BIPRU 4.6 The IRB approach: Retail exposures
Application
BIPRU 4.6 applies with respect to the exposures referred to in BIPRU 4.6.2 R.
Definition of retail exposures
To be eligible to be treated as a retail exposure, exposures must meet the following criteria:
- (1)
they must be either to an individual person or persons, or to a small or medium sized entity, provided in the latter case that the total amount owed to the firm and parent undertaking and its subsidiary undertakings, including any past due exposure, by the obligor client or group of connected clients, but excluding claims or contingent claims secured on residential real estate collateral, must not, to the knowledge of the firm, which must have taken reasonable steps to confirm the situation, exceed EUR 1 million;
- (2)
they are treated by the firm in its risk management consistently over time and in a similar manner;
- (3)
they are not managed just as individually as exposures in the corporate exposure IRB exposure class;and
- (4)
they each represent one of a significant number of similarly managed exposures.
[Note: BCD Article 86(4) (part)]
The present value of retail minimum lease payments is eligible to be treated as a retail exposure.
[Note: BCD Article 86(4) (part)]
- (1)
This paragraph sets out guidance on BIPRU 4.6.2 R so far as it relates to the boundary between retail exposures and corporate exposures.
- (2)
In deciding what steps are reasonable for the purposes of BIPRU 4.6.2 R (1), a firm may take into account complexity and cost, as well as the materiality of the impact upon its capital calculation. A firm should be able to demonstrate to the FSA that it has complied with the obligation to take reasonable steps under BIPRU 4.6.2 R (1) in the way it takes these factors into account.
- (3)
If a firm has exposures to an owner of a retail SME in his personal capacity and exposures to the retail SME the firm should aggregate the two types of exposure for the purpose of BIPRU 4.6.2 R (1), although it should not include claims secured on residential real estate collateral. In deciding what steps are reasonable for the purposes of BIPRU 4.6.2 R (1) in aggregating these two types of exposure, a firm may take into account the materiality of those personal exposures. A firm should be able to demonstrate to the FSA that it has complied with the obligation to take reasonable steps under BIPRU 4.6.2 R (1) when taking into account materiality in this way.
- (4)
The definition of group of connected clients is set out in the glossary. Paragraph (2) of that definition is "two or more persons ... who are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, the other or all of the others would be likely to encounter repayment difficulties". Say that a firm has exposures to A and B. When deciding whether A and B come within paragraph (2) of the definition two conditions should be satisfied. Firstly the connections between A and B should mean that if A experiences financial problems, B should be likely to encounter repayment difficulties. Secondly, the connections between A and B should mean that if B experiences financial problems, A should be likely to encounter repayment difficulties
- (5)
A firm should have its own documented policy on the types of exposures that, in accordance with BIPRU 4.6, qualify as retail SME exposures. The FSA would not expect that a definition based on the EUR 1m exposure limit would be adequate on its own.
- (6)
The purpose of the definition of retail exposure is to separate a non-granular retail and small and medium sized business portfolio from other business so that a separate capital calculation may be applied to that portfolio that takes into account its non-granularity. Where retail exposures are assigned to pools it is the statistical characteristics of these pools which are used to derive the IRB approach estimates. Therefore pools should be reasonably homogenous and subject to consistent risk management practices.
- (7)
A firm should have sufficient controls to ensure that any inadvertent assignment of non-eligible exposures to the retail exposure IRB exposure class is sufficiently immaterial that it does not result in any significant distortion of the overall statistical characteristics of the sub-sets of that IRB exposure class which arise when the exposures are assigned to grades or pools. Cost considerations do not justify inclusion of non-eligible exposures if the effect would be material. Sample testing could be one method of demonstrating that the impact would be immaterial. BIPRU 4.1.25 R applies to exposures treated in accordance with this sub-paragraph (7).
- (8)
If an exposure to a small or medium sized business crosses the retail exposure size boundary it should be treated as a corporate, unless, in accordance with BIPRU 4.1.25 R, the excess is immaterial because of its size or because it is temporary.
- (9)
BIPRU 4.6.2 R does not require that exposures to retail SMEs should never be individually managed. In deciding whether the frequency and extent of individual management does or does not make exposures ineligible for the retail exposure IRB exposure class, a firm should consider whether that individual management is:
- (a)
sufficiently insignificant not to disrupt the homogeneity of the pool;
- (b)
consistent with the management of other exposures in the same retail exposure pool; and
- (c)
significantly different in extent from the individual management that occurs for corporate exposures, looked at as a whole.
