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Supervisory Statement | SS11/13

Internal Ratings Based approachesDecember 2013

11 November 2015 – this document has been updated, see http://www.bankofengland.co.uk/pra/Pages/publications/ss/2015/ss1113update.aspx

Prudential Regulation Authority20 MoorgateLondon EC2R 6DA

Prudential Regulation Authority, registered office: 8 Lothbury, London EC2R 7HH.Registered in England and Wales No: 07854923


Supervisory Statement | SS11/13

Internal Ratings Based approachesDecember 2013

© Prudential Regulation Authority 2013


1 Introduction 5

2 Application of requirements to EEA groups applying the IRB approach on a unified basis 5

3 Third country equivalence 5

4 Materiality of non-compliance 6

5 Corporate governance 6

6 Permanent partial use 6

7 Sequential implementation following significant acquisition 7

8 Classification of retail exposures 7

9 Documentation 7

10 Overall requirements for estimation 8

11 Definition of default 10

12 Probability of default in IRB approaches 10

13 Loss Given Default in IRB approaches 14

14 Own estimates of exposure at default (EAD) in IRB approaches 17

15 Maturity for exposures to corporates, institutions or central governments and central banks 20

16 Stress tests used in assessment of capital adequacy 20

17 Validation 21

18 Income-producing real estate portfolios 21

19 Notification and approval of changes to approved models 24

20 Appendix A: Slotting criteria 28

21 Appendix B: Model change pro-forma required when pre or post-notifying changes to a ratings system 34

22 Appendix C: Wholesale LGD and EAD framework 35

Contents


Internal Ratings Based approaches December 2013 5

1 Introduction

1.1 This supervisory statement is aimed at firms to whichCRD IV applies.

1.2 Article 143(1) of the CRR requires the PrudentialRegulation Authority (PRA) to grant permission to use theInternal Ratings Based (IRB) approach where it is satisfied thatthe requirements of Title II Chapter 3 of the CRR are met. Thepurpose of this supervisory statement is to provideexplanation, where appropriate, of the PRA’s expectationswhen assessing whether firms meet those requirements,including in respect of the conservatism applied.

1.3 Responsibility for ensuring that internal models areappropriately conservative and are CRR compliant rests with firms themselves. The PRA stated in The PRA’s approachto banking supervision that ‘if a firm is to use an internal model in calculating its regulatory capital requirements, the PRA will expect the model to be appropriatelyconservative’.

1.4 Firms should be aware that where approval to use theIRB approach is subject to a joint decision under CRRArticle 20, the expectations set out in this supervisorystatement will be subject to discussion between the PRA andother EEA regulators regarding the joint decision.

1.5 Some parts of this supervisory statement will requirerevision in due course as a result of the development by theEBA of binding technical standards required by the CRR. ThePRA expects to amend or delete these parts of this supervisorystatement when those technical standards enter into force.

1.6 The PRA expects that this document will be revised on aperiodic basis.

2 Application of requirements to EEAgroups applying the IRB approach on a unifiedbasis

2.1 The CRR provides that where the IRB approach is used on aunified basis by an EEA group, the PRA is required to permitcertain IRB requirements to be met on a collective basis bymembers of that group. The PRA considers that where a firm isreliant upon a rating system or data provided by anothermember of its group it will not meet the condition that it isusing the IRB approach on a unified basis unless:

(a) the firm only does so to the extent that it is appropriate,given the nature and scale of the firm’s business andportfolios and the firm’s position within the group;

(b) the integrity of the firm’s systems and controls is notadversely affected;

(c) the outsourcing of these functions meets therequirements of SYSC;(1) and

(d) the abilities of the PRA and the lead regulator of thegroup to carry out their responsibilities under the CRRare not adversely affected.

(CRR Article 20(6))

2.2 Prior to reliance being placed by a firm on a rating system,or data provided by another member of the group, the PRAexpects the proposed arrangements to have been explicitlyconsidered, and found to be appropriate, by the governingbody of the firm.

2.3 If a firm uses a rating system or data provided by anothergroup member, the PRA expects the firm’s governing body todelegate those functions formally to the persons or bodies thatare to carry them out.

(CRR Article 20(6))

3 Third country equivalence

3.1 CRR Article 107(3) allows exposures to third countryinvestment firms, third country credit institutions and/orthird country clearing houses and exchanges to be treated asexposures to an institution only if the third country appliesprudential and supervisory requirements to that entity that areat least equivalent to those applied in the Union. Thedefinition of ‘large financial sector entity’ in CRRArticle 142(1)(4) depends in part on whether the third countryin question applies prudential and supervisory requirementsto that entity that are at least equivalent to those applied inthe Union.

3.2 Prior to the end of 2013, the PRA will set out the approachto be taken during 2014 in the absence of an equivalencedetermination by the European Commission.

(1) Senior Management Arrangements, Systems and Controls, as contained in thePRA Handbook.


4 Materiality of non-compliance

4.1 Where a firm seeks to demonstrate to the PRA that theeffect of its non-compliance with the requirements ofCRR Title II Chapter 3 is immaterial under CRR Article 146(b),the PRA expects it to have taken into account all instances ofnon-compliance with the requirements of the IRB approachand to have demonstrated that the overall effect ofnon-compliance is immaterial.

(CRR Article 146(b))

5 Corporate governance

5.1 Where a firm’s rating systems are used on a unified basispursuant to CRR Article 20(6), the PRA considers that thegovernance requirements in CRR Article 189 can be met only if the subsidiary undertakings have delegated to the governing body or designated committee of the EEA parentinstitution, EEA parent financial holding company or EEAparent mixed financial holding company responsibility forapproval of all material aspects of rating and estimationprocesses.

5.2 The PRA expects an appropriate individual in a SignificantInfluence Function (SIF) role to provide to the PRA on anannual basis written attestation that:

(i) the firm’s internal approaches for which it has received a permission comply with the CRR requirements and any applicable PRA IRB supervisory statements; and

(ii) where a model rating system has been found not to becompliant, a credible plan for a return to compliance isin place and being completed.

5.3 Firms should agree with the PRA the appropriate SIF forproviding this attestation. The PRA would not expect to agreemore than two SIFs to cover all the firm’s IRB models. Inagreeing which SIF (or SIFs) may provide the annualattestation, the PRA will consider the firm’s arrangements forapproving rating and estimation processes under CRRArticle 189.

(CRR Article 189, 20(6) and CRD Article 3(1)(7))

6 Permanent partial use

Policy for identifying exposures6.1 The PRA expects a firm that is seeking to apply theStandardised Approach on a permanent basis to certainexposures to have a well-documented policy, explaining the

basis on which exposures would be selected for permanentexemption from the IRB approach. This policy should beprovided to the PRA when the firm applies for permission touse the IRB approach and maintained thereafter. Where a firmalso wishes to undertake sequential implementation, the PRAexpects the firm’s roll-out plan to provide for the continuingapplication of that policy on a consistent basis over time.

(CRR Article 143(1), 148(1) and CRR Article 150(1))

Exposures to sovereigns and institutions6.2 The PRA may permit the exemption of exposures tosovereigns and institutions under CRR Articles 150(1)(a) and150(1)(b) respectively, only if the number of materialcounterparties is limited and it would be unduly burdensometo implement a rating system for such counterparties.

6.3 The PRA considers that the ‘limited number of materialcounterparties’ test is unlikely to be met if for the UK grouptotal exposures to ‘higher-risk’ sovereigns and institutionsexceed either £1 billion or 5% of total assets (other than in thecase of temporary fluctuations above these levels). For thesepurposes, ‘higher-risk’ sovereigns and institutions areconsidered to be those that are unrated or carry ratings ofBBB+ (or equivalent) or lower. In determining whether togrant this exemption, the PRA will also consider whether a firmincurs exposures to ‘higher-risk’ counterparties which arebelow the levels set out below, but are outside the scope of itscore activities.

6.4 In respect of the ‘unduly burdensome’ condition, the PRA considers that an adequate, but not perfect, proxy for the likely level of expertise available to a firm is whether itsgroup has a trading book. Accordingly, if a firm’s group doesnot have a trading book, the PRA is likely to accept theargument that it would be unduly burdensome to implement a rating system.

(CRR Article 150(1)(a) and 150(1)(b))

Non-significant business units and immaterialexposures classes and types6.5 Where a firm wishes permanently to apply thestandardised approach to certain business units on the groundsthat they are non-significant, and/or certain exposure classesor types of exposures on the grounds that they are immaterialin terms of size and perceived risk profile, the PRA expects topermit this exemption only to the extent that therisk-weighted exposure amounts calculated underparagraphs (a) and (f) of CRR Article 92(3) that are based onthe standardised approach (insofar as they are attributable tothe exposures to which the standardised approach ispermanently applied) — would be no more than 15% of therisk-weighted exposure amounts calculated under

6 Internal Ratings Based approaches December 201311 November 2015 – this document has been updated, see http://www.bankofengland.co.uk/pra/Pages/publications/ss/2015/ss1113update.aspx

paragraphs (a) and (f) of CRR Article 92, based on whichever ofthe standardised approach and the IRB approach would applyto the exposures at the time the calculation was made.

6.6 The following points set out the level at which the PRAwould expect the 15% test to be applied for firms that aremembers of a group:

(a) if a firm were part of a group subject to consolidatedsupervision in the EEA and for which the PRA was thelead regulator, the calculations in part (a) would becarried out with respect to the wider group;

(b) if a firm were part of a group subject to consolidatedsupervision in the EEA and for which the PRA was notthe lead regulator the calculation set out in part (a)would not apply but the requirements of the leadregulator related to materiality would need to be metin respect of the wider group;

(c) if the firm were part of a subgroup subject toconsolidated supervision in the EEA, and part of a widerthird-country group subject to equivalent supervision bya regulatory authority outside of the EEA, thecalculation set out in part (a) would not apply but therequirements of the lead regulator related to materialitywould need to be met in respect of both the subgroupand the wider group; and

(d) if the firm is part of a subgroup subject to consolidatedsupervision in the EEA, and is part of a widerthird-country group that is not subject to equivalentsupervision by a regulatory authority outside of the EEA,then the calculation in part (a) would apply in respect ofthe wider group if supervision by analogy (as referred toin CRR) is applied and in respect of the subgroup ifother alternative supervisory techniques are applied.

6.7 Whether a third-country group is subject to equivalentsupervision, whether it is subject to supervision by analogy, asreferred to in the CRR, or whether other alternativesupervisory techniques apply, is decided in accordance withCRD Article 126.

(CRR Article 150(1)(c) and CRD Article 126)

Identification of connected counterparties6.8 Where a firm wished permanently to apply thestandardised approach to exposures to connectedcounterparties in accordance with CRR Article 150(1)(e), thePRA will normally grant permission to do so only if the firm hasa policy that identifies connected counterparty exposures thatwould be permanently exempted from the IRB approach andalso identifies connected counterparty exposures (if any) thatwould not be permanently exempted. The PRA expects a firm

to use the IRB approach either for all of its intra-groupexposures or for none of them.

(CRR Article 150(1)(e))

7 Sequential implementation followingsignificant acquisition

7.1 In the event that a firm with an IRB permission acquires asignificant new business, it should discuss with the PRAwhether sequential roll-out of the firm’s IRB approach to theseexposures would be appropriate. In addition, the PRA wouldexpect to review any existing time period and conditions forsequential roll-out and determine whether these remainappropriate.

(CRR Article 148)

8 Classification of retail exposures

8.1 CRR Article 154(4)(d) specifies that for an exposure to betreated as a Qualified Revolving Retail Exposure (QRRE), itneeds to exhibit relatively low volatility of loss rates. The PRAexpects firms to assess the volatility of loss rates for thequalifying revolving retail exposure portfolio relative to thevolatilities of loss rates of other relevant types of retailexposures for these purposes. Low volatility should bedemonstrated by reference to data on the mean and standarddeviation of loss rates over a time period that can be regardedas representative of the long-run performance of the portfoliosconcerned.

8.2 CRR Article 154(4)(e) specifies that for an exposure to betreated as a QRRE this treatment should be consistent withthe underlying risk characteristics of the subportfolio. The PRAconsiders that a subportfolio consisting of credit card oroverdraft obligations will usually meet this condition and thatit is unlikely that any other type of retail exposure would do so.If a firm wishes to apply the treatment in CRR Article 154(4) toproduct types other than credit card or overdraft obligationsthe PRA expects it to discuss this with the PRA before doing so.

(CRR Article 154(4))

9 Documentation

9.1 The PRA expects a firm to ensure that all documentationrelating to its rating systems (including any documentationreferenced in this supervisory statement or required by theCRR requirements that relate to the IRB approach) is stored,arranged and indexed in such a way that it could make themall, or any subset thereof, available to the PRA immediately ondemand or within a short time thereafter.

Internal Ratings Based approaches December 2013 711 November 2015 – this document has been updated, see http://www.bankofengland.co.uk/pra/Pages/publications/ss/2015/ss1113update.aspx

10 Overall requirements for estimation

High-level expectations for estimation10.1 In order to be able to determine that the requirements inCRR Article 144(1) have been met, the PRA would typicallyhave the high level expectations set out in this subsection.

10.2 The PRA expects the information that a firm produces oruses for the purpose of the IRB approach to be reliable andtake proper account of the different users of the informationproduced (customers, shareholders, regulators and othermarket participants).

10.3 The PRA expects firms to establish quantified anddocumented targets and standards, against which it shouldtest the accuracy of data used in its rating systems. Such testsshould cover:

(a) a report and accounts reconciliation, including whetherevery exposure has a Probability of Default (PD), LossGiven Default (LGD) and, if applicable, conversion factor(CF) for reporting purposes;

(b) whether the firm’s risk control environment has key riskindicators for the purpose of monitoring and ensuringdata accuracy;

(c) whether the firm has an adequate business andinformation technology infrastructure with fullydocumented processes;

(d) whether the firm has clear and documented standardson ownership of data (including inputs andmanipulation) and timeliness of current data (daily,monthly, real time); and

(e) whether the firm has a comprehensive quantitativeaudit programme.

