orderly realisation or restructuring of the debt cannot be assigned a risk weight lower than the risk weight that would apply if the equity holding were treated as a debt exposure (i.e. if it had remained in the debt portfolio).

A transitional arrangement will be introduced to allow the gradual phasing-in of the new risk weights applicable to equity exposures. Importantly, institutions may continue to assign the current risk weight to equity exposures with respect to entities of which they have been a shareholder on 27 October 2021 for six consecutive years and have significant influence or sufficient control.

Requirements under CRR III – IRB Approach

a) Reduction in scope

In addition to the introduction of the output floor, CRR III will limit the scope of exposure classes to which the IRB Approach could be used.

Notably, the use of the advanced IRB Approach (i.e. allowing the modelling of all risk parameters) will only be permitted for exposure classes where robust modelling is possible.

For example, for exposures to "large corporates" (i.e. undertakings with consolidated annual sales greater than EUR 500 million or belonging to a group where the total annual sales for the consolidated group is more than EUR 500 million), exposures to institutions, and exposures to other financial sector entities (including those treated as corporates), the advanced IRB Approach is not permitted. The result is that only the foundation IRB approach can be applied for these exposures which means institutions can only model the "probability of default" / "PD" value and not the other risk parameters.

For equity exposures, the IRB approach will no longer be available and the SA-CR will need to be used instead. Institutions that currently have permission to apply the IRB Approach to calculate the risk-weighted exposure amount for equity exposures will be subject to a transitional arrangement until the end of 2029.

b) New exposure class for regional governments, local authorities, and public sector entities

A new exposure class will be introduced under the IRB Approach for regional governments, local authorities and public sector entities (RGLA-PSE). This class is sub-divided into exposures to the regional governments and local authorities, and exposures to public sector entities.

The risk-weighted exposures amounts for exposures to RGLA-PSE will be subject to the same formulae set out in the revised Article 153 of the CRR.

However, the treatment of assimilated RGLA-PSE exposures, which under the Standardised Approach for credit risk would qualify for a treatment as exposures to the central government, would not be assigned to the new RGLA-PSE exposure class under the IRB Approach and would not be subject to "input floors".

For exposures to RGLA-PSE, the PD "input floor" value is lower than that for exposures to institutions or corporates (i.e. 0.03% compared to 0.05%). The LGD "input floor" value for the unsecured RGLA-PSE exposures is set at 5% which is lower than the 25% input floor for unsecured corporate exposures.

c) Input floors under the IRB Approach

The "input floors" (i.e. the minimum values for institutions' own estimates of the risk parameters which are used as inputs to calculate the risk-weighted exposure amounts under the IRB Approach) will be revised under CRR III.

Broadly, some of the key changes are outlined below:

(i) "Probability of default" ! "PD" risk parameter: For corporate and retail exposures, the input floor will be raised to 0.05% (from 0.03% under the current rules). For qualifying revolving retail exposures, the floor is set at 0.1%. As mentioned above, the PD input floor for RGLA-PSE exposures will be 0.03%.

(ii) "Loss given default" ! "LGD" risk parameter: For corporate exposures, the LGD input floor of unsecured exposures is 25%, whereas for fully secured exposures the floor varies depending on the type of collateral. As mentioned above, the LGD input floor for RGLA-PSE exposures will be 5%. Retail exposures will also be subject to new input floors.

(iii) "Credit conversion factors" ! "CCF" risk parameter: The IRB-specific CCF input floor is set according to the 50% of the applicable Standardised Approach CCF.

The input floors will not apply to exposures to the extent that they are covered by an
eligible guarantee provided by a central government or central bank, or by the European Central Bank.

A transitional arrangement will allow LGD input floors applicable to specialised lending exposures treated under the advanced IRB Approach to be scaled up over a five-year period.

d) Simplifying the risk weight calculations

The 1.06 multiplier in the risk weight equations under the IRB Approach in Articles 153(1) and 154(1) of the CRR will be removed.

Moreover, the "double default" treatment for certain guaranteed exposures will be removed which means the multiplier for the PD of the protection provider will not need to be applied.

e) IRB "roll-out" and permanent partial use

Currently, institutions applying the IRB Approach to one exposure class would need to "roll-out" the IRB Approach for all exposure classes of its banking book, except for those exposures for which a permanent partial use (PPU) of the SA-CR is permitted by the competent authority.

This "IRB roll-out" requirement will be dropped. Instead, institutions that have implemented the IRB Approach for certain types of exposures would only need to do so for all other exposures within that exposure class (unless permission for PPU of the SA-CR is obtained).

In order to maintain a level-playing field between institutions currently treating exposures under the IRB Approach and those that are not, a new transitional arrangement will be introduced to allow institutions to revert to less sophisticated approaches for one or more exposure classes. Institutions only need to notify their competent authorities at least six months prior to the reversion, provided the authority has not objected within three months of the notification. The reversion cannot be made with a view to regulatory arbitrage but there is guidance clarifying that the mere fact a reversion would lead to a reduction in own funds requirements would not, in itself, constitute regulatory arbitrage.

 a)  LGD under the foundation IRB Approach

The LGD value for senior unsecured exposures to central government and central banks, financial sector entities, or RGLA-PSE is set kept at 45%. However, senior unsecured exposures to corporate has been reduced to 40%.

b)  Calculation methods for own estimates of credit conversion factors

The scope and calculation methods for the computation of own estimates of "CCFs" which are used to determine the exposure value of off-balance sheet items (other than derivative contracts) have been revised.

c)  Guarantors treated under a less sophisticated approach than the exposure

If an exposure which is treated under the advanced IRB Approach is guaranteed by a guarantor who is treated under the foundation IRB approach or the SA-CR, then the guaranteed exposure would generally need to be treated under the foundation IRB Approach or the SA-CR, respectively.

Technical standards

The EBA is required to deliver over 140 mandates under the CRR III / CRD VI package, ranging from producing regulatory and implementing technical standards, guidelines, opinions, and reports, to maintaining various lists and registers.

The EBA has produced a roadmap in December 2023 which details how it envisages the mandates will be delivered and the relevant implementation timelines. In particular, the EBA intends to develop the roadmap over four phases and, with respect to credit risk specifically, the phases will be sequenced as follows:

a) Phase 1:

Critical elements of the Standardised Approach and reviewing targeted elements of the IRB frameworks. This will cover mandates related to the SA-CR (with the exception of a review of the frameworks on the definition of default and the categorisation of model change).

b) Phase 2:

Specification of the treatment of project finance under the Standardised Approach and commencement of the IRB repair programme products. This will cover mandates relating to the clarification of the IRB Approach, and some specifications on the specialised lending exposure class under the Standardised Approach.

c) Phase 3:

Complement the IRB repair programme. The key product will be the publication of the guidelines on CCF estimation.

d) Phase 4:

Finalisation of the assessment of the framework. Most of the mandates will relate to the reports assessing specific elements of the Basel III framework, as implemented in the EU.