CP10 (Full Document) - European Banking Authority

· Variable time horizon approach. This is a generalisation of the
fixed time horizon. It consists of using several reference times
within the chosen time horizon rather than one (for example,
comparing the drawn amount at default with the drawn amounts
at one month, two months, three months, etc. before default)
· Momentum approach – Some institutions have traditionally
expressed Conversion Factors in their internal systems as a
percentage of the total outstanding limit (total­limit ratio), and
not of the undrawn amount. Institutions that use this approach
have no intrinsic need to decide on a reference point in time prior
to default, since the drawn amount at the time of default is
compared only to the total limit at the time of default.
254. In its simplest form, the momentum approach does not fulfil the
requirements of the CRD, because it estimates the total­limit ratio
rather than the CRD­compliant conversion factor defined as a
percentage of the undrawn amount. This has the consequence that
the currently drawn amount is not considered. However the method
could be a starting point, if the institution addressed this weakness
by recalculating the total­limit ratio as a CRD­compliant Conversion
Factor using relevant information from the CF grade assignment
process. The use of this method can only be a transitory solution,
however, subject to reconsideration by the supervisory authorities.
255. At this stage, and until more detailed empirical evidence is gathered,
supervisors are not ruling out any of the above approaches.
Institutions are encouraged to develop more sophisticated rating and
estimation systems for Conversion Factors. Regardless of the
approach chosen, supervisors expect institutions to:
· Analyse and discuss their reasons for adopting a given approach,
justify their choices, and assess the impact that the use of a
different timeframe would have;
· Identify the possible weaknesses of the chosen approach and
propose methods to address or compensate for them;
· Evaluate the impact of the chosen approach on final CF grades
and estimates by investigating dynamic effects such as
interactions with time­to­default and credit quality
256. A sound approach to model development and an effective validation
challenge should take these and other considerations into account.
The documentation should provide clear information about these
(and other) issues.
Own vs. Supervisory estimates
257. Own estimates of Conversion Factors are discussed in Annex VII,
Part 3, Paragraph 11:
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