10.4 The PRA expects that in respect of data inputs, thetesting for accuracy of data, including the reconciliationreferred to above, should be sufficiently detailed so that,together with other available evidence, it provides reasonableassurance that data input into the rating system is accurate,complete and appropriate. The PRA considers that input datawould not meet the required standard if it gave rise to aserious risk of material misstatement in the capitalrequirement, either immediately or subsequently.

10.5 In respect of data outputs, as part of the reconciliationreferred to above, the PRA expects a firm to be able to identifyand explain material differences between the outputsproduced under accounting standards and those producedunder the requirements of the IRB approach, including inrelation to areas that address similar concepts in different

ways (for example expected loss (EL) and accountingprovisions).

10.6 The PRA expects a firm to have clear and documentedstandards and policies about the use of data in practice(including information technology standards) which should inparticular cover the firm’s approach to the following:

(a) data access and security;(b) data integrity, including the accuracy, completeness,

appropriateness and testing of data; and(c) data availability.

(CRR Article 144(1)(a))

Ratings systems: policies10.7 In order for the PRA to be satisfied that a firm documentsits ratings systems appropriately in accordance with CRRArticle 144(1)(e) the PRA expects a firm to be able todemonstrate that it has an appropriate policy in respect of itsratings systems in relation to:

(a) any deficiencies caused by its not being sensitive tomovements in fundamental risk drivers or for any otherreason;

(b) the periodic review and action in the light of suchreview;

(c) providing appropriate internal guidance to staff toensure consistency in the use of the rating system,including the assignment of exposures or facilities topools or grades;

(d) dealing with potential weaknesses of the rating system;

(e) identifying appropriate and inappropriate uses of therating system and acting on that identification;

(f) novel or narrow rating approaches; and

(g) ensuring the appropriate level of stability over time ofthe rating system.

(CRR Article 144(1)(a) and 144(1)(e))

Collection of data10.8 In order to be satisfied that the requirements in CRRArticle 179(1) are met, the PRA expects a firm to collect dataon what it considers to be the main drivers of the riskparameters of PD, LGD, CF and EL, for each group of obligorsor facilities, to document the identification of the main driversof risk parameters, and to be able to demonstrate that theprocess of identification is reasonable and appropriate.

10.9 In its processes for identifying the main drivers of riskparameters, the PRA expects that a firm should set out its


reasons for concluding that the data sources chosen provide inthemselves sufficient discriminative power and accuracy, andwhy additional potential data sources do not provide relevantand reliable information that would be expected materially toimprove the discriminative power and accuracy of its estimatesof the risk parameter in question. The PRA would not expectthis process necessarily to require an intensive analysis of allfactors.

(CRR Article 179(1)(a), 179(1)(d) and CRR Article 179(1)(e))

Data quality10.10 In order to demonstrate that rating systems provide formeaningful assessment, the PRA expects that a firm’sdocumentation relating to data include clear identification ofresponsibility for data quality. The PRA expects a firm to setstandards for data quality, aim to improve them over time andmeasure its performance against those standards.Furthermore, the PRA expects a firm to ensure that its data areof sufficiently high quality to support the firm’s riskmanagement processes and the calculation of its capitalrequirements.


Use of models and mechanical methods to produceestimates of parameters10.11 Further detail of standards that the PRA would expectfirms to meet when it assesses compliance with CRRArticle 174 are set out in the sections on PD, LGD and Exposureat Default (EAD).

10.12 In assessing whether the external data used by a firm tobuild models are representative of its actual obligors orexposures, the PRA expects a firm to consider whether thedata are appropriate to its own experience and whetheradjustments are necessary.

(CRR Article 174 and 174(c))

Calculation of long-run averages of PD, LGD and EAD10.13 In order to estimate PDs that are long-run averages ofone year default rates for obligor grades or pools, the PRAexpects firms to estimate expected default rates for thegrade/pool over a representative mix of good and badeconomic periods, rather than simply taking the historicaverage of default rates actually incurred by the firm over aperiod of years. The PRA expects that a long-run estimatewould be changed when there is reason to believe that theexisting long-run estimate is no longer accurate, but that itwould not be automatically updated to incorporate theexperience of additional years, as these may not berepresentative of the long-run average.

(CRR Article 180)

10.14 In order to be able to demonstrate compliance with CRRArticle 144(1)(1), the PRA expects a firm to take into accountthe following factors in understanding differences betweentheir historic default rates and their PD estimates, and inadjusting the calibration of their estimates as appropriate:

(a) the rating philosophy of the system and the economicconditions in the period over which the defaults havebeen observed;

(b) the number of defaults, as a low number is less likely tobe representative of a long-run average. Moreover,where the number of internal defaults is low, there islikely to be a greater need to base PDs on externaldefault data as opposed to purely internal data;

(c) the potential for under-recording of actual defaults; and

(d) the level of conservatism applied.

10.15 The PRA expects that a firm that is not able to produce along-run estimate, as described above, to consider what actionit would be appropriate for it to take to comply with CRRArticle 180(1)(a). In some circumstances, it may beappropriate for firms to amend their rating system so that thePD used as an input into the IRB capital requirement is anappropriately conservative estimate of the actual default rateexpected over the next year. However, such an approach is notlikely to be appropriate where default rates are dependent onthe performance of volatile collateral.

(CRR Article 179(1)(f) and 180(1)(a))

10.16 In accordance with CRR Article 181(1)(b) and CRRArticle 182(1)(b), where the estimates appropriate for aneconomic downturn are more conservative than the long-runaverage, we would expect the estimate for each of theseparameters to represent the LGD or CF expected, weighted bythe number of defaults, over the downturn period. Where thiswas not the case we would expect the estimate to be used tobe the expected LGD or CF, weighted by the number ofdefaults, over a representative mix of good and bad economicperiods.

(CRR Article 179, 181 and 182)

Assignment to grades or pools10.17 In order to demonstrate that a rating system providedfor a meaningful differentiation of risk and accurate andconsistent quantitative estimates of risk the PRA expects thata firm would have regard to the sensitivity of the rating tomovements in fundamental risk drivers, in assigning exposuresto grades or pools within a rating system.

(CRR Article 171)


11 Definition of default

Identification of obligors11.1 The PRA expects that if a firm ordinarily assigns exposuresin the corporate, institution or central government and centralbank exposure classes to a member of a group substantially onthe basis of membership of that group and a common grouprating, and the firm does so in the case of a particular obligorgroup, the firm should consider whether members of thatgroup should be treated as a single obligor for the purpose ofthe definition of default set out in CRR Article 178(1).

11.2 The PRA would not expect a firm to treat an obligor aspart of a single obligor under the preceding paragraph if thefirm rated its exposures on a stand alone basis or if its ratingwas notched. (For these purposes a rating is notched if it takesinto account individual risk factors, or otherwise reflects riskfactors that are not applied on a common group basis.)Accordingly, if a group has two members which are separatelyrated, the PRA would not expect that the default of one wouldnecessarily imply the default of the other.

Days past due11.3 Under CRR Article 178(2)(d) the PRA is empowered toreplace 90 days with 180 days in the days past due componentof the definition of default for exposures secured by residentialor SME commercial real estate in the retail exposure class, aswell as exposures to public sector entities (PSEs).

11.4 We would expect to replace 90 days with 180 days in thedays past due component of the definition of default forexposures secured by residential real estate in the retailexposure class, and/or for exposures to PSEs, where this wasrequested by the firm. Where this occurred, it would bespecified in a firm’s IRB permission.

Unlikeliness to pay: distressed restructuring11.5 The PRA expects that a credit obligation be considered adistressed restructuring if an independent third party, withexpertise in the relevant area, would not be prepared toprovide financing on substantially the same terms andconditions.

(See CRR Article 178(2)(d))

Return to performing status11.6 In order to be satisfied that a firm complies with thedocumentation requirements set out in CRR Article 175(3) thePRA expects that a firm should have a clear and documentedpolicy for determining whether an exposure that has been indefault should subsequently be returned to performing status.


12 Probability of default in IRB approaches

Rating philosophy12.1 ‘Rating philosophy’ describes the point at which a ratingsystem sits on the spectrum between the stylised extremes ofa point in time (PiT) rating system and a through the cycle(TTC) rating system. Points (a) and (b) explain these conceptsfurther:

(a) PiT: firms seek explicitly to estimate default risk over afixed period, typically one year. Under such an approachthe increase in default risk in a downturn results in ageneral tendency for migration to lower grades. Whencombined with the fixed estimate of the long-rundefault rate for the grade, the result is a higher capitalrequirement. Where data are sufficient, grade leveldefault rates tend to be stable and relatively close to thePD estimates; and

(b) TTC: firms seek to remove cyclical volatility from theestimation of default risk, by assessing borrowers’performance across the economic cycle. TTC ratings donot react to changes in the cycle, so there is noconsequent volatility in capital requirements. Actualdefault rates in each grade diverge from the PD estimatefor the grade, with actual default rates relatively higherat weak points in the cycle and relatively lower at strongpoints.

12.2 Most rating systems sit between these two extremes.Rating philosophy is determined by the cyclicality of thedrivers/criteria used in the rating assessment, and should notbe confused with the requirement for grade level PDs to be‘long run’. The calibration of even the most PiT rating systemneeds to be targeted at the long-run default rates for itsgrades; the use of long-run default rates does not convertsuch a system into one producing TTC ratings or PDs.

12.3 Firms should understand where their rating systems lieon the PiT/TTC spectrum to enable them to estimate howchanges in economic conditions will affect their IRB capitalrequirements. The PRA also expects firms to be able tocompare the actual default rates incurred against the defaultrate expected over the same period given the economicconditions pertaining, as implied by their PD estimate.

Variable scalar approachesUse of variable scalar approaches12.4 We use the term ‘variable scalar’ to describe approachesin which the outputs of an underlying, relatively PiT, ratingsystem are transformed to produce final PD estimates used forregulatory capital requirements that are relatively non-cyclical. Typically this involves basing the resultingrequirement on the long-run default rate of the portfolio orsegments thereof.


12.5 CRR Article 169(3) allows the use of direct estimates ofPDs, though such a measure could be assessed over a varietyof different time horizons which CRR does not specify.Accordingly, the PRA considers it acceptable in principle to usemethodologies of this type in lieu of estimation of long-runaverages for the grade/pool/score of the underlying ratingsystem where conditions set out below are met. Meetingthese conditions would require firms using the variable scalarapproach to have a deep understanding of how and why theirdefault rates varied over time.

(a) firms meet the following four principles which addressthe considerable conceptual and technical challenges tobe overcome in order to carry out variable scalaradjustments in an appropriate way:

Principle 1: both the initial calculations of andsubsequent changes to the scalar should be able totake account of changes in default risk that are notpurely related to the changes in the cycle;

Principle 2: a firm should be able accurately tomeasure the long-run default risk of its portfolio; thismust include an assumption that there are no changesin the business written;

Principle 3: a firm should use a data series ofappropriate length in order to provide a reasonableestimate of the long-run default rate referred to inparagraph 10.13; and

Principle 4: a firm should be able to demonstrate theappropriateness of the scaling factor being usedacross a portfolio.

(b) stress testing includes a stress test covering thedownturn scenarios outlined by the PRA, based on thePDs of the underlying PiT rating system, in addition tothe stress test based on the parameters used in thePillar 1 capital calculation (ie the portfolio level averagelong-run default rates); and

(c) firms are able to understand and articulate upfront howthe scaling factor would vary over time in order toachieve the intended effect.

12.6 The PRA will not permit firms using a variable scalarapproach to revert to using a PiT approach during more benigneconomic conditions.

12.7 Principle 1 is the most important and challenging toachieve as it requires an ability to be able to distinguishmovements not related to the economic cycle, from changespurely related to the economic cycle, and not to average theseaway. This is because a variable scalar approach removes the

ability of a rating system to take account automatically ofchanges in risk through migration between its grades.

12.8 Accordingly, the PRA expects firms using a variable scalarapproach to adopt a PD that is the long-run default rateexpected over a representative mix of good and bad economicperiods, assuming that the current lending conditions includingborrower mix and attitudes and the firm’s lending policiesremain unchanged. If the relevant lending conditions orpolicies change, then we would expect the long-run defaultrate to change.

(CRR Article 180(1)(a), 180(1)(b) and 180(2)(a))

Variable scalar considerations for retail portfolios12.9 The PRA considers that until more promising accountlevel arrears data is collected, enabling firms to better explainthe movement in their arrears rate over time, the likelihood offirms being able to develop a compliant variable scalarapproach for non-mortgage retail portfolios is low. This isbecause of the difficulty that firms have in distinguishingbetween movements in default rates that result from cyclicalfactors and those that result from non-cyclical reasons forthese portfolios. In practice therefore the rest of this sectionapplies to residential mortgage portfolios.

12.10 For the purposes of this subsection ‘non-mortgage retailportfolios’ refers to non-mortgage lending to individuals(eg credit cards, unsecured personal loans, auto-finance) butdoes not include portfolios of exposures to small andmedium-sized entities (SMEs in the retail exposure class).

12.11 The PRA considers that one variable scalar approach,potentially compliant with the four principles set out above,could involve:

(a) segmenting a portfolio by its underlying drivers ofdefault risk; and

(b) estimating separate long-run default rates for each ofthese segmented pools.

Segmentation12.12 A firm that applied a segmentation approach properlycould satisfy both Principle 1 and Principle 4. The choice of thebasis of segmentation and the calibration of the estimatedlong-run default rate for the segments would both be ofcritical importance.