- (a)
- (10)
Where an exposure is denominated in other currencies, a firm may calculate the Euro equivalent for the purposes of BIPRU 4.6.2 R (1) using any appropriate set of exchange rates provided its choice has no obvious bias and that the firm is consistent in its approach to choosing rates.
- (11)
A firm may monitor compliance with the €1m threshold in BIPRU 4.6.2 R (1) on the basis of approved limits provided that it has internal control procedures that are sufficient to ensure that amounts owed cannot diverge from those approved limits to such an extent as to give rise to a breach of the €1m threshold or, if the firm is relying on provisions relating to reasonable steps in BIPRU 4.6.2 R (1), any material breach of that threshold.
Rating system: Structure of rating system
Further material on the structure of rating systems can be found in BIPRU 4.3.25 R - BIPRU 4.3.28 R.
Rating system: Assignment to grades or pools
Rating systems must reflect both obligor and transaction risk, and must capture all relevant obligor and transaction characteristics.
[Note: BCD Annex VII Part 4 point 13]
The level of risk differentiation must ensure that the number of exposures in a given grade or pool is sufficient to allow for meaningful quantification and validation of the loss characteristics at the grade or pool level. The distribution of exposures and obligors across grades or pools must be such as to avoid excessive concentrations.
[Note: BCD Annex VII Part 4 point 14]
- (1)
This paragraph contains guidance on the level of differentiation referred to in BIPRU 4.6.7 R.
- (2)
It is important that a firm achieves adequate segmentation to deliver robust estimates of LGD and conversion factors, as well as PD. Whether the focus should be more on exposure size or collateral type is a question of fact for the particular circumstances in which the assignment of exposures to grades or pools occurs. Typically the FSA would expect both to be important.
- (3)
A firm may allocate retail exposures to pools based on direct estimates of PD, LGD and conversion factors as well as using an approach under which the firm segments first and attributes PD, LGD and conversion factors afterwards. However the result should in either case be that the pools are sufficiently homogenous.
- (4)
The number and size of pools should be determined in relation to the objective of establishing homogeneous risk. Pools should be of sufficient size to permit the production of robust risk estimates but should not be so large as to obscure variations in quality.
A firm must be able to demonstrate to the FSA that the process of assigning exposures to grades or pools provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures, and allows for accurate and consistent estimation of loss characteristics at grade or pool level.
[Note: BCD Annex VII Part 4 point 15 (part)]
For purchased receivables, BIPRU 4.8 contains material about assignment to grades or pools.
- (1)
A firm must consider the following risk drivers when assigning exposures to grades or pools:
- (2)
In the case of (1)(b) a firm must explicitly address cases where several exposures benefit from the same collateral.
- (3)
However:
- (a)
a firm need not consider delinquency if this is compatible with its IRB permission; and
- (b)
(in the case of a firm with an IRB permission that permits the firm not to consider delinquency) it should be able to demonstrate to the FSA that delinquency is not a material risk driver for the exposures treated in this way.
- (a)
[Note: BCD Annex VII Part 4 Point 16]
Rating system: Assignment of exposures
Rating system: Overrides
Material on overrides can be found in BIPRU 4.3.50 R.
Rating system: Integrity of assignment process
A firm must at least annually update obligor and facility assignments or review the loss characteristics and delinquency status of each identified risk pool whichever is applicable. A firm must also at least annually review in a representative sample the status of individual exposures within each pool as a means of ensuring that exposures continue to be assigned to the correct pool.
[Note: BCD Annex VII Part 4 point 29]
Annual rescoring is one method of meeting the requirement in BIPRU 4.6.14 R. However a firm need not carry out this update by means of a full re-run of a credit scoring model if it is able to demonstrate that its method is appropriate to the portfolio given its materiality and its impact on its capital requirements and that the firm still meets the minimum IRB standards.
Rating system: Use of models
Material on the use of models can be found in BIPRU 4.3.51 R - BIPRU 4.3.53 G.
Rating system: Documentation
Material on documentation can be found in BIPRU 4.3.19 R - BIPRU 4.3.24 R.
