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234. The Workout LGD technique can be applied using either direct estimates or a twostep approach. When direct estimates are used, a quantitative estimate is derived for each individual exposure based on its specific characteristics. In a twostep approach, an average LGD is estimated for all exposures covered by the same facility grade or pool. If a pooling approach is used in the Retail exposure class, individual direct estimates must be averaged to produce an LGD for the pool, because it is necessary to produce an aggregated LGD for all exposures in a pool. However, the CRD proposal also allows Retail estimates to be derived using grades, in a similar way to those for Corporate, Institution, and Sovereign exposures. Where this method is used, there is no need to aggregate LGD estimates for Retail exposures. 235. A direct estimation procedure allows the automatic calculation of each of the discrete elements that make up LGD, based on the experience of each of the corresponding elements in an RDS which is relevant for the element in question (e.g., real estate recovery values, or discount rates). One example of a direct estimation procedure is a statistical model which uses risk drivers as explanatory variables. Under a twostep procedure there would instead be an overall adjustment to the LGD applied to the grade or pool as a whole, to reflect the extent to which the average LGD for the requisite RDS is not representative of the forwardlooking longrun default weighted average (or economic downturn estimate). 236. Market information may be used in a number of different ways in LGD estimation. Historical market prices realised on collateral or in exchange for some or all of the claim on the obligor will inform estimates in the RDS, when the Workout LGD technique is being used. Current market prices of collateral on current exposures will influence their estimated LGD. As an alternative to Workout LGD, the RDS may instead be derived from the observation of market prices on defaulted bonds or marketable loans soon after default or upon their emergence from bankruptcy. If a institution uses market information as an alternative to workout LGD (for example, in the case of scarce data), the market data must conform to the general requirements for the use of external data (see section 3.4.4. on data sources). An institution may derive the best estimate of expected loss for its defaulted exposures directly from their market prices where these exist. LGD estimates based on the market prices of defaulted obligations are known as Market LGDs. It is also possible to derive estimated LGDs from the market prices of nondefaulted loans or bonds or credit default instruments. These are referred to as Implied Market LGDs. 237. LGD estimates based on an institution’s own loss and recovery experience should in principle be superior to other types of estimates, all other things being equal, as they are likely to be most representative of future outcomes. However, such estimates may be improved by the careful use of external information such as market Page 56 of 123
prices on defaulted exposures, and this will be necessary where internal data is scarce. It is challenging to derive a CRDcompliant LGD element from the credit spreads on performing exposures. Nevertheless, implied Market LGDs may be used where no other data are available to produce reliable estimates, and if validation results show that these estimates are reliable. 238. In practice, the market and implied market LGD techniques can currently be used only in limited circumstances. They may be suitable where capital markets are deep and liquid. It is unlikely that any use of market LGD can be made for the bulk of the loan portfolio. 239. The implied historical LGD technique is allowed only for the Retail exposure class. LGD estimates for Retail exposures may be derived from realised losses on exposures within the grade or pool and from appropriate estimates of PDs. The ‘realised loss’ for such Retail exposures is the total loss divided by the total number of exposures in the grade or pool, while the ‘average realised LGD’ is the same total loss divided by the number of defaulted exposures in the grade or pool. (See Annex VII, Part 4, Paragraphs 73, 74, and 82.) The estimation of implied historical LGD is accepted in cases where institutions can estimate the expected loss for every facility rating grade or pool of exposures, but only if all the minimum requirements for estimation of PD are met. The estimation of PD should cover all the qualitative and quantitative requirements of validation. The estimation of EL (in lieu of LGD) seems to bring additional challenges. 3.3.3.3. Conversion Factors 240. The third parameter used in the supervisory formula for calculating regulatory capital requirements is Exposure Value. However, the CRD requires that the parameter to be estimated is the Conversion Factor (CF). Throughout this chapter, reference will therefore be made to CF rather than Exposure Value. 241. Article 87(9) of the CRD allows institutions to use own estimates of Conversion Factors. However, industry practice in this area is still at an early stage. In particular, the basic definitions and main principles that underlie the CF estimation process need to be clarified. A large proportion of this section is therefore devoted to definitions. It is envisaged that with time, and as industry practice develops, more detailed guidelines on CF estimation and validation methodologies will be produced. High level principles 242. CF estimates should reflect the experience and practices of the institution as well as the external environment in which it operates. CF, even more than PD and LGD, depends on how the relationship Page 57 of 123
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CEBS CP 10 11 July 2005 Guidelines
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ANNEXES ...........................
Page 5 and 6: to use these approaches. 6. The gui
Page 7 and 8: IRB approach can be given only if t
Page 9 and 10: approaches for regulatory purposes
Page 11 and 12: purposes, when the group has submit
Page 13 and 14: efficient running of the process, u
Page 15 and 16: and/or 105 of the CRD, subject to t
Page 17 and 18: 58. Institutions intending to move
Page 19 and 20: translated, supervisors will organi
Page 21 and 22: 76. The issues that supervisors are
Page 23 and 24: holding company, the competent auth
Page 25 and 26: · A new approval process shall not
Page 27 and 28: · Institutions may not be ready to
Page 29 and 30: 2. Asking institutions to notify su
Page 31 and 32: 116. ‘Immaterial’ should refer
Page 33 and 34: 128. The EU Council has proposed th
Page 35 and 36: should start with inputs, and those
Page 37 and 38: to be only broadly compliant with t
Page 39 and 40: institutions to be able to identify
Page 41 and 42: differentiated if their loss rates
Page 43 and 44: payments are originating from the s
Page 45 and 46: any of its subsidiaries in full, wi
Page 47 and 48: 197. As a general rule, the rating
Page 49 and 50: · Their discounting method results
Page 51 and 52: grades. In this case, all of the re
Page 53 and 54: of challenges, including choosing t
Page 55: 228. In principle, supervisors do n
Page 59 and 60: LGD estimation, they have to be tak
Page 61 and 62: The exposure value for the followin
Page 63 and 64: investigating the potential drivers
Page 65 and 66: advisable in some circumstances not
Page 67 and 68: terms) the proof of consistency wit
Page 69 and 70: 302. The information used in credit
Page 71 and 72: exposures to obligors or facilities
Page 73 and 74: Pooled data sets for good predictiv
Page 75 and 76: inputs to the IRB approach. Supervi
Page 77 and 78: used to quantify the risk parameter
Page 79 and 80: years for the economy as a whole, a
Page 81 and 82: · Institutions must be able to bri
Page 83 and 84: Benchmarking the outputs of interna
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Page 87 and 88: systems” (Annex VII, Part 4, Para
Page 89 and 90: · Examining reports from Internal
Page 91 and 92: organisational point of view (e.g.,
Page 93 and 94: conclusions are wellfounded. Inte
Page 95 and 96: 401. The role played by the CRC fun
Page 97 and 98: subsidiary, or by different subsidi
Page 99 and 100: way of a formal notification). The
Page 101 and 102: · The rollout plan should have a
Page 103 and 104: Principles and examples 1. The purp
Page 105 and 106: etween systems, recording of data t
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· The definition of an appropriate
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incorporate forwardlooking elemen
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· Approving proactive risk managem
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frequency and format of the interna
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· Development of internal processe
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· Understanding the extent and nat
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‣ If not, inform the other superv
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the decision. ‣ Agree on the proc
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