12.13 The PRA expects segmentation to be done on the basisof the main drivers of both willingness and ability to pay. Inthe context of residential mortgages, an example of the formeris the amount of equity in the property and an example of thelatter is the ratio of debt to income of the borrower. The PRAexpects firms to:


• incorporate an appropriate number of drivers of riskwithin the segmentation to maximise the accuracy ofthe system;

• provide detailed explanations supporting their choicesof drivers, including an explanation of the drivers theyhave considered but chosen not to use; and

• ensure that the drivers reflect their risk processes andlending policy, and are not be chosen using onlystatistical criteria (ie a judgemental assessment of thedrivers chosen is applied).

(CRR Article 179(1)(d))

12.14 To the extent that the basis of segmentation is notsufficient completely to explain movements in non-cyclicaldefault risk, the long-run default rate for that segment will notbe stable (eg a change in the mix of the portfolio within thesegment could change the long-run default rate). In suchcases, we expect firms to make a conservative compensatingadjustment to the calibration of the long-run average PD forthe affected segments and to be able to demonstrate that theamount of judgement required to make such adjustments isnot excessive. Where judgement is used, considerableconservatism may be required. The PRA expects conservatismapplied for this reason not to be removed as the cycle changes.

Long-run default rate12.15 The PRA expects firms to review and amend as necessarythe long-run default rate to be applied to each segment on aregular (at least an annual) basis. When reviewing thelong-run default rate to be applied to each segment, the PRAexpects firms to consider the extent to which:

(a) realised default rates are changing due to cyclical factorsand the scaling factors needs to be changed;

(b) new information suggests that both the PiT PDs and thelong-run PDs should be changed; and

(c) new information suggests that the basis ofsegmentation should be amended.

12.16 The PRA expects that over time the actual default ratesincurred in each segment would form the basis of PDestimates for the segments. However at the outset the keycalibration issue is likely to be the setting of the initial long-rundefault rate for each segment, as this will underpin the PD ofthe entire portfolio for some years to come. The PRA expectsfirms to apply conservatism in this area and this is somethingon which the PRA is likely to focus on in particular in PRAmodel reviews.

Governance12.17 The PRA expects firms to put in place a governanceprocess to provide a judgemental overlay to assess theirchoices of segments, PD estimates and scalars, both initiallyand on a continuing basis. Moreover, where the basis of theirestimation is a formulaic approach, we would consider that theact of either accepting or adjusting the estimate suggested bythe formula would represent the exercise of judgement.

12.18 The PRA expects firms to consider what use they canmake of industry information. However, we would expectfirms to seek to measure the absolute level of and changes totheir own default risk, rather than changes in default riskrelative to the industry. Given the potential for conditions tochange across in the market as a whole, the PRA expects afirm should not to draw undue comfort from the observationthat its default risk is changing in the same way as the industryas a whole. Doing so would not allow them to meetPrinciple 1.

12.19 The PRA expects firms to be able to demonstrate thatthey have adequate information and processes in order tounderpin the decisions outlined above on choice ofsegmentation, source of data, and adequacy of conservatism inthe calibration, and that this information is reflected in thereports and information being used to support the variablescalar governance process. Given that, for retail business,these decisions would be likely to affect only the regulatorycapital requirements of the firm and not the day-to-dayrunning of its business, we will be looking for a high level ofreassurance and commitment from firms’ senior managementto maintain an adequate governance process.

Data considerations12.20 The PRA expects firms to consider the following issueswhen seeking to apply a variable scalar approach forUK mortgages:

(a) in respect of Principle 2, the commonly used Council forMortgage Lenders database was based on arrears dataand not defaults during a period, and the use of thesedata without further analysis and adjustment canundermine the accuracy of any calculations; and

(b) in respect of Principle 3, the historical data time periodchosen for use in the calculations will vary the long-runPDs, and thus capital requirements, when there is nochange in the underlying risk.

12.21 The PRA expects firms that are including mortgagearrears data as a proxy for default data to:

(a) carry out sensitivity analysis identifying thecircumstances in which the assumption that arrears maybe used as a proxy for default would produce inaccuracyin long-run PD estimates;


(b) set a standard for what might constitute a potentiallysignificant level of inaccuracy, and demonstrate why inpractice the use of this proxy would not result in anysignificant inaccuracy;

(c) establish a process for assessing the on-going potentialfor inaccuracy, including thresholds beyond which thelevel of inaccuracy may no longer be insignificant; and

(d) consider the use of conservative adjustments to addressthe potential inaccuracy.

12.22 When using historical mortgage data as a key input intovariable scalar models the PRA expects firms to:

(a) carry out sensitivity analysis identifying the implicationsof using different cut-off dates for the start of thereference data set; and

(b) justify the appropriateness of their choice of cut-offdate.

Retail exposures: obligor level definition of default12.23 Where a firm has not chosen to apply the definition ofdefault at the level of an individual credit facility in accordancewith CRR Article 178(1), the PRA expects it to ensure that thePD associated with unsecured exposures is not understated asa result of the presence of any collateralised exposures.

12.24 The PRA expects the PD of a residential mortgage wouldtypically be lower than the PD of an unsecured loan to thesame borrower.


Retail exposures: facility level definition of default12.25 Where a firm chooses to apply the definition of defaultat the level of an individual credit facility in accordance withCRR Article 178(1) and a customer has defaulted on a facility,then default on that facility is likely to influence the PDassigned to that customer on other facilities. The PRA expectsfirms to take this into account in its estimates of PD.(CRR Article 178(1))

Multi-country mid-market corporate PD models12.26 In order to ensure that a rating system provides ameaningful differentiation of risk and accurate and consistentquantitative estimates of risk, the PRA would expect firms todevelop country-specific mid-market PD models. Where firmsdevelop multi-country mid-market PD models, we wouldexpect firms to be able to demonstrate that the model rankorders risk and predicts default rates for each country where itis to be used for regulatory capital calculation.

12.27 The PRA expects firms to have challenging standards inplace to meaningfully assess whether a model rank orders risk

and accurately predict default rates. These standards shouldspecify the number of defaults that are needed for ameaningful assessment to be done.

12.28 We would expect firms to assess the model’s ability topredict default rates using a time series of data (ie not onlybased on one year of default data).

12.29 In our view a model is not likely to be compliant wherethe firm cannot demonstrate that it rank orders risk andpredicts default rates for each country regardless of anyapparent conservatism in the model.

Use of external ratings agency grades12.30 We would expect firms using a rating agency grades asthe primary driver in their IRB models to be able todemonstrate (and document) compliance with the followingcriteria:

(a) the firm has its own internal rating scale;

(b) the firm has a system and processes in place that allowit continuously to collect and analyse all relevantinformation, and the ‘other relevant information’considered by the firm in accordance with CRRArticle 171(2) reflects the information collected andanalysed by the firm when extending credit to new orexisting obligors;

(c) the ‘other relevant information’ considered by the firmis included in an IRB model in a transparent andobjective way and is subject to challenge. We wouldexpect the firm to be able to demonstrate whatinformation was used and why, and, how it wasincluded; and if no additional information is included,to be able to document what information was discardedand why;

(d) the development of final grades includes the followingsteps:

(i) the firm takes into account all available information(eg external agency grades and any ‘other relevantinformation’) prior to allocating obligors to internalgrades. The firm does not automatically assignobligors to grades based on the rating agency grade;

(ii) any overrides are applied to these grades; and

(iii) the firm has a system and processes in place thatallows it to continuously collect and analyse finalrating overrides.

(e) the grades to which obligors are assigned is reassessedat least annually. The firm is able to demonstrate how


the grades are reassessed on a more frequent thanannual basis when new relevant information becomesavailable; and

(f) firms can demonstrate that a modelling approach isbeing applied, both in terms of the choice of the ratingagency grade as the primary driver and, whereinformation is found materially and consistently to addto the accuracy or predictive power of the internal ratinggrade, that they have incorporated this information asan additional driver. The PRA expects this work to beanalytical (rather than entirely subjective) and couldform part of the annual independent review of themodel.

12.31 In the PRA’s view, if a firm does not have any additionalinformation to add to the external ratings for the significantpart of its portfolio then the PRA expects it will not meet therequirements for using an IRB approach.

Low default portfolios12.32 The PRA expects a firm to estimate PD for a ratingsystem in accordance with this section where a firm’s internalexperience of defaults for that rating system was 20 or fewer,and reliable estimates of PD cannot be derived from externalsources of default data including the use of market pricerelated data. In PD estimation for all exposures covered bythat rating system, the PRA expects firms to:

(a) use a statistical technique to derive the distribution ofdefaults implied by the firm’s experience, estimatingPDs (the ‘statistical PD’) from the upper bound of aconfidence interval set by the firm in order to produceconservative estimates of PDs in accordance with CRRArticle 179(f);

(b) use a statistical technique to derive the distribution ofdefault which takes account, as a minimum, of thefollowing modelling issues:

(i) the number of defaults and number of obligor yearsin the sample;

(ii) the number of years from which the sample wasdrawn;

(iii) the interdependence between default events forindividual obligors;

(iv) the interdependence between default rates fordifferent years; and

(v) the choice of the statistical estimators and theassociated distributions and confidence intervals.

(c) further adjust the statistical PD to the extent necessaryto take account of the following:

(i) any likely differences between the observed defaultrates over the period covered by the firm’s defaultexperience and the long-run PD for each graderequired by CRR Articles 180(1)(a) and 180(2)(a);and

(ii) any other information that indicates (taking intoaccount the robustness and cogency of thatinformation) that the statistical PD is likely to be aninaccurate estimate of PD.

12.33 The PRA expects firms to take into account only defaultsthat occurred during periods that are relevant to the validationunder the CRR of the model or other rating system in questionwhen determining whether there are 20 defaults or fewer.

Supervisory slotting criteria for specialised lending12.34 The PRA expects firms to assign exposures to therisk-weight category for specialised lending exposures basedon the criteria set out in the tables in Appendix A. Draft EBAregulatory technical standards due to be developed by31 December 2014 will specify these assignments.

13 Loss Given Default in IRB approaches

Negative LGDs13.1 The PRA expects firms to ensure that no LGD estimate isless than zero.

Low LGDs13.2 The PRA does not expect firms to be using zero LGDestimates in cases other than where they had cash collateralsupporting the exposures.

13.3 The PRA expects firms to justify any low LGD estimatesusing analysis on volatility of sources of recovery, notably oncollateral, and cures (as outlined below). This includes:

(a) recognising that the impact of collateral volatility onlow LGDs is asymmetric as surpluses over amountsowed need to be returned to borrowers and that thiseffect may be more pronounced when estimatingdownturn rather than normal period LGDs; and

(b) recognising the costs and discount rate associatedwith realisations and the requirements of CRRArticle 181(1)(e).

13.4 In order to ensure that the impact of collateral volatilityis taken into account, the PRA expects firms’ LGD frameworkto include non-zero LGD floors which are not solely related toadministration costs.

(CRR Article 179(1)(f))


Treatment of cures13.5 Where firms wish to include cures in their LGD estimates,the PRA expects them to do so on a cautious basis withreference to both their current experience and how this isexpected to change in downturn conditions. In particular, thisinvolves being able to articulate clearly both the precise courseof events that will allow such cures to take place and anyconsequences of such actions for other elements of their riskquantification. For example:

(a) Where cures are driven by the firm’s own policies, wewould expect firms to consider whether this is likely toresult in longer realisation periods and larger forced salediscounts for those exposures that do not cure, andhigher default rates on the book as a whole, relative tothose that might be expected to result from a lessaccommodating attitude. To the extent feasible, thePRA expects cure assumptions in a downturn to besupported by relevant historical data.

(b) The PRA expects firms to be aware of and properlyaccount for the link between cures and subsequentdefaults. In particular, an earlier cure definition is, otherthings being equal, likely to result in a higher level ofsubsequent defaults.

(CRR Article 5(2))

Incomplete workouts13.6 In order to ensure that estimates of LGDs take intoaccount the most up to date experience, we would expectfirms to take account of data in respect of relevant incompleteworkouts (ie defaulted exposures for which the recoveryprocess is still in progress, with the result that the final realisedlosses in respect of those exposures are not yet certain).

(CRR Article 179(1)(c))

LGD — sovereign floor13.7 To ensure that sovereign LGD models are sufficientlyconservative in view of the estimation error that may arisefrom the lack of data on losses to sovereigns, the PRA expectsfirms to apply a 45% LGD floor to each unsecured exposure inthe sovereign asset class.

(CRR Articles 144(1) and 179(1)(a)

LGD — UK retail mortgage property sales referencepoint(2)13.8 The PRA believes that an average reduction in propertysales prices of 40% from their peak price, prior to the marketdownturn, forms an appropriate reference point whenassessing downturn LGD for UK mortgage portfolios. Thisreduction captures both a fall in the value of the property due

to house price deflation as well as a distressed forced salediscount.

13.9 Where firms adjust assumed house price values withintheir LGD models to take account of current market conditions(for example with reference to appropriate house price indices)we recognise that realised falls in market values may becaptured automatically. Firms adopting such approaches mayremove observed house price falls from their downturn houseprice adjustment so as not to double count. The PRA expectsall firms wishing to apply such an approach to seek the consentof the PRA and to be able to demonstrate that the followingcriteria are met:

(a) the adjustment applied to the market value declineelement of a firm’s LGD model is explicitly derived fromthe decrease in indexed property prices (ie the processis formulaic, not judgemental);

(b) the output from the adjusted model has been assessedagainst the 40% peak-to-trough property sales pricesdecrease reference point (after inclusion of a forced salediscount);

(c) a minimum 5% market value decline applies at all timesin the LGD model; and

(d) the firm has set a level for reassessment of the propertymarket price decline from its peak. For example, if afirm had initially assumed a peak-to-trough marketdecline of 15%, then it will have set a level of marketvalue decline where this assumption will be reassessed.