Rating system: Data maintenance
In addition to complying with BIPRU 4.3.54 R (Data maintenance) a firm must collect and store:
- (1)
data used in the process of allocating exposures to grades or pools;
- (2)
data on the estimated PDs, LGDs and conversion factors associated with grades or pools of exposures;
- (3)
- (4)
for defaulted exposures, data on the grades or pools to which the exposure was assigned over the year prior to default and the realised outcomes on LGD and conversion factor; and
- (5)
data on loss rates for qualifying revolving retail exposures.
[Note: BCD Annex VII Part 4 point 39]
Risk quantification: Definition of default
Material on the definition of default can be found in BIPRU 4.3.56 R - BIPRU 4.3.72 G.
- (1)
This rule, in accordance with BIPRU 4.3.57 R (4) (Definition of default), sets the exact number of days past due that a firm must abide by in the case of retail exposures.
- (2)
For retail exposures to counterparts situated within the United Kingdom the number of days past due is 180 days with the exception of retail SME exposures. For these exposures the number is 90 days.
- (3)
For retail exposures to counterparts situated in another EEA State the number of days past due is the lower of:
- (a)
180; and
- (b)
the number of days past due fixed under the CRD implementation measure in that EEA State with respect to paragraph 48 of Part 4 of Annex VII of the Banking Consolidation Directive for such exposures.
- (a)
- (4)
For retail exposures to counterparts in a state outside the EEA the number of days past due is the lower of:
- (a)
180; and
- (b)
(if a number of days past due for such exposures has been fixed under any national law of that state applicable to undertakings in the banking sector or the investment services sector that implements the IRB approach) that number.
- (a)
[Note: BCD Annex VII Part 4 point 44 (part) and point 48 (part)]
Risk quantification: Overall requirements for estimation
Material on the overall requirements for estimation can be found in BIPRU 4.3.73 R - BIPRU 4.3.94 R.
Risk quantification: Requirements specific to PD estimation
A firm must regard internal data for assigning exposures to grades or pools as the primary source of information for estimating loss characteristics. A firm may use external data (including pooled data) or statistical models for quantification provided a strong link can be demonstrated between:
- (1)
the firm's process of assigning exposures to grades or pools and the process used by the external data source; and
- (2)
the firm's internal risk profile and the composition of the external data.
[Note: BCD Annex VII Part 4 point 69]
If a firm derives long run average estimates of PD and LGD for retail exposures from an estimate of total losses, and an appropriate estimate of PD or LGD, the process for estimating total losses must meet the minimum IRB standards1 for estimation of PD and LGD, and the outcome must be consistent with the concept of LGD as set out in BIPRU 4.3.99 R (Default weighted average).
[Note: BCD Annex VII Part 4 point 70]
Irrespective of whether a firm is using external, internal, pooled data sources or a combination of the three, for its estimation of loss characteristics, the length of the underlying historical observation period used must be at least five years for at least one source. If the available observation spans a longer period for any source, and these data are relevant, this longer period must be used. However:
- (1)
a firm need not give equal importance to historic data if this is compatible with its IRB permission; and
- (2)
(in the case of a firm with an IRB permission that permits this treatment of historic data) the firm must be able to convince the FSA that more recent data is a better predictor of loss rates.
[Note: BCD Annex VII Part 4 point 71 (part)]
A firm may have, when implementing the IRB approach, relevant data covering a period of two years. The period to be covered must increase by one year each year until relevant data covers a period of five years.
[Note: BCD Annex VII Part 4 point 71 (part)]
Risk quantification: Requirements specific to own-LGD estimation
Notwithstanding BIPRU 4.3.128 R (Additional drawings), a firm may reflect future drawings either in its conversion factor or in its LGD estimates.
[Note: BCD Annex VII Part 4 point 84]
Estimates of LGD must be based on data over a minimum of five years. Notwithstanding BIPRU 4.3.99 R (Default weighted average):
- (1)
a firm need not give equal importance to historic data if this is permitted by its IRB permission; and
- (2)
(in the case of a firm with an IRB permission that permits this treatment of historic data) the firm must be able to convince the FSA that more recent data is a better predictor of loss rates.
[Note: BCD Annex VII Part 4 point 86 (part)]
A firm may have, when it implements the IRB approach, relevant data covering a period of two years. The period to be covered must increase by one year each year until relevant data covers a period of five years.
