CRR III: Credit Risk for the Internal Ratings Based Approach

The Capital Requirements Regulation III (CRR III) marks a significant evolution in the European Union’s regulatory framework for banking, particularly in the realm of credit risk. As part of the broader European Banking Package, CRR III integrates the final Basel III Accord into EU law, thereby enhancing the stability and resilience of the financial system. This regulation sets stringent capital requirements for banks, aiming to mitigate the risks exposed by previous financial crises and to fortify the banking sector against future economic shocks.

On July 17, 2024, the European Banking Authority (EBA) issued a pivotal statement outlining the operational application of CRR III. This statement is particularly important as it provides detailed guidance on how banks should implement the new regulation, especially concerning the Internal Ratings Based (IRB) Approach to credit risk modeling. The EBA’s emphasis on active dialogue between institutions and competent authorities is crucial for ensuring a seamless transition to the new regulatory framework set to take effect on January 1, 2025.

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[1]

CRR III Regulation

Explore the strategic implications of the proposed CRR III Regulation extension. This vital postponement offers EU banks time to ensure full compliance and maintain competitiveness in the global financial landscape.

GrandAlessandro Micagni

[2]

Capital Requirement Regulation (CRR): EBA RTS

EBA’s consultation on the Capital Requirements Regulation (CRR) is pivotal for banks, especially in the EU. It addresses changes in risk models under FRTB, impacting risk management and capital requirements.

GrandAlessandro Micagni

CRR III’s implementation brings several enhancements over its predecessors. It aims to:

• Improve Risk Sensitivity: By refining the standardized approaches and instituting robust safeguards for internal modeling, CRR III enhances the accuracy with which banks assess and manage their risk exposures. This includes incorporating more granular risk weights and considering a broader range of risk factors.
• Establish Stringent Controls: The regulation introduces rigorous controls over internal models used by banks to estimate risk parameters. This is designed to reduce undue variability in risk-weighted assets (RWAs) and ensure more consistent and reliable capital requirements.
• Increase Transparency and Oversight: Through detailed communication and reporting requirements, CRR III ensures that competent authorities have better oversight of banks' risk management practices. This transparency helps in early identification and mitigation of potential risks.
• Strengthen Capital Buffers: By setting higher capital requirements and introducing new regulatory buffers, CRR III aims to enhance the overall capital adequacy of banks. This includes the introduction of new minimum capital ratios and additional buffers for systemic risks.
• Enhance Resilience Against Crises: Learning from the financial crises, CRR III incorporates measures that make the banking sector more resilient to economic shocks. This includes provisions for stress testing and contingency planning to ensure banks can withstand severe economic downturns.

The EBA’s guidance on CRR III provides a detailed roadmap for banks to follow, ensuring that the transition to the new regulatory framework is smooth and effective. This guidance covers critical aspects such as the communication of targeted model landscapes, assessment and categorisation of changes, and the implementation of new modeling standards and credit risk mitigation techniques.

CRR III and Its Impact on Credit Risk

The Capital Requirements Regulation III (CRR III) builds upon the foundations of previous regulations by incorporating lessons learned from financial crises, such as the COVID-19 pandemic and the energy crisis, and advancements in risk management practices. This regulation is a critical component of the European Union’s strategy to enhance the stability and resilience of its financial system. A primary area of focus within CRR III is credit risk, particularly regarding the Internal Ratings Based (IRB) Approach. This approach allows banks to utilize their own internal models to estimate risk parameters and calculate regulatory capital, thus providing a more tailored and potentially more accurate reflection of their risk profiles.

EBA’s Clarification on CRR III and Credit Risk Modelling

On July 17, 2024, the European Banking Authority (EBA) issued a comprehensive statement on the operational application of CRR III, underscoring the necessity for proactive and continuous dialogue between financial institutions and competent authorities. The EBA’s guidance covers several key directives essential for ensuring a smooth transition to the updated regulatory framework by January 1, 2025.