CRR Article 181(1)(b))Downturn LGDs13.10 In order to ensure that their LGD estimates are orientedtowards downturn conditions, the PRA expects firms to have aprocess through which they:

(a) identify appropriate downturn conditions for each IRBexposure class within each jurisdiction;

(b) identify adverse dependencies, if any, between defaultrates and recovery rates; and

(c) incorporate adverse dependencies, if identified, betweendefault rates and recovery rates in the firm’s estimatesof LGD in a manner that meets the requirementsrelating to an economic downturn.

(CRR Article 181(1)(b))

Discounting cash flows13.11 In order to ensure that their LGD estimates incorporatematerial discount effects, the PRA expects firms’ methods for


discounting cash flows to take account of the uncertaintiesassociated with the receipt of recoveries with respect to adefaulted exposure, for example by adjusting cash flows tocertainty equivalents or by using a discount rate that embodiesan appropriate risk premium; or by a combination of the two.

13.12 If a firm intends to use a discount rate that does not takefull account of the uncertainty in recoveries, we would expectit to be able to explain how it has otherwise taken into accountthat uncertainty for the purposes of calculating LGDs. This canbe addressed by adjusting cash flows to certainty equivalentsor by using a discount rate that embodies an appropriate riskpremium for defaulted assets; or by a combination of the two.

13.13 In addition to the above measures the PRA expects firmsto ensure that no discount rate used to estimate LGD is lessthan 9%.

(CRR Article 5(2))

Wholesale LGD13.14 The PRA expects firms using AIRB approaches to havedone the following in respect of wholesale LGD estimates:

(a) applied LGD estimates at transaction level;

(b) ensured that all LGD estimates (both downturn andnon-downturn) are cautious, conservative andjustifiable, given the paucity of observations. Inaccordance with CRR Article 179(1)(a), estimates mustbe derived using both historical experience andempirical evidence, and not be based purely onjudgemental consideration. We expect the justificationas to why the firm thinks the estimates are conservativeto be documented;

(c) identified and explained at a granular level how eachestimate has been derived. This should include anexplanation of how internal data, external data, expertjudgement or a combination of these has been used toproduce the estimate;

(d) clearly documented the process for determining andreviewing estimates, and the parties involved in theprocess in cases where expert judgement was used;

(e) demonstrated an understanding of the impact of theeconomic cycle on collateral values and be able to usethat understanding in deriving their downturn LGDestimates;

(f) demonstrated sufficient understanding of any externalbenchmarks used and identified the extent of theirrelevance and suitability to the extent that the firm cansatisfy itself that they are fit for purpose;

(g) evidenced that they are aware of any weaknesses intheir estimation process and have set standards, forexample related to accuracy, that their estimates aredesigned to meet;

(h) demonstrated that they have sought and utilisedrelevant and appropriate external data, includingthrough identifying all relevant drivers of LGD and howthese will be affected by a downturn;

(i) ensured, in most cases, estimates incorporate effectivediscrimination on the basis of at least security type andgeography. In cases where these drivers are notincorporated into LGD estimates then we would expectthe firm to be able to demonstrate why they are notrelevant;

(j) have put in place an on-going data collection frameworkto collect all relevant internal loss and exposure datarequired for estimating LGD and a framework to startusing these data as soon as any meaningful informationbecomes available; and

(k) ensured it can articulate the data the firm intends to usefrom any industry-wide data collection exercises inwhich it is participating, and how the data will be used.

(CRR Section 6)

13.15 We have developed a framework for assessing theconservatism of firms’ wholesale LGD models for which thereare a low number of defaults. The framework is set out inAppendix C and does not apply to sovereign LGD estimateswhich are floored at 45%. We are in the process of using thisframework to assess the calibration of firms’ material.

LGD models for low-default portfolios13.16 In the following cases, the PRA expects firms todetermine the effect of applying the framework set out inAppendix C to models which include LGD values that arebased on fewer than 20 ‘relevant’ data points (as defined inAppendix C):

(a) the model is identified for review by the PRA; or

(b) the firm submits a request for approval for a materialchange to its LGD model.

13.17 In such cases firms should contact their supervisor toobtain the relevant data templates that should be populatedand submitted to the PRA.


Unexpected loss (UL) on defaulted assets(1)

13.18 The CRR is unclear in how UL should be calculated fordefaulted assets. This was also the case for the BCD. Theanswer to transposition group question 655 on the calculationof UL for defaulted assets under the BCD referred to twoapproaches:

(a) the independent calculation approach; and

(b) subtraction of the best estimate of expected loss frompost-default LGD.

13.19 The PRA considers that both of the approaches set out inthe CRD transposition group answer are acceptable inprinciple.

13.20 Where an independent calculation approach is adoptedfor the calculation of unexpected loss on defaulted assets thePRA expects firms to ensure that estimates are at least equal,at a portfolio level, to a 100% risk-weight, ie 8% capitalrequirement on the amount outstanding net of provisions.(2)

(CRR Article 181(1)(h))

Unsecured LGDs where the borrowers’ assets aresubstantially used as collateral13.21 The extent to which a borrower’s assets are alreadygiven as collateral will affect the recoveries available tounsecured creditors. If the degree to which assets are pledgedis substantial this will be a material driver of LGDs on suchexposures. Although potentially present in all transactions,the PRA expects firms to be particularly aware of this driver insituations in which borrowing on a secured basis is the normalform of financing, leaving relatively few assets available for theunsecured debt. Specialist lending (including property), hedgefunds, some SME/mid-market lending are examples of suchcases.

13.22 The PRA expects firms to take into account the effect ofassets being substantially used as collateral for otherobligations estimating LGDs for borrowers for which this is thecase. The PRA expects firms not to use unadjusted data setsthat ignore this impact, and note that it is an estimate fordownturn conditions that is normally required. In the absenceof relevant data to estimate this effect, conservative LGDs —potentially of 100% — are expected to be used.

(CRR Articles 171(2), 179(1)(a))

14 Own estimates of exposure at default(EAD) in IRB approaches

Estimation of EAD in place of conversion factors14.1 The PRA considers that a firm may provide own estimatesof EAD in place of the own estimates of CFs that it is permittedor required to provide under CRR Article 151.

14.2 In this supervisory statement references to EAD refer toboth direct estimates of EAD and CFs unless specifiedotherwise.

(CRR Article 151)

General expectations for estimating EAD14.3 The PRA expects that EAD estimates should not be lessthan current drawings (including interest accrued to date).Consequently, the PRA expects CF estimates not to be lessthan zero.

14.4 The EAD required for IRB purposes is the exposure(s)expected to be outstanding under a borrower’s currentfacilities should it go into default in the next year, assumingthat economic downturn conditions occur in the next year anda firm’s policies and practices for controlling exposures remainunchanged other than changes that result from the economicdownturn conditions.

14.5 In order to achieve sufficient coverage of the EAD, thePRA expects firms to take into account all facility types thatmay result in an exposure when an obligor defaults, includinguncommitted facilities.

14.6 To the extent that a firm makes available multiplefacilities, the PRA expects firms to be able to demonstrate:

(a) how they deal with the fact that exposures on onefacility may become exposures under another on whichthe losses are ultimately incurred; and

(b) the impact of its approach on its capital requirements.

14.7 The PRA expects firms using own estimates of EAD tohave done the following in respect of EAD estimates:

(a) applied EAD estimates at the level of the individualfacility;

(b) where there is a paucity of observations, ensured that allEAD estimates are cautious, conservative and justifiable.In accordance with Article 179(1)(a), estimates must bederived using both historical experience and empiricalevidence, and must not be based purely on judgementalconsideration. The PRA would expect the justification asto why the firm thinks the estimates are conservative tobe documented;


(1) http://ec.europa.eu/yqol/index.cfm?fuseaction=question.show&questionID=655.(2) Independent calculation approaches are an alternative to measuring the UL on

defaulted asserts as being the difference between downturn LGD and best estimateLGD. See link in footnote (1) above for further information.


(c) identified and explained at a granular level how eachestimate has been derived. This should include anexplanation of how internal data, any external data,expert judgement or a combination of these has beenused to produce the estimate.

(d) ensured that where expert judgement has been usedthere is clear documentation of the process for arrivingat and reviewing the estimates, and identifying theparties involved;

(e) demonstrated an understanding of the impact of theeconomic cycle on exposure values and be able to usethat understanding in deriving downturn EAD estimates;

(f) demonstrated sufficient understanding of any externalbenchmarks used and identified the extent of theirrelevance and suitability to the extent that the firm cansatisfy itself that they are fit for purpose;

(g) evidenced that they are aware of any weaknesses intheir estimation process and have set standards thattheir estimates are designed to meet (eg related toaccuracy);

(h) ensured, in most cases, that estimates incorporateeffective discrimination on the basis of at least productfeatures and customer type. In cases where thesedrivers are not incorporated into EAD estimates thenthe PRA expects the firm to be able to demonstrate whythey are not relevant;

(i) have an on-going data collection framework in place tocollect all relevant internal exposure data required forestimating EAD and a framework to start using this dataas soon as any meaningful information becomesavailable;

(j) made use of the data they are collecting to identify allrelevant drivers of EAD and to understand how thesedrivers will be affected by a downturn; and

(k) identified dependencies between default rates andconversion factors for various products and marketswhen estimating downturn EADs. Firms are expected toconsider how they expect their own policies regardingexposure management to evolve in a downturn.

14.8 The PRA has developed a framework for assessing theconservatism of firms’ wholesale EAD models for which thereare a low number of defaults. The PRA is in the process ofusing this framework to assess the calibration of firms’material EAD models for low-default portfolios.

14.9 In the following cases, the PRA expects firms todetermine the effect of applying the framework set out in

Appendix C to models which include EAD values that are basedon fewer than 20 ‘relevant’ data points (as defined inAppendix C):

(a) the model is identified for review by the PRA; or

(b) the firm submits a request for approval for a materialchange to its EAD model.

14.10 In such cases firms should contact their supervisor toobtain the relevant data templates that should be populatedand submitted to the PRA.

(CRR Articles 4(56), 166, Section 6)

Time horizon14.11 The PRA expects firms to use a time horizon of one yearfor EAD estimates, unless they can demonstrate that anotherperiod would be more conservative.

14.12 EAD estimates can be undertaken on the basis thatdefault occurs at any time during the time horizon (the ‘cohortapproach’), or at the end of the time horizon (the‘fixed-horizon approach’). The PRA considers that eitherapproach is acceptable in principle.

14.13 The PRA expects the time horizon for additionaldrawings to be the same as the time horizon for defaults. Ineffect this means that EAD estimation need cover onlyadditional drawings that might take place in the next year,such that:

(a) no capital requirement need be held against facilities, orproportions of facilities that cannot be drawn downwithin the next year; and

(b) where facilities can be drawn down within the next year,firms may in principle reduce their estimates to theextent that they can demonstrate that they are able andwilling, based on a combination of empirical evidence,current policies, and documentary protection to preventfurther drawings.

(CRR Article 182)

Direct estimates of EAD14.14 There are a range of approaches that focus on the totalamount that will be drawn down at the time of default anddirectly estimate EAD. Typically, but not in all cases, these willestimate EAD as a percentage of Total Limit. These approachescan be described collectively as ‘momentum’ approaches.

14.15 A ‘momentum’ approach can be used either:


(a) by using the drawings/limit percentage to formulaicallyderive a conversion factor on the undrawn portion of thelimit; or

(b) by using the higher of percentage of the limit and thecurrent balance as the EAD.

14.16 The PRA considers that the use of momentumapproaches in both of the ways outlined above is acceptable inprinciple as an alternative to direct estimation of conversionfactors.

(CRR Article 4(56))

Distortions to conversion factor estimates caused bylow undrawn limits14.17 In cases where firms estimate CFs directly, using areference data set that includes a significant number of highCFs as a result of very low undrawn limits at the observationdate, the PRA expects firms to:

(a) investigate the distribution of realised CFs in thereference data set;

(b) base the estimated CF on an appropriate point alongthat distribution that results in the choice of a CFappropriate for the exposures to which it is beingapplied and consistent with the requirement inCRR Article 179 for estimates to include a margin ofconservatism related to errors; and

(c) be cognisant that while the median of the distributionmight be a starting point, they should not assumewithout analysis that the median represents areasonable unbiased estimate. The PRA expects firms toconsider whether the pattern of distribution in realisedCFs means that some further segmentation is needed(eg treating facilities that are close to full utilisationsdifferently).


Identification of exposures for which an EAD must beestimated

14.18 The PRA expects firms to treat a facility as an exposurefrom the earliest date at which a customer is able to makedrawings under it.

14.19 Where the facility is of the type that it is customary notto advise the borrower of its availability, the PRA expects anEAD/CF to be applied from the time that the existence of thefacility is recorded on the firm’s systems in a way that wouldallow the borrower to make a drawing.

14.20 If the availability of a facility is subject to a furthercredit assessment by the firm, an EAD/CF may not be required.However, the PRA expects this to be the case only if thesubsequent credit assessment were of substantially equivalentrigour to that of the initial credit approval, and if this includesa re-rating or a confirmation of the rating of the borrower.

14.21 Firms are not expected to include in their EAD/CFestimates the probability of increases in limits betweenobservation and default date. If the reference data setincluded the impact of such increases, the PRA expects firms tobe able to adjust their estimates accordingly with the aim ofassessing what the exposure would have been at default if thelimit had not been increased.

14.22 The PRA expects firms to investigate the incidence ofexposures existing at default that arise from products orrelationships that are not intended to result in a creditexposure and, consequently, have no credit limit establishedagainst them and are not reflected in their estimates of EAD.Unless such exposures are immaterial, the PRA expects firmsto apply a Pillar 1 capital charge on a portfolio basis to suchexposures.

14.23 The PRA expects firms to investigate how their EADestimates are impacted by exposures that are in excess oflimits at either the observation date (if in the reference dataset) or at the current reporting date (for the existing book towhich estimates need to be applied). Unless a momentumapproach is being used exposures in excess of limit should beexcluded from the reference data set (as the undrawn limit isnegative and nonsensical answers would result from theirinclusion). The PRA expects firms to ensure that their EADestimation includes the risk of further drawings on accountsthat are in excess of their limits.