[Note: BCD Annex VII Part 4 point 86 (part)]
The FSA does not assume that all portfolios are sensitive to downturns. The FSA also accepts that for some portfolios, particularly in unsecured lending, the impact of the material drivers on LGD may be weak. However the burden is on the firm to demonstrate that its models are appropriate for the circumstances in which they are applied.
Additional material on requirements specific to own-LGD estimation can be found in BIPRU 4.3.98 R - BIPRU 4.3.123 R.
Risk quantification: Requirements specific to own-conversion factor estimates
Notwithstanding BIPRU 4.3.128 R (Additional drawings), a firm may reflect future drawings either in its conversion factors or in its LGD estimates.
[Note: BCD Annex VII Part 4 point 94]
Estimates of conversion factors must be based on data over a minimum of five years. Notwithstanding BIPRU 4.3.125 R:
- (1)
a firm need not give equal importance to historic data if this is permitted by its IRB permission; and
- (2)
(in the case of a firm with an IRB permission that permits this treatment of historic data) the firm must be able to convince the FSA if asked that more recent data is a better predictor of loss rates.
[Note: BCD Annex VII Part 4 point 95 (part)]
A firm may have, when it implements the IRB approach, relevant data covering a period of two years. The period to be covered must increase by one year each year until relevant data cover a period of five years.
[Note: BCD Annex VII Part 4 point 95 (part)]
Additional material on requirements specific to own-conversion factor estimation can be found in BIPRU 4.3.124 R - BIPRU 4.3.131 R.
Calculation of risk weighted exposure amounts for retail exposures: General
Subject to BIPRU 4.6.43 R and BIPRU 4.6.44 R, the risk weighted exposure amounts for retail exposures must be calculated according to the formulae in the table in BIPRU 4.6.42 R.
[Note: BCD Annex VII Part 1 point 10 1st sentence]
Table: Risk weighted exposure amounts for retail exposures
This table belongs to BIPRU 4.6.41 R
Correlation (R) |
0.03 × (1 - EXP(-35*PD))/(1-EXP(-35)) + 0.16* |
[1-(1-EXP(-35*PD))/(1-EXP(-35))] |
|
Risk weight (RW) |
(LGD*N[(1-R)-0.5*G(PD)+(R/(1-R))0.5 *G(0.999)]-PD*LGD)* 12.5*1.06 |
N(x) |
denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x). |
G(z) |
denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value x such that N(x) = z). |
PD = 1 |
For PD = 1 (defaulted exposure), RW must be: Max {0, 12.5 *(LGD- ELBE)} where ELBEmust be the firm's best estimate of expected loss for the defaulted exposure according to BIPRU 4.3.122 R. |
equals RW*exposure value |
[Note: BCD Annex VII Part 1 point 10 (part)]
Calculation of risk weighted exposure amounts for retail exposures: Retail mortgages
For retail exposures secured by real estate collateral a correlation (R) of 0.15 must replace the correlation formula in the table in BIPRU 4.6.42 R.
[Note: BCD Annex VII Part 1 point 12]
Calculation of risk weighted exposure amounts for retail exposures: Qualifying revolving retail exposures
- (1)
For qualifying revolving retail exposures a correlation (R) of 0.04 must replace the correlation formula in the table in BIPRU 4.6.42 R.
- (2)
Retail exposures qualify as qualifying revolving retail exposures if they meet the following conditions:
- (a)
the IRB permission of the firm in question does not disapply this paragraph;
- (b)
the exposures are to individuals;
- (c)
the exposures are revolving, unsecured, and, to the extent they are not drawn, immediately and unconditionally cancellable by the firm;
- (d)
the maximum exposure to a single individual in the sub-portfolio is EUR 100,000 or less;
- (e)
the firm is able to demonstrate to the FSA that the use of the correlation formula in this paragraph is limited to portfolios that have exhibited low volatility of loss rates, relative to their average level of loss rates, especially within the low PD bands; and
- (f)
the firm is able to demonstrate to the FSA that treatment as a qualifying revolving retail exposure is consistent with the underlying risk characteristics of the sub-portfolio.
- (a)
- (3)
In the context of this rule revolving exposures are defined as those where customers' outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the firm in question. Undrawn commitments may be considered as unconditionally cancellable if the terms permit the firm to cancel them to the full extent allowable under consumer protection and related legislation.