Targeted Model Landscape Communication

Institutions are mandated to communicate their targeted model landscape to their respective competent authorities. This communication must encompass a thorough discussion on the application of the IRB Approach for each exposure class, as specified in Article 147(2) of CRR III. Key aspects of this communication include:

• Rating Systems: Institutions need to identify the rating systems that will be used for the exposures of each exposure class. This ensures that the models employed are appropriate and meet regulatory standards.
• Permanent Partial Use and Rollout Plans: Detailed plans and updates that require permission from competent authorities, as outlined in Articles 148 and 150, must be provided. This includes both the initial deployment and any subsequent updates or changes to the models.
• Reversion to Less Sophisticated Approaches: Institutions must also consider the possibility of reverting to less sophisticated approaches as permitted by Articles 149 and 494d. This process requires necessary notifications to be submitted to competent authorities at least six months prior to the reversion.
• Implementation Plan for Reversal to Less Sophisticated Approaches: Developing a comprehensive plan for mandatory reversals to less sophisticated approaches is crucial. This plan should include new credit risk mitigation requirements as specified in Articles 108, 235a, and 236a.

Assessment and Categorization of Changes

A vital component of the EBA’s guidance is the assessment and categorisation of changes resulting from the implementation of CRR III that impact the performance of rating systems. This assessment should be aligned with the EU Commission’s Delegated Regulation on the materiality of changes to the IRB Approach. Key considerations include:

• Material Changes: Institutions must identify and categorize any changes that significantly affect the performance of their rating systems. These changes should be bundled for permission or notification, ensuring that competent authorities are fully aware and can provide necessary approvals.
• Non-Material Changes: Changes that do not impact the performance of rating systems are not subjected to the regulation. However, institutions must still communicate these changes to ensure transparency and maintain regulatory compliance.

Implementation Plan for Modelling Updates

Institutions are required to share a detailed implementation plan for foreseen modeling updates linked to future EBA supervisory products. This plan should address several critical areas:

• Credit Conversion Factor (CCF) Parameters: Updates related to CCF parameters, such as the 12-month fixed horizon reference date, may be deprioritized until the application date of the EBA Guidelines on IRB-CCF. This allows institutions to manage their resources efficiently while ensuring compliance with evolving regulatory requirements.

Technical Considerations for CRR III Implementation

The successful implementation of Capital Requirements Regulation III (CRR III) necessitates meticulous attention to technical details and stringent adherence to regulatory requirements. Institutions must undertake several critical steps to ensure compliance and effectiveness in their risk management practices. Key considerations include:

Regular Review and Performance Assessment

A cornerstone of CRR III is the regular review and performance assessment of rating systems. Institutions must ensure that their rating systems remain representative, perform adequately, and are appropriately calibrated to the current risk landscape. This process involves:

• Ongoing Calibration: Continually calibrating models to ensure they reflect the most recent data and risk factors. This includes updating probability of default (PD), loss given default (LGD), and exposure at default (EAD) estimates.
• Performance Monitoring: Regularly monitoring the performance of rating systems to detect any deviations or deficiencies. This involves using back-testing and benchmarking techniques to compare model predictions against actual outcomes.
• Representativeness Checks: Ensuring that the data used in models is representative of the institution's current and future risk profile. This includes assessing the relevance and accuracy of input data and making necessary adjustments.

For material and complex rating systems, especially those facing significant reductions in their range of application, an early review of estimates is crucial. This review, as mandated by Article 144(1)(a) of CRR III, verifies that the rating systems continue to perform adequately under new regulatory requirements.

Materiality of Changes

Institutions must carefully assess the materiality of any changes to their rating systems. According to the EU Commission’s Delegated Regulation on materiality of changes to the IRB Approach, changes are categorized based on their impact on model performance. Key steps include:

• Impact Analysis: Conducting thorough impact analyses to determine whether changes significantly affect model outputs. This helps in classifying changes as material or non-material.
• Bundling Changes: Grouping changes for submission to competent authorities. This ensures that all material changes are reviewed and approved, maintaining regulatory compliance.
• Documentation and Reporting: Keeping detailed records of all changes and their justifications. This documentation supports transparency and facilitates regulatory reviews.

Credit Risk Mitigation Requirements

CRR III introduces new requirements related to credit risk mitigation (CRM). Institutions must implement these requirements to ensure their rating systems accurately capture the effects of CRM techniques. This includes:

• Collateral Management: Ensuring that models account for the value and volatility of collateral. This involves updating LGD estimates to reflect secured exposures more accurately.
• Guarantees and Credit Derivatives: Incorporating the impact of guarantees and credit derivatives into risk assessments. This requires adjusting PD and LGD estimates to consider the risk-reducing effects of these instruments.
• Comprehensive Evaluation: Regularly evaluating the effectiveness of CRM techniques. This includes stress testing CRM assumptions to ensure they hold under adverse conditions.