(CRR Article 4(56))

Accrued interest14.24 Exposures include not only principal amounts borrowedunder facilities but also interest accrued which will fluctuatebetween payment dates. In order to ensure proper coverage ofinterest, the PRA expects firms to take the following approach:

(a) accrued interest to date should be included in currentexposure for performing exposures;

(b) firms may choose whether estimated increases inaccrued interest up to the time of default should beincluded in LGD or EAD;

(c) in the estimation of EAD increases in accrued interestmay be offset against reductions in other outstandings;


(d) estimation of changes in accrued interest needs to takeaccount of changes in the contractual interest rate overthe time horizon up to default, and in a way consistentwith the scenario envisaged in the calculation of thedownturn/default weighted average;

(e) inclusion of estimates of future post-default interest isnot necessary in either EAD or LGD; and

(f) firms’ accounting policies will determine the extent towhich interest accrued to date is reflected in currentexposure as opposed to LGD for defaulted exposures.


Netting14.25 The PRA considers that there is scope within the CRR forfirms to recognise on-balance sheet netting (including inrespect of cross-currency balances) through EAD as analternative to LGD in those cases where the general conditionsfor on-balance sheet netting set out in the CRR Article 205 aremet.

14.26 As regards the CF on undrawn limits, this may beapplied on the basis of the net limit provided the conditions inthe CRR for the use of net limits are met. However, firms arereminded that the purpose of the measure is to estimate theamount that would be outstanding in the event of a default.This implies that their ability in practice to constrain thedrawdown of credit balances will be particularly tested.Moreover the PRA expects the appropriate conversion factor tobe higher as a percentage of a net limit than of a gross limit.

14.27 The lower the net limit as a percentage of gross limits orexposures, the greater will be the need on the part of the firmto ensure that it is restricting exposures below net limits inpractice and that it will be able to continue to do so shouldborrowers encounter difficulties. The application of a zero netlimit is acceptable in principle, but there is a consequently avery high obligation on the firm to ensure that breaches of thisare not tolerated.


Underwriting commitments14.28 Estimation of CFs on underwritten facilities in thecourse of primary market syndication may take account ofanticipated sell down to other parties.

14.29 Firms are reminded that since the basis of EADestimation is that default by the borrower is expected to takeplace in a one-year time horizon, and quite possibly indownturn conditions, the PRA expects any reduction in theirCF in anticipation of syndication to take account of thisscenario.

(CRR Article 4(56))

15 Maturity for exposures to corporates,institutions or central governments andcentral banks

15.1 The PRA expects all firms that have not receivedpermission to use own estimates of LGDs and conversionfactors to use the maturity approach set out in CRRArticle 162(2) to 162(3) for these exposures. This will bereflected in their permissions to use the IRB approach.

(CRR Article 166)

16 Stress tests used in assessment of capitaladequacy

16.1 In order to be satisfied that the credit risk stress testundertaken by a firm pursuant to CRR Article 177(2) ismeaningful and considers the effects of severe, but plausible,recession scenarios the PRA would expect that the stress testwould be based on an economic cycle that is consistent withthe supervisory statement on the Internal Capital AdequacyAssessment Process (ICAAP) and the Supervisory Review andEvaluation Process (SREP) — SS5/13.


17 Validation

17.1 The PRA expects a firm to have a validation process thatincludes the following:

(a) standards of objectivity, accuracy, stability andconservatism that it designs its ratings systems to meetand processes that establish whether its rating systemsmeet those standards;

(b) standards of accuracy of calibration (ie whetheroutcomes are consistent with estimates) anddiscriminative power (ie the ability to rank-order risk)that it designs its rating systems to meet and processesthat establish whether its rating systems meet thosestandards;

(c) policies and standards that specify the actions to betaken when a rating system fails to meet its specifiedstandards of accuracy and discriminative power.

(d) a mix of developmental evidence, benchmarking andprocess verification and policies on how this mixturevaries between different rating systems;

(e) use of both quantitative and qualitative techniques;


(f) policies on how validation procedures are expected tovary over time; and

(g) ensuring independent input into and review of its ratingsystems.

(CRR Article 188)

17.2 In the paragraph above:

(a) developmental evidence means evidence thatsubstantiates whether the logic and quality of a ratingsystem (including the quantification process)adequately discriminates between different levels of,and delivers accurate estimates of PD, EL, LGD and CFs(as applicable); and

(b) process verification means the process of establishingwhether the methods used in a rating system todiscriminate between different levels of risk and toquantify PD, EL, LGD and CFs are being used, monitoredand updated in the way intended in the design of therating system.

(CRR Article 188)

17.3 The PRA expects a firm to be able to explain theperformance of its rating systems against its chosen measure(or measures) of discriminative power. In making thiscomparison a firm should rely primarily on actual historicdefault experience where this is available. In particular, thePRA expects a firm be able to explain the extent of anypotential inaccuracy in these measures, caused in particular bysmall sample size and the potential for divergence in thefuture, whether caused by changing economic conditions orother factors. Firms’ assessment of discriminative powershould include appropriate use of external benchmarks whereavailable.

17.4 The PRA will take into consideration the sophistication ofthe measure of discrimination chosen when assessing theadequacy of a rating system’s performance.

17.5 In the case of a portfolio for which there is insufficientdefault experience to provide any confidence in statisticalmeasures of discriminative power, the PRA expects a firm touse other methods. For example, analysis of whether thefirm’s rating systems and an external measurement approach,eg external ratings, rank common obligors in broadly similarways. Where such an approach is used we would expect a firmto ensure it does not systematically adjust its individualratings with the objective of making them closer to theexternal ratings as this would be counter to the philosophy ofan internal rating approach. The PRA expects a firm to be able

to explain the methodology it uses and the rationale for itsuse.

18 Income-producing real estate portfolios

CRR compliance18.1 The PRA considers income-producing real estate (IPRE) tobe a particularly difficult asset class for which to build effectiverating systems that are compliant with the CRR’s requirementsfor the IRB approach.

18.2 As with all asset classes, firms should assess whethertheir IPRE model is CRR compliant and not whether it is thenearest they can get to compliance given the constraintsimposed on their model development (eg lack of data orresource constraints).

18.3 Where material non-compliance is identified and cannotbe remediated in a timely fashion, firms should adopt acompliant approach for calculating regulatory capital. In mostcases this is likely to be the slotting approach.


Drivers of risk18.4 The PRA expects firms to be able to demonstrate that themodel drivers selected offer sufficient discriminatory powerand to justify why other potential data sources are notexpected to materially improve the discriminatory power andaccuracy of estimates.

18.5 The PRA expects that an IPRE rating system will only becompliant if a firm is able to demonstrate the following inrespect of its treatment of cash flows (except where the firmcan demonstrate that this is not an appropriate risk driver):

(a) the difference in deal ratings when tenant ratings arealtered is intuitive;

(b) the transformation of ratings into non-rent paymentprobability is intuitive;(1)

(c) selection of parameter values and/or distributions, andtheir impact on deal ratings, is well supported andintuitive;

(d) impact on the deal rating is intuitive for such features as:type of building, geographical location and buildingquality; and


(1) Even where tenants are rated by the firm the PD will not usually represent a directread across to probability of non-payment due to, for example, model philosophyissues. Addressing this is likely to be a key area since many firms struggle withdefining what divergence is expected between observed default rate and PD indifferent economic conditions in the mid-corporate space.


(e) where data are missing or unavailable the treatment isconservative.

18.6 The PRA expects that an IPRE rating system will only becompliant if a firm is able to demonstrate the following inrespect of its treatment of interest rate risk (IRR):

(a) IRR is included as a relevant risk driver (unless theportfolio is exclusively hedged);

(b) the way in which interest rate risk is included in the dealrating is intuitive with respect to model philosophy;(1)

and

(c) the model rates deals where IRR is hedged by the firmdifferently from deals where IRR is unhedged and themagnitude of the difference in these ratings is intuitive.

18.7 The PRA expects that an IPRE rating system will only becompliant if a firm is able to demonstrate the following inrespect of its treatment of refinance risk:

(a) refinance risk is included as a relevant risk driver (unlessthe portfolio contains only amortising loans);

(b) the model rates interest only and amortising dealsdifferently in the final year and that the magnitude ofthe difference in these ratings is intuitive;

(c) given the time horizon associated with IRB estimates(ie twelve months) the refinance risk could have a zeroweight until the deal enters its final year for point intime models;(2) and

(d) the firm is able to report by borrowers that havepreviously had a distressed restructuring unlikeliness topay indicator (even if they are now performing) bynumber, EAD and risk-weighted assets (RWA).

Calibration18.8 The PRA expect that firms will not be compliant with thecalibration requirements relating to use of a long-run defaultrate unless it can demonstrate that:

(a) the internal data series is the longest relevant andaccurate data series, on a CRR compliant definition ofdefault, that is available;

(b) the determination of long-run default rate includesreference to an appropriate source of downturn data;(3)

(c) the relevance of any external data used is analysed, andthe relationship between internal default data and theexternal data used is considered over a multi-yearperiod; and

(d) where uncertainty is introduced due to, for example, thequality of internal data or shortcomings in the relevanceof external data a conservative adjustment to theestimates should be made.

18.9 The PRA expects that a firm will only be compliant withthe calibration requirements relating to model philosophy if itcan demonstrate that:

(a) model philosophy is clearly articulated and justified;(4)

and

(b) in addition to encapsulating this information in acoherent way in the calibration, the impact of capturingrisks such as IRR and refinance risk is clearlydocumented.

Low default portfolios18.10 Where the rating system is classed as a low defaultportfolio in accordance with this supervisory statement firmsshould be able to demonstrate that the framework appliedadequately considers:

(a) economic environment of data used;

(b) changes in portfolio composition over time;

(c) parameter choices; and

(d) model philosophy.

Constructed theoretically18.11 Under CRR Article 144(1) all models, including thoseconstructed from a theoretical basis without reference to anyempirical default data (such as Monte Carlo cash flowsimulation models) must meet the IRB requirements that areset out in CRR Title II Chapter 3.

18.12 The PRA considers that to meet these requirements itwill be necessary for firms to demonstrate that a firm has agood understanding of PD models that are constructedtheoretically and that the parameter estimates reflect aone-year PD. In addition, even if empirical data were not usedto determine the PD estimate it should, where available, beused to back-test the estimates.

18.13 The PRA expects that, as most models of this type willbe able to produce one-year estimates of PD that correspond

22 Internal Ratings Based approaches December 2013

(1) For example a ‘point in time’ rating should consider the current interest rate andlikely change over a one-year time horizon, whereas a ‘through the cycle’ modelneeds to consider the interest rate risk averaged over an economic cycle.

(2) In these cases the risk should be captured in stress testing and Pillar 2.(3) This may require the use of external data.(4) Justification should include analysis of the performance of assets, and the

corresponding ratings assigned, over a change in economic conditions (ie as long aperiod as possible).


closely to ‘point in time’ estimates, firms should conductrobust back-testing as such estimates by comparing themwith realised default rates. Firms would need to demonstratethat the results of such back-testing meets pre-defined andstringent standards in order for the PRA to be satisfied that theIRB requirements are met.

18.14 Because assumptions in the model build process arelikely materially to impact the resulting PDs, the PRA expectsthese choices to be clearly justified in the modeldocumentation and to have been subject to independentreview. In order to be satisfied that a firm is complying withCRR Article 176(1)(d) the PRA expects a firm to supportjustification for all assumptions with analysis of the sensitivityof the model outputs to changes in the assumptions.

18.15 Where the firm has fewer than 20 defaults in its internaldata set, the PRA expects it to be necessary for the firm toperform a statistical low default portfolio calibration, as setout in this Supervisory Statement.

Validation18.16 The PRA expects that a firm will be compliant with thevalidation requirements only where it can demonstrate inrespect of discriminatory power that:

(a) appropriate minimum standards that the rating systemis expected to reach are defined together with reasoningbehind the adoption of such standards and that thefactors considered when determining the tests areclearly documented;

(b) an objective rank ordering metric, measured using anappropriate time horizon (eg using ratings one year priorto default) or cohort approach), such as Gini or AccuracyRatio of 50% is achieved over time;

(c) where there are sufficient defaults from different timeperiods the discriminatory power is shown to havereached the appropriate minimum standard over anextended time period (ie longest period possibleincluding most recent data); and

(d) any concentrations in ratings from the model aredemonstrated to be appropriate.

18.17 The PRA expects that a firm will be compliant with thevalidation requirements only where it can demonstrate inrespect of the calibration that:

(a) observed default rate versus PD is considered at gradelevel and across a range of economic environments(ie as long as period as possible);

(b) where the PD does not relates to a pure point in timeestimate either the PD or the observed default rate is

transformed such that comparison between the two ismeaningful. This transformation should be consistentwith the model philosophy and calibration techniqueapplied; and

(c) pre-defined tolerances for the degree of divergence, andthe associated actions for what should happen whenthey are not met, are set.

18.18 The PRA also expects that firms will be compliant withthe validation requirements only where it can demonstratethat:

(a) appropriate stability metrics are considered across arange of economic environments (ie longest periodpossible including most recent data);

(b) the tolerances for the degree of divergence, andassociated actions for what should happen when theyare not met, is pre-defined; and

(c) subsections of portfolios by characteristics affecting riskprofile, and therefore potentially model performance,are investigated. Such subsections could include:

(i) loan type (amortising/interest only); (ii) degree ofhedging;

(ii) building type; and(iii) other factors such as non-special purpose vehicle

(SPV) lending in a predominately SPV lending bookor vice versa.