[Note: BCD Annex VII Part 1 point 13 (part) and Part 3 point 9(a) (part)]
A firm should be able to demonstrate the low volatility of loss rates mentioned in BIPRU 4.6.44 R (2)(e) at the time of the initial application for an IRB permission and thereafter at any time on request. The benchmark level should be the volatility of loss rates for the qualifying revolving retail exposure portfolio relative to the volatilities of loss rates of other relevant types of retail exposures. A firm should demonstrate low volatility by reference to data on the mean and standard deviation of loss rates over a time period that can be regarded as representative of the long-run performance of the portfolios concerned.
In the FSA's view a sub-portfolio consisting of credit card or overdraft obligations will usually meet the condition in BIPRU 4.6.44 R (2)(f). In the FSA's view it is unlikely that any other type of retail exposure will do so. If a firm wishes to apply the treatment in BIPRU 4.6.44 R (1) to product types other than credit card or overdraft obligations it should first discuss this with the FSA.
Calculation of expected loss amounts
Expected loss amounts must be calculated according to the formulae in the table in BIPRU 4.6.48 R.
[Note: BCD Annex VII Part 1 point 30 (part)]
Table: Formulae for the calculation of expected loss amounts
This table belongs to BIPRU 4.6.47 R
Expected loss amount |
|
For defaulted exposures (PD = 1) where a firm uses its own estimates of LGDs, EL must be ELBE, the firm's best estimate of expected loss for the defaulted exposure according to BIPRU 4.3.122 R. For exposures subject to the treatment set out in BIPRU 4.4.79 R (Double default) EL must be 0. |
|
[Note: BCD Annex VII Part 1 point 30 (part)]
Calculation of PDs
A firm must provide its own estimates of PDs in accordance with its IRB permission and the minimum IRB standards.
[Note: BCD Article 87(6) (part)]
Unfunded credit protection may be recognised by adjusting PDs subject to BIPRU 4.6.54 R. For dilution risk, where a firm does not use its own estimates of LGDs, this must be subject to compliance with BIPRU 5 (Credit risk mitigation) modified by BIPRU 4.10 and, for this purpose, a firm may recognise unfunded credit protection providers other than those indicated in the CRM eligibility conditions provided the firm is able to demonstrate that the unfunded protection provider giving the undertaking is sufficiently reliable and that the protection agreement is legally effective in accordance with BIPRU 5.2.7 R (Unfunded credit protection).
[Note: BCD Annex VII Part 2 point 20]
Calculation of LGDs
A firm must provide its own estimates of LGDs in accordance with its IRB permission and the minimum IRB standards.
[Note: BCD Article 87(7) (part)]
Unfunded credit protection may be recognised as eligible by adjusting PD or LGD estimates subject to the minimum IRB standards as specified in BIPRU 4.10.43 R - BIPRU 4.10.48 R and in accordance with the IRB permission either in support of an individual exposure or a pool of exposures. A firm must not assign guaranteed exposures an adjusted PD or LGD such that the adjusted risk weight would be lower than that of a comparable, direct exposure to the guarantor.
[Note: BCD Annex VII Part 2 point 22]
Calculation of exposure values and own conversion factors
Except where otherwise specified, BIPRU 4.4.37 R - BIPRU 4.4.39 R (Exposure value and conversion factors), BIPRU 4.4.45 R (AIRB conversion factors) and BIPRU 4.4.71 R - BIPRU 4.4.78 R (Calculation of exposure values for sovereigns, institutions and corporates) also apply to retail exposures.
A firm must provide its own estimates of conversion factors in accordance with its IRB permission and the minimum IRB standards.
[Note: BCD Article 87(7) (part)]
Double default
The risk weighted exposure amount for each exposure to retail SME as defined in BIPRU 4.6.2 R which meets the requirements set out in BIPRU 4.4.83 R and BIPRU 4.4.85 R may be calculated according to BIPRU 4.4.79 R (Double default).
[Note: BCD Annex VII Part 1 point 11]
Notwithstanding BIPRU 4.6.54 R for the purposes of BIPRU 4.4.80 R the LGD of a comparable direct exposure to the protection provider must either be the LGD associated with an unhedged facility to the guarantor or the unhedged facility of the obligor, depending upon whether in the event both the guarantor and obligor default during the life of the hedged transaction available evidence and the structure of the guarantee indicate that the amount recovered would depend on the financial condition of the guarantor or obligor, respectively.
[Note: BCD Annex VII Part 2 point 23]