Capital Requirements Regulation III: Compliance and Effective Communication

Maintaining continuous and transparent communication with competent authorities is crucial for CRR III compliance. Institutions must establish robust processes for reporting and collaboration, including:

• Implementation Plans: Developing and communicating detailed implementation plans for CRR III-related changes. These plans should outline timelines, responsibilities, and the expected impact on risk-weighted exposure amounts and own funds requirements.
• Non-Compliance Notifications: If institutions cannot meet the requirements of Chapter 3 of Title II of Part Three of CRR III, they must notify their competent authorities in accordance with Article 146. This notification should include the reasons for non-compliance and proposed remediation actions.
• Updates Linked to EBA Supervisory Products: Institutions should avoid premature updates to definitions of default or other parameters linked to future EBA supervisory products. This ensures that updates align with finalized guidelines and regulatory expectations.

Credit Risk Mitigation and IRB-CCF Updates

Implementing changes related to credit risk mitigation and updates to the Internal Ratings Based (IRB) Approach's Credit Conversion Factors (CCF) is a critical component of CRR III compliance. These updates are essential to ensure that institutions accurately capture and mitigate the risks associated with their credit exposures.

Credit Risk Mitigation (CRM) Requirements

CRR III introduces several new requirements aimed at enhancing the effectiveness of credit risk mitigation techniques. Institutions must ensure that their rating systems and risk management practices are updated to reflect these changes. Key areas of focus include:

• Collateral Valuation and Management: Institutions must update their models to accurately reflect the value and volatility of collateral. This involves regular revaluation of collateral assets and incorporating stress testing to account for potential value fluctuations under adverse market conditions. The updated models should adjust Loss Given Default (LGD) estimates to reflect secured exposures more accurately.
• Guarantees and Credit Derivatives: The impact of guarantees and credit derivatives on credit risk must be fully integrated into the risk assessment process. Institutions need to adjust Probability of Default (PD) and LGD estimates to consider the risk-reducing effects of these instruments. This requires a detailed analysis of the terms and conditions of guarantees and the performance of credit derivatives under different scenarios.
• Comprehensive Evaluation of CRM Techniques: Institutions should conduct thorough evaluations of their CRM techniques to ensure their effectiveness. This includes back-testing historical data to validate the performance of CRM strategies and making necessary adjustments to improve accuracy. Regular reviews and updates to CRM policies are essential to maintain alignment with CRR III standards.

IRB-CCF Updates

The EBA's guidance on CRR III also includes specific requirements for updating IRB models, particularly regarding Credit Conversion Factors (CCF). These updates are designed to improve the accuracy and reliability of credit risk assessments. Key aspects include:

• Scope of Application: Institutions must implement changes impacting the scope of application of IRB-CCF. This includes limiting the application to revolving commitments, as specified in Article 166(8b) of CRR III. Ensuring that the IRB-CCF models accurately capture the characteristics of revolving exposures is critical for maintaining compliance and enhancing risk assessment accuracy.
• CCF Input Floors: CRR III introduces new regulatory floors for CCF inputs. Institutions are required to update their models to reflect these new floors by the CRR III application date. This involves recalibrating models to ensure that the minimum regulatory thresholds are met, thereby improving the consistency and reliability of risk-weighted asset calculations.
• Deferral of Certain Updates: The EBA allows for the deferral of some IRB-CCF updates until the finalization of relevant guidelines. For example, changes related to the 12-month fixed horizon reference date may not need to be prioritized immediately. Institutions should assess the materiality of temporary non-compliance and discuss appropriate mitigation measures with competent authorities to manage the transition effectively.
• Temporary Non-Compliance and Mitigation Measures: In cases where institutions cannot fully implement the required changes by the CRR III application date, they must assess the materiality of this non-compliance. Discussions with competent authorities are essential to determine suitable mitigation measures that can be put in place until full compliance is achieved. This proactive approach ensures that potential risks are managed effectively during the transition period.