(CRR Article 188)

Other requirements18.19 The PRA expects that a firm would only be able tocomply with certain other CRR requirements where it candemonstrate that:

(a) in relation to CRR Article 144(1)(e), where more thanone model was used, the rationale and the associatedboundary issues were clearly articulated and justified.The PRA expects the criteria for assigning an asset to arating model are objective and clear;

(b) in relation to CRR Article 173(1)(c), the firm has aprocess in place to ensure valuations of the property areappropriate and up to date;

(c) in relation to CRR Article 171(2), the firm makesreference to information available from the InvestmentProperty Databank where relevant. Where this data isutilised at a broad level when more granular data isavailable this is fully justified with appropriate analysis;


(d) in relation to CRR Article 173(1)(b), the rating historiesdemonstrate that deals are re-rated every time materialinformation becomes available;(1)

(e) in relation to CRR Article 189(3), managementinformation covering all aspects required by the CRR isproduced and reviewed regularly by senior managementand the tolerances for the degree of divergence, andassociated actions for what should happen when theyare not met, are pre-defined; and

(f) in relation to CRR Article 177(2), the impact on PDs andRWAs in a firm’s credit risk stress test is consistent withmodel philosophy (although ratings should be affectedby events such as tenant defaults even if they are TTC)and impairment projections are justified with referenceto past internal data.

19 Notification and approval of changes toapproved models

Changes to approved models19.1 This section sets out the PRA’s expectations in respect ofthe notifications and changes to approved models. Forclarification, the term ‘approved model’ refers to all aspects ofthe IRB rating system that were in place at the time that themodel was approved and implemented. This would includeany judgemental overlays or conservatism that were put inplace or processes for manually overriding the model outputs,updating house price indices or ongoing recalibrations forpoint in time PD models.

19.2 Where a firm intends to make changes to an approvedmodel these must be pre-notified to the PRA if they aresignificant and post-notified otherwise. Firms may nominatecertain models for exclusion from these notificationrequirements on the grounds of immateriality. In addition, incertain circumstances temporary adjustments may be made tocapital requirements outside of this framework. Further detailsare set out below.

Pre-notification of significant changes19.3 Model changes may necessitate a modification to the IRBapproval originally granted. For the avoidance of doubt, anychange that requires a revision to the IRB permission and/orjoint decision must be pre-notified.

19.4 In addition, firms must notify the PRA of significantchanges to IRB models prior to these changes beingimplemented. A firm’s IRB permission offers some broadguidelines around the factors that constitute significantchange.

19.5 In addition to these broad guidelines, the following areexamples of factors which constitute significant change(please note that this is not an exhaustive list):

(a) Rating system development (eg changes to the ratingsphilosophy of a material rating system).

(b) Extension of rating systems or development of newrating systems for new products and where partial useprovisions were employed to migrate standardisedportfolios to IRB.

(c) Mergers and acquisitions — a firm with IRB modelapproval may acquire rating systems which are not IRBcompliant, or firms may have legacy capital models thatthey wish to amalgamate.

(d) Upgrades to IRB approaches — for example, fromFoundation to Advanced IRB.

(e) A change resulting in a change in credit risk capitalrequirements for the UK consolidation group that isgreater than 1%. In assessing changes to credit riskcapital requirements firms should take into accountchanges in expected loss and treatment of securitisationpositions as well as changes arising from RWAs.

(f) A recalibration that results in a reduction in portfoliolevel credit risk capital requirements greater than 5%. Ifa recalibration has an impact below 5% at the portfoliolevel but above 1% at the group level then such arecalibration would count as a significant reduction byvirtue of (e) above. ‘Portfolio level’ should beinterpreted as the portion of the group’s overallexposures covered by the ratings system that the firm isproposing to modify. In assessing changes to credit riskcapital requirements firms should take into accountchanges in expected loss and treatment of securitisationpositions as well as changes arising from RWAs.

(g) A significant change to the outputs of the ratingssystem resulting from a series of changes that inisolation may not be significant but cumulatively havea significant effect.

19.6 In relation to paragraph 19.5(e) and 19.5(f) above, in thecontext of a CRR Article 20 joint decision, it should be open forthe PRA and other EEA regulators to agree to the parameterfor defining a significant change, so that there is consensus onhow these cases are dealt with within the CRR Article 20framework. Where the PRA is the consolidated supervisor, itwill attempt to agree the thresholds for significance with otherEEA regulators.


(1) For example where the deal enters its final year (and refinance risk becomes relevant)or a tenant defaults, is replaced or has their rating changed.


19.7 Firms should implement a formal internal policy whichgoverns the IRB changes that require pre and post-notification,or are de minimis and require no notification.

19.8 An IRB permission may specify that one or more ratingsystems is to be rolled out within a time window and mayspecify that the PRA will review the rating system prior torollout. Where the PRA has not indicated in the permissionthat it will review the ratings system prior to rollout, firmsshould nonetheless follow the above approach in determiningwhether pre-notification of a model change is necessary.

Process for pre-notifying a change19.9 Firms should follow the process outlined below topre-notify a change:

Step 1. Submit the information set out in the pro-formain Appendix B.

Step 2. The firm should advise its PRA supervisor aboutfuture proposed changes as far in advance as possible.Formal pre-notification to the PRA of specific changes inmore detail may follow. Such advance notice mighttake the form of a periodic report setting out the firm’scurrent thinking on future changes, in aggregate acrossthe group.

Advance notice is particularly important in the case offirms with an IRB permission that is subject to jointdecision under CRR Article 20, where the PRA may needto revise the joint decision in consultation with otherEEA regulators, or more generally where a proposedchange impacts on overseas jurisdictions where it maybe appropriate to consult with other regulators. Thecommon decision by the PRA and other regulators mustbe reached within six months.

Step 3. Conduct a self-assessment of the changeagainst the relevant CRR requirements and guidance inthis supervisory statement, noting any areas of CRRnon-compliance with details of how these gaps will beclosed.

Step 4. If the change affects a rating system, then, inaddition to the information provided in the pro-forma inAppendix B, the firm should also comment on thefollowing areas:

(i) the way in which the rating system complies withthe use test;

(ii) what the internal governance arrangements andsign-off procedures were for the rating system;

(iii) what validation work has been performed on theratings system or is planned; and

(iv) how the firm’s Pillar 1 stress-testing practices,including the impact on the quantitative results ofstress testing, have been affected by the change.

Step 5. Send the material from Steps 1, 2, 3 and 4 to itsPRA supervisor. The material needs to be sentsufficiently far in advance of the proposed change toallow the PRA time to review it prior to implementation.If the PRA chooses to review the change, it may ask foradditional information and, if necessary, meetings oron-site visits. The PRA is content for firms to provideinternal documentation for this purpose, provided thisaddresses clearly and sufficiently the processrequirements set out above.

Process for post-notifying a change19.10 Where a change to an approved model may be notifiedto the PRA after it has occurred, firms should prepare andsubmit the following information:

(a) the information set out in the pro-forma in Appendix B;

(b) confirmation that the change has been reviewedthrough the firm’s internal governance processes; and

(c) confirmation that a self-assessment of the changeagainst the relevant CRR requirements and guidance inthis supervisory statement has been completed and hasnot identified any areas of CRR non-compliance.

19.11 After the post-notification, the PRA may requestadditional information to assist in any review that the PRAmay undertake.

Immaterial models19.12 The PRA will normally permit firms to nominate anumber of models, which in total account for no more than 1%of the credit risk capital requirement of the UK consolidationgroup, for which neither pre-notification nor post-notificationis ordinarily necessary.

Fees19.13 There will be some circumstances where a fee may beapplied, for example, where a firm is upgrading from FIRB toAIRB, or a special project fee in the case of a merger oracquisition.

Self-assessment19.14 The self-assessment process described above need onlybe an assessment against the CRR requirements and guidancein this supervisory statement that are relevant to the change inquestion. While it is the firm’s responsibility to decide on themethod of conducting the self-assessment, this should besufficiently rigorous to allow the firm to identify areas ofnon-compliance.


19.15 A high-level ‘gap analysis’ or a process that placesreliance on the firm’s governance process or on the firm’sdevelopmental process to deliver a compliant approach isunlikely to form an adequate self-assessment, at least in theearly years of IRB operation.

Temporary adjustments to approved models19.16 Firms should address identified model issues in a timelyfashion with suitable model changes, and ensure that suchchanges are implemented in accordance with the modelchanges process outlined above. The PRA recognises, however,that there are instances where it is prudent and correct forfirms to adjust the capital requirements produced by theirmodels on a temporary basis. The PRA does not expect anysuch adjustment to be in place for a period longer thansix months and firms should take any action required toremove an adjustment (including notifying the PRA of a modelchange where appropriate) within that period.

19.17 Firms should meet the following criteria in respect ofany temporary adjustments to approved models:

(a) The framework must be applied at a portfolio level. Forthis a ‘portfolio’ is defined as the group of assetscovered by the IRB model the adjustment is being madefor. If adjustments are being made to more than onemodel (eg PD and LGD) which cover overlapping assets(eg a global LGD model and regional PD models), then aportfolio(s) must be defined as the subset of assetscovered by the same models (eg in the example abovethe assets covered by the regional PD model would beclassified as a single portfolio).

(b) Irrespective of what model component the adjustmentis for (eg PD, LGD or EAD) the RWA and EL adjustmentsare made as a portfolio level add-on to therequirements produced by the approved models (ie theunderlying models must not be recalibrated or changedto give the desired capital outcome).

(c) Firms’ PD, LGD and EAD models remain in place untilthe correct level of approval has been obtained for anychanges. These models continue to be monitored asrequired by the CRR.

(d) Only adjustments that increase RWA and EL are madeand there should be no netting of adjustments acrossportfolios (eg if there are two data issues, in separateportfolios, one which increases RWA by £200 millionand one that decreased RWA by £100 million, only theadjustment increase of £200 million is applied). Wherenetting of impacts is proposed, this is applied in therelevant portfolio (ie where a model covers a number ofportfolios, netting can only be done at a portfolio level).

(e) A list of all model adjustments is included in the firm’smodel monitoring information presented to seniormanagement, containing the following information as aminimum:

(i) the portfolio and model component affected;

(ii) a description of the issue and why it requires theadjustment;

(iii) the date when the issue was first identified;

(iv) what action is being taken to address the issue andthe timeline for this action; and

(v) the increase to RWA and EL as a result of theadjustment.

(f) Firms may make adjustments across model components(eg PD, LGD and EAD), however if the PRA judges that afirm is not applying the netting across componentsappropriately, or with the correct degree ofconservatism, then it will require that netting ispermitted only within a model component (eg if theadjustment to PD increases capital and to LGDdecreases capital, the firm would only apply theincreased capital that results from the PD adjustment).

19.18 Firms should include any EL and RWA adjustments intheir regulatory returns. In respect of the FSA004 return,uplifts should be made by adjusting the total figures within therelevant IRB asset classes. In respect of the FSA045 return thetotal RWA and EL figures for each of the PD grades should beincreased proportionally.



20 Appendix A: Slotting criteria

Table 1 Supervisory rating grades for project finance exposures

Strong Good Satisfactory Weak

Financial strength

Market conditions. Few competing suppliers orsubstantial and durable advantagein location, cost, or technology.Demand is strong and growing.

Few competing suppliers or betterthan average location, cost, ortechnology but this situation maynot last. Demand is strong andstable.

Project has no advantage inlocation, cost, or technology.Demand is adequate and stable.

Project has worse than averagelocation, cost, or technology.Demand is weak and declining.

Financial ratios (eg debt servicecoverage ratio (DSCR), loan lifecoverage ratio (LLCR), project lifecoverage ratio (PLCR), anddebt-to-equity ratio).

Strong financial ratios consideringthe level of project risk; very robusteconomic assumptions.

Strong to acceptable financialratios considering the level ofproject risk; robust projecteconomic assumptions.

Standard financial ratiosconsidering the level of project risk.

Aggressive financial ratiosconsidering the level of project risk.

Stress analysis. The project can meet its financialobligations under sustained,severely stressed economic orsectoral conditions.

The project can meet its financialobligations under normal stressedeconomic or sectoral conditions.The project is only likely to defaultunder severe economic conditions.

The project is vulnerable to stressesthat are not uncommon through aneconomic cycle, and may default ina normal downturn.

The project is likely to defaultunless conditions improve soon.

Financial structure

Duration of the credit compared tothe duration of the project.

Useful life of the projectsignificantly exceeds tenor of the loan.

Useful life of the project exceedstenor of the loan.

Useful life of the project exceedstenor of the loan.

Useful life of the project may notexceed tenor of the loan.

Amortisation schedule. Amortising debt. Amortising debt. Amortising debt repayments withlimited bullet payment.

Bullet repayment or amortisingdebt repayments with high bulletrepayment.

Political and legal environment

Political risk, including transferrisk, considering project type andmitigants.

Very low exposure; strongmitigation instruments, if needed.

Low exposure; satisfactorymitigation instruments, if needed.

Moderate exposure; fair mitigationinstruments.

High exposure; no or weakmitigation instruments.

Force majeure risk (war, civilunrest, etc).

Low exposure. Acceptable exposure. Standard protection. Significant risks, not fullymitigated.

Government support and project’simportance for the country overthe long term.

Project of strategic importancefor the country (preferablyexport-oriented). Strong supportfrom Government.

Project considered important forthe country. Good level of supportfrom Government.

Project may not be strategic butbrings unquestionable benefits forthe country. Support fromGovernment may not be explicit.

Project not key to the country. Noor weak support from Government.

Stability of legal and regulatoryenvironment (risk of change inlaw).

Favourable and stable regulatoryenvironment over the long term.

Favourable and stable regulatoryenvironment over the mediumterm.

Regulatory changes can bepredicted with a fair level ofcertainty.

Current or future regulatory issuesmay affect the project.

Acquisition of all necessarysupports and approvals for suchrelief from local content laws.

Strong Satisfactory Fair Weak

Enforceability of contracts,collateral and security.

Contracts, collateral and securityare enforceable.

Contracts, collateral and securityare enforceable.

Contracts, collateral and securityare considered enforceable even ifcertain non-key issues may exist.

There are unresolved key issues inrespect if actual enforcement ofcontracts, collateral and security.




Transaction characteristics

Design and technology risk. Fully proven technology anddesign.

Fully proven technology anddesign.

Proven technology and design —start-up issues are mitigated by astrong completion package.

Unproven technology and design;technology issues exist and/orcomplex design.

Construction risk

Permitting and siting. All permits have been obtained. Some permits are still outstandingbut their receipt is considered verylikely.

Some permits are still outstandingbut the permitting process is welldefined and they are consideredroutine.

Key permits still need to beobtained and are not consideredroutine. Significant conditions may be attached.

Type of construction contract. Fixed-price date-certain turnkeyconstruction EPC (engineering andprocurement contract).

Fixed-price date-certain turnkeyconstruction EPC.

Fixed-price date-certain turnkeyconstruction contract with one orseveral contractors.

No or partial fixed-price turnkeycontract and/or interfacing issueswith multiple contractors.

Completion guarantees. Substantial liquidated damagessupported by financial substanceand/or strong completionguarantee from sponsors withexcellent financial standing.

Significant liquidated damagessupported by financial substanceand/or completion guarantee fromsponsors with good financialstanding.

Adequate liquidated damagessupported by financial substanceand/or completion guarantee fromsponsors with good financialstanding.

Inadequate liquidated damages ornot supported by financialsubstance or weak completionguarantees.

Track record and financial strengthof contractor in constructingsimilar projects.

Strong. Good. Satisfactory. Weak.

Operating risk

Scope and nature of operations andmaintenance (O&M) contracts.

Strong long-term O&M contract,preferably with contractualperformance incentives, and/orO&M reserve accounts.

Long-term O&M contract, and/orO&M reserve accounts.

Limited O&M contract or O&Mreserve account.

No O&M contract: risk of highoperational cost overruns beyondmitigants.

Operator’s expertise, track record,and financial strength.

Very strong, or committedtechnical assistance of thesponsors.

Strong. Acceptable. Limited/weak, or local operatordependent on local authorities.

Off-take risk

(a) If there is a take-or-pay orfixed-price off-take contract:

Excellent creditworthiness ofoff-taker; strong terminationclauses; tenor of contractcomfortably exceeds the maturityof the debt.

Good creditworthiness of off-taker;strong termination clauses; tenorof contract exceeds the maturity ofthe debt.

Acceptable financial standing ofoff-taker; normal terminationclauses; tenor of contract generallymatches the maturity of the debt.

Weak off-taker; weak terminationclauses; tenor of contract does notexceed the maturity of the debt.

(b) If there is no take-or-pay orfixed-price off-take contract:

Project produces essential servicesor a commodity sold widely on aworld market; output can readilybe absorbed at projected priceseven at lower than historic marketgrowth rates.

Project produces essential servicesor a commodity sold widely on aregional market that will absorb itat projected prices at historicalgrowth rates.

Commodity is sold on a limitedmarket that may absorb it only atlower than projected prices.

Project output is demanded by onlyone or a few buyers or is notgenerally sold on an organisedmarket.

Supply risk

Price, volume and transportationrisk of feed-stocks; supplier’s trackrecord and financial strength.

Long-term supply contract withsupplier of excellent financialstanding.

Long-term supply contract withsupplier of good financial standing.

Long-term supply contract withsupplier of good financial standing— a degree of price risk mayremain.

Short-term supply contract orlong-term supply contract withfinancially weak supplier — adegree of price risk definitelyremains.

Reserve risks (eg natural resourcedevelopment).

Independently audited, proven anddeveloped reserves well in excess ofrequirements over lifetime of theproject.

Independently audited, proven anddeveloped reserves in excess ofrequirements over lifetime of theproject.

Proven reserves can supply theproject adequately through thematurity of the debt.

Project relies to some extent onpotential and undevelopedreserves.

Strength of sponsor

Sponsor track record, financialstrength, and country/sectorexperience.

Strong sponsor with excellent trackrecord and high financial standing.

Good sponsor with satisfactorytrack record and good financialstanding.

Adequate sponsor with adequatetrack record and good financialstanding.

Weak sponsor with no orquestionable track record and/orfinancial weaknesses.

Sponsor support, as evidenced byequity, ownership clause andincentive to inject additional cashif necessary.

Strong. Project is highly strategicfor the sponsor (core business —long-term strategy).

Good. Project is strategic for the sponsor (core business —long-term strategy).

Acceptable. Project is consideredimportant for the sponsor (core business).

Limited. Project is not key tosponsor’s long-term strategy orcore business.



Table 2 Supervisory rating grades for income-producing real estate expo


Security package

Assignment of contracts andaccounts.

Fully comprehensive. Comprehensive. Acceptable. Weak.

Pledge of assets, taking intoaccount quality, value and liquidityof assets.

First perfected security interest inall project assets, contracts,permits and accounts necessary torun the project.

Perfected security interest in allproject assets, contracts, permitsand accounts necessary to run theproject.

Acceptable security interest in allproject assets, contracts, permitsand accounts necessary to run theproject.

Little security or collateral forlenders; weak negative pledgeclause.

Lender’s control over cash flow (eg cash sweeps, independentescrow accounts).

Strong. Satisfactory. Fair. Weak.

Strength of the covenant package(mandatory prepayments, paymentdeferrals, payment cascade,dividend restrictions…).

Covenant package is strong for thistype of project.

Project may issue no additionaldebt.

Covenant package is satisfactoryfor this type of project.

Project may issue extremelylimited additional debt.

Covenant package is fair for thistype of project.

Project may issue limitedadditional debt.

Covenant package is Insufficient forthis type of project.

Project may issue unlimitedadditional debt.

Reserve funds (debt service, O&M,renewal and replacement,unforeseen events, etc).

Longer than average coverageperiod, all reserve funds fullyfunded in cash or letters of creditfrom highly rated bank.

Average coverage period, all reservefunds fully funded.

Average coverage period, all reservefunds fully funded.

Shorter than average coverageperiod, reserve funds funded fromoperating cash flows.


Financial strength

Market conditions. The supply and demand for theproject’s type and location arecurrently in equilibrium. Thenumber of competitive propertiescoming to market is equal or lowerthan forecasted demand.

The supply and demand for theproject’s type and location arecurrently in equilibrium. Thenumber of competitive propertiescoming to market is roughly equalto forecasted demand.

Market conditions are roughly inequilibrium. Competitiveproperties are coming on themarket and others are in theplanning stages. The project’sdesign and capabilities may not bestate of the art compared to newprojects.

Market conditions are weak. It isuncertain when conditions willimprove and return to equilibrium.The project is losing tenants atlease expiration. New lease termsare less favourable compared tothose expiring.

Financial ratios and advance rate. The property’s debt servicecoverage ratio (DSCR) is consideredstrong (DSCR is not relevant for theconstruction phase) and its loan tovalue ratio (LTV) is considered lowgiven its property type. Where asecondary market exists, thetransaction is underwritten tomarket standards.

The DSCR (not relevant fordevelopment real estate) and LTVare satisfactory. Where asecondary market exists, thetransaction is underwritten tomarket standards.

The property’s DSCR hasdeteriorated and its value hasfallen, increasing its LTV.

The property’s DSCR hasdeteriorated significantly and itsLTV is well above underwritingstandards for new loans.

Stress analysis. The property’s resources,contingencies and liability structureallow it to meet its financialobligations during a period ofsevere financial stress (eg interestrates, economic growth).

The property can meet its financialobligations under a sustainedperiod of financial stress(eg interest rates, economicgrowth). The property is likely to default only under severeeconomic conditions.

During an economic downturn, theproperty would suffer a decline inrevenue that would limit its abilityto fund capital expenditures andsignificantly increase the risk ofdefault.

The property’s financial condition isstrained and is likely to defaultunless conditions improve in thenear term.

Cash-flow predictability

(a) For complete and stabilisedproperty.

The property’s leases are long-termwith creditworthy tenants and theirmaturity dates are scattered. Theproperty has a track record oftenant retention upon leaseexpiration. Its vacancy rate is low.Expenses (maintenance, insurance,security, and property taxes) are predictable.

Most of the property’s leases arelong-term, with tenants that rangein creditworthiness. The propertyexperiences a normal level oftenant turnover upon leaseexpiration. Its vacancy rate is low.Expenses are predictable.

Most of the property’s leases aremedium rather than long-termwith tenants that range increditworthiness. The propertyexperiences a moderate level oftenant turnover upon leaseexpiration. Its vacancy rate ismoderate. Expenses are relativelypredictable but vary in relation to revenue.

The property’s leases are of variousterms with tenants that range increditworthiness. The propertyexperiences a very high level oftenant turnover upon leaseexpiration. Its vacancy rate is high.Significant expenses are incurredpreparing space for new tenants.

(b) For complete but not stabilisedproperty.

Leasing activity meets or exceedsprojections. The project shouldachieve stabilisation in the nearfuture.

Leasing activity meets or exceedsprojections. The project shouldachieve stabilisation in the nearfuture.

Most leasing activity is withinprojections; however, stabilisationwill not occur for some time.

Market rents do not meetexpectations. Despite achievingtarget occupancy rate, cash flowcoverage is tight due todisappointing revenue.

(c) For construction phase. The property is entirely pre-leasedthrough the tenor of the loan orpre-sold to an investment gradetenant or buyer, or the bank hasa binding commitment for take-out financing from aninvestment-grade lender.

The property is entirely pre-leasedor pre-sold to a creditworthytenant or buyer, or the bank has abinding commitment forpermanent financing from acreditworthy lender.

Leasing activity is withinprojections but the building maynot be pre-leased and there maynot exist a take-out financing.The bank may be the permanentlender.

The property is deteriorating due to cost overruns, marketdeterioration, tenant cancellationsor other factors. There may be adispute with the party providingthe permanent financing.




Asset characteristics

Location. Property is located in highlydesirable location that isconvenient to services that tenants desire.

Property is located in desirablelocation that is convenient toservices that tenants desire.

The property location lacks acompetitive advantage.

The property’s location,configuration, design andmaintenance have contributed to the property’s difficulties.

Design and condition. Property is favoured due to itsdesign, configuration, andmaintenance, and is highlycompetitive with new properties.

Property is appropriate in terms ofits design, configuration andmaintenance. The property’sdesign and capabilities arecompetitive with new properties.

Property is adequate in terms of itsconfiguration, design andmaintenance.

Weaknesses exist in the property’sconfiguration, design ormaintenance.

Property is under construction. Construction budget isconservative and technical hazardsare limited. Contractors are highlyqualified.

Construction budget isconservative and technical hazards are limited. Contractorsare highly qualified.

Construction budget is adequateand contractors are ordinarilyqualified.

Project is over budget or unrealistic given its technicalhazards. Contractors may be under qualified.

Strength of sponsor/developer

Financial capacity and willingnessto support the property.

The sponsor/developer made asubstantial cash contribution to theconstruction or purchase of theproperty. The sponsor/developerhas substantial resources andlimited direct and contingentliabilities. The sponsor/developer’sproperties are diversifiedgeographically and by propertytype.

The sponsor/developer made amaterial cash contribution to theconstruction or purchase of theproperty. The sponsor/developer’sfinancial condition allows it tosupport the property in the eventof a cash flow shortfall. Thesponsor/developer’s properties arelocated in several geographicregions.

The sponsor/developer’scontribution may be immaterial ornon-cash. The sponsor/developer isaverage to below average infinancial resources.

The sponsor/developer lackscapacity or willingness to supportthe property.

Reputation and track record withsimilar properties.

Experienced management and high sponsors’ quality. Strongreputation and lengthy andsuccessful record with similarproperties.

Appropriate management andsponsors’ quality. The sponsor ormanagement has a successfulrecord with similar properties.

Moderate management andsponsors’ quality. Management orsponsor track record does not raiseserious concerns.

Ineffective management andsubstandard sponsors’ quality.Management and sponsordifficulties have contributed todifficulties in managing propertiesin the past.

Relationships with relevant realestate actors.

Strong relationships with leadingactors such as leasing agents.

Proven relationships with leadingactors such as leasing agents.

Adequate relationships with leasingagents and other parties providingimportant real estate services.

Poor relationships with leasingagents and/or other partiesproviding important real estateservices.

Security package

Nature of lien. Perfected first lien.(a) Perfected first lien.(a) Perfected first lien.(a) Ability of lender to foreclose isconstrained.

Assignment of rents (for projectsleased to long-term tenants).

The lender has obtained anassignment. They maintain currenttenant information that wouldfacilitate providing notice to remitrents directly to the lender, such asa current rent roll and copies of theproject’s leases.

The lender has obtained anassignment. They maintain currenttenant information that wouldfacilitate providing notice to thetenants to remit rents directly tothe lender, such as current rent rolland copies of the project’s leases.

The lender has obtained anassignment. They maintain currenttenant information that wouldfacilitate providing notice to thetenants to remit rents directly tothe lender, such as current rent rolland copies of the project’s leases.

The lender has not obtained anassignment of the leases or has notmaintained the informationnecessary to readily provide noticeto the building’s tenants.

Quality of the insurance coverage. Appropriate. Appropriate. Appropriate. Substandard.

(a) Lenders in some markets extensively use loan structures that include junior liens. Junior liens may be indicative of this level of risk if the total LTV inclusive of all senior positions does not exceed a typical first loan LTV.


Financial strength

Market conditions. Demand is strong and growing,strong entry barriers, lowsensitivity to changes in technologyand economic outlook.

Demand is strong and stable.Some entry barriers, somesensitivity to changes in technologyand economic outlook.

Demand is adequate and stable,limited entry barriers, significantsensitivity to changes in technologyand economic outlook.

Demand is weak and declining,vulnerable to changes intechnology and economic outlook,highly uncertain environment.

Financial ratios (debt service coverage ratio and loan to value ratio)

Strong financial ratios consideringthe type of asset. Very robusteconomic assumptions.

Strong/acceptable financial ratiosconsidering the type of asset.Robust project economicassumptions.

Standard financial ratios for theasset type.

Aggressive financial ratiosconsidering the type of asset.

Stress analysis. Stable long-term revenues, capable of withstanding severelystressed conditions through aneconomic cycle.

Satisfactory short-term revenues.Loan can withstand some financialadversity. Default is only likelyunder severe economic conditions.

Uncertain short-term revenues.Cash flows are vulnerable tostresses that are not uncommonthrough an economic cycle. Theloan may default in a normaldownturn.

Revenues subject to stronguncertainties; even in normaleconomic conditions the asset maydefault, unless conditions improve.

Market liquidity. Market is structured on aworldwide basis; assets arehighly liquid.

Market is worldwide or regional;assets are relatively liquid.

Market is regional with limitedprospects in the short term,implying lower liquidity.

Local market and/or poor visibility.Low or no liquidity, particularly onniche markets.

Table 3 Supervisory rating grades for object finance exposures





Political risk, including transfer risk. Very low; strong mitigationinstruments, if needed.

Low; satisfactory mitigationinstruments, if needed.

Moderate; fair mitigationinstruments.

High; no or weak mitigationinstruments.

Legal and regulatory risks. Jurisdiction is favourable torepossession and enforcement ofcontracts.

Jurisdiction is favourable torepossession and enforcement ofcontracts.

Jurisdiction is generally favourableto repossession and enforcement ofcontracts, even if repossessionmight be long and/or difficult.

Poor or unstable legal andregulatory environment.Jurisdiction may make repossessionand enforcement of contractslengthy or impossible.

Transaction characteristics

Financing term compared to theeconomic life of the asset.

Full payout profile/minimumballoon. No grace period.

Balloon more significant, but still atsatisfactory levels.

Important balloon with potentiallygrace periods.

Repayment in fine or high balloon.

Operating risk

Permits/licensing. All permits have been obtained;asset meets current andforeseeable safety regulations.

All permits obtained or in theprocess of being obtained; assetmeets current and foreseeablesafety regulations.

Most permits obtained or inprocess of being obtained,outstanding ones consideredroutine, asset meets current safetyregulations.

Problems in obtaining all requiredpermits, part of the plannedconfiguration and/or plannedoperations might need to berevised.

Scope and nature of O&Mcontracts.

Strong long-term O&M contract,preferably with contractualperformance incentives, and/orO&M reserve accounts (if needed).

Long-term O&M contract, and/orO&M reserve accounts (if needed).

Limited O&M contract or O&Mreserve account (if needed).

No O&M contract: risk of highoperational cost overruns beyondmitigants.

Operator’s financial strength, trackrecord in managing the asset typeand capability to remarket assetwhen it comes off-lease.

Excellent track record and strongremarketing capability.

Satisfactory track record and remarketing capability.

Weak or short track record anduncertain remarketing capability.

No or unknown track record andinability to remarket the asset.


Configuration, size, design andmaintenance (ie age, size for aplane) compared to other assetson the same market.

Strong advantage in design andmaintenance. Configuration isstandard such that the objectmeets a liquid market.

Above average design andmaintenance. Standardconfiguration, maybe with verylimited exceptions — such that theobject meets a liquid market.

Average design and maintenance.Configuration is somewhat specific,and thus might cause a narrowermarket for the object.

Below average design andmaintenance. Asset is near the endof its economic life. Configurationis very specific; the market for theobject is very narrow.

Resale value. Current resale value is well abovedebt value.

Resale value is moderately abovedebt value.

Resale value is slightly abovedebt value.

Resale value is below debt value.

Sensitivity of the asset value andliquidity to economic cycles.

Asset value and liquidity arerelatively insensitive to economiccycles.

Asset value and liquidity aresensitive to economic cycles.

Asset value and liquidity are quitesensitive to economic cycles.

Asset value and liquidity are highlysensitive to economic cycles.

Strength of sponsor

Operator’s financial strength, trackrecord in managing the asset typeand capability to remarket assetwhen it comes off-lease

Excellent track record and strongremarketing capability.

Satisfactory track record andremarketing capability.

Weak or short track record anduncertain remarketing capability.

No or unknown track record andinability to remarket the asset.

Sponsors’ track record and financialstrength.

Sponsors with excellent trackrecord and high financial standing.

Sponsors with good track recordand good financial standing.

Sponsors with adequate trackrecord and good financial standing.

Sponsors with no or questionabletrack record and/or financialweaknesses.

Security package

Asset control. Legal documentation provides thelender effective control (eg a firstperfected security interest, or aleasing structure including suchsecurity) on the asset, or on thecompany owning it.

Legal documentation provides thelender effective control (eg aperfected security interest, or aleasing structure including suchsecurity) on the asset, or on thecompany owning it.

Legal documentation provides thelender effective control (eg aperfected security interest, or aleasing structure including suchsecurity) on the asset, or on thecompany owning it.

The contract provides little securityto the lender and leaves room tosome risk of losing control on theasset.

Rights and means at the lender’sdisposal to monitor the locationand condition of the asset.

The lender is able to monitor thelocation and condition of the asset,at any time and place (regularreports, possibility to leadinspections).

The lender is able to monitor thelocation and condition of the asset,almost at any time and place.

The lender is able to monitor thelocation and condition of the asset,almost at any time and place.

The lender is able to monitor thelocation and condition of the assetare limited.

Insurance against damages. Strong insurance coverageincluding collateral damages withtop quality insurance companies.

Satisfactory insurance coverage(not including collateral damages)with good quality insurancecompanies.

Fair insurance coverage (notincluding collateral damages) withacceptable quality insurancecompanies.

Weak insurance coverage (notincluding collateral damages) orwith weak quality insurancecompanies.



Table 4 Supervisory rating grades for commodities finance exposures


Financial strength

Degree of over-collateralisation of trade.

Strong. Good. Satisfactory. Weak.


Country risk. No country risk. Limited exposure to country risk (in particular, offshore location ofreserves in an emerging country).

Exposure to country risk (inparticular, offshore location ofreserves in an emerging country).

Strong exposure to country risk (in particular, inland reserves in anemerging country).

Mitigation of country risks. Very strong mitigation:

Strong offshore Mechanisms.

Strategic commodity.

1st class buyer.

Strong mitigation:

Offshore mechanisms.

Strategic commodity.

Strong buyer.

Acceptable mitigation:

Offshore mechanisms.

Less strategic commodity.

Acceptable buyer.

Only partial mitigation:

No offshore mechanisms.

Non-strategic commodity.

Weak buyer.


Liquidity and susceptibility todamage.

Commodity is quoted and can behedged through futures or OTCinstruments. Commodity is notsusceptible to damage.

Commodity is quoted and can behedged through OTC instruments.Commodity is not susceptible todamage.

Commodity is not quoted but isliquid. There is uncertainty aboutthe possibility of hedging.Commodity is not susceptible todamage.

Commodity is not quoted.Liquidity is limited given the sizeand depth of the market. Noappropriate hedging instruments.Commodity is susceptible todamage.

Strength of sponsor

Financial strength of trader. Very strong, relative to tradingphilosophy and risks.

Strong. Adequate. Weak.

Track record, including ability tomanage the logistic process.

Extensive experience with the typeof transaction in question. Strongrecord of operating success andcost efficiency.

Sufficient experience with the typeof transaction in question. Aboveaverage record of operating successand cost efficiency.

Limited experience with the type oftransaction in question. Averagerecord of operating success andcost efficiency.

Limited or uncertain track record ingeneral. Volatile costs and profits.

Trading controls and hedgingpolicies.

Strong standards for counterpartyselection, hedging, and monitoring.

Adequate standards forcounterparty selection, hedging,and monitoring.

Past deals have experienced no orminor problems.

Trader has experienced significantlosses on past deals.

Quality of financial disclosure. Excellent. Good. Satisfactory. Financial disclosure contains someuncertainties or is insufficient.

Security package

Asset control. First perfected security interestprovides the lender legal control ofthe assets at any time if needed.

First perfected security interestprovides the lender legal control ofthe assets at any time if needed.

At some point in the process, thereis a rupture in the control of theassets by the lender. The rupture ismitigated by knowledge of thetrade process or a third partyundertaking as the case may be.

Contract leaves room for some riskof losing control over the assets.Recovery could be jeopardised.

Insurance against damages. Strong insurance coverageincluding collateral damages withtop quality insurance companies.

Satisfactory insurance coverage(not including collateral damages)with good quality insurancecompanies.

Fair insurance coverage (notincluding collateral damages) with acceptable quality insurancecompanies.

Weak insurance coverage (notincluding collateral damages) orwith weak quality insurancecompanies.



21 Appendix B: Model change pro-forma requiredwhen pre or post-notifying changes to a ratingssystem

Firm:

Date notification sent to PRA:

Pre or post change notification:

Rating system: Name:

Asset type: PD/LGD/EAD

Brief description of change(s):

Portfolio information:

[Credit risk capital information on the ratings system that the firm is proposing to change — this informationshould be prior to the application of the proposed change.]

EAD £xxx (date)

RWA £xxx (date)

EL £xxx (date)

Group information:

[Credit risk capital information for UK consolidation group.]

EAD £xxx (date)

RWA £xxx (date)

EL £xxx (date)

Materiality of change: RWA impact £xxx

RWA % change %

EL impact £xxx

EL % change %

Reason change is pre/post notified:

[Explain here why the change is classed as pre or post notified.]

Relevant committee approval:

[Committee responsible for approval of change.]

Name:

Date of approval:

Proposed implementation date:

[Date from which changes are intended to affect capital calculations, subject to approval received in the caseof material pre-notified changes.]

Attach supporting documentation here:

[Including the following where available: development document(s); validation document(s); materials presented to approval committee; approval committeeminutes; other supplementary materials.]



22 Appendix C: Wholesale LGD and EAD framework22.1 The following framework should be used to assesswholesale LGD models in the circumstances set out inparagraph 13.15 of this supervisory statement:

(a) For unsecured recoveries, if a firm has fewer than20 relevant default observations of recoveries in aspecific country for an individual type of exposure, thenthe maximum recovery a firm can assume must beequivalent to that which would give a 45% LGD forsenior unsecured exposures, 75% for subordinatedexposures and 11.25% for covered bonds.

(b) If a firm is taking account of non-financial collateralwhich is not eligible under the foundation approach,where they do not have 20 or more relevant data pointsof recovery values for that type of collateral or do nothave a reliable time series of market price data for thecollateral in a specific country, then the LGD for theexposure to which the collateral is applied must befloored at 45%.

(c) If a firm is taking account of non-financial collateral,which is eligible under the foundation approach, wherethey do not have 20 or more relevant data points ofrecovery values for that type of collateral or do not havea reliable time series of market price data for thatcollateral in a specific country, then the LGD for theexposure to which the collateral is applied must befloored at 35%.

22.2 Firms should note the following when applying theframework to LGD models:

(a) The 20 or more relevant data points can include internalor external data, however the PRA expects firms toensure that each data point is independent,representative and an accurate record of the recoveryfor that exposure or collateral type in that specificcountry.

(b) We would anticipate firms being able to use marketprice data within the framework where they have lessthan 20 defaults only in exceptional circumstances. Asa minimum, firms would need to demonstrate that themarket price data being used is representative of theircollateral and that it is over a long enough time periodto ensure that an appropriate downturn and forced salehaircut can be estimated.

(c) The framework does not affect the use of financialcollateral.

(d) The framework does not affect the use of unfundedcredit protection.

(e) Where a model takes account of multiple collateraltypes, if this only includes collateral that is eligibleunder the foundation approach then LGDs must befloored at 35%, and if any collateral type is not eligibleunder the foundation approach then LGDs must befloored at 45%.

(f) The effect of this framework is to floor bank andnon-bank financial institution (NBFI) exposures atfoundation values unless sufficient country-specificrecovery data is available. This floor should be appliedwhere the exposures are to types of banks and NBFIsthat are not sufficiently represented in the availablehistoric data (eg if the historic recovery data only relatesto small banks then the floor will affect large banks).

(g) When applying the framework the PRA expects firms toassess whether the 11.25% LGD floor for covered bondsis sufficient given the quality of the underlying assets.

22.3 Firms should select the most appropriate of the followingthree options when using the framework to assess wholesaleEAD models in the circumstances set out in paragraph 14.8 ofthis supervisory statement:

(a) Rank-order the off balance sheet product types(separately for lending and trade finance) according totheir drawdown risk. The EAD parameter for a productwith 20 or more default observations can then beapplied to low-default products with a lower drawdownrisk; or

(b) For product types where the firm has the defaultsneeded to estimate the EAD for committed credit lines(or an estimate derived from the option above) but lessthan 20 defaults for uncommitted credit lines, use 50%of the committed credit line conversion factor as anestimate of the uncommitted credit line conversionfactor; or

(c) Apply the foundation parameters.

22.4 Firms should note the following when applying theframework to EAD models:

(a) Firms may select more than one option when applyingthe framework providing that they can demonstratethat their chosen combination is appropriate, reflectingtheir particular mix of products and risks, and is notselected in order to minimise their capital requirements.

(b) As we believe that the EAD experienced by firms isdependent on their own credit management processeswe would expect only internal data to be used toestimate EAD. However, where firms can convincingly



demonstrate to the PRA’s satisfaction that the creditprocess are consistent across countries then we wouldaccept that data sourced from these countries could becombined to estimate the EAD for each product (ie the20 default data points do not have to be countryspecific for the purposes of estimating EAD).

(c) Firms using the option in paragraph 22.3(a) aboveshould be able to demonstrate that a sufficiently robustapproach has been taken to rank-ordering their producttypes by drawdown risk. This approach must be fullydocumented and assessed by an independent reviewer.


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