IFPRU 4.3 Guidance on internal ratings based approach: high level material

Responsibility for ensuring that internal models are appropriately conservative and that approaches are compliant with the EU CRR rests with the firm itself.

A significant IFPRU firm should consider developing internal credit risk assessment capacity and to increase use of the internal ratings based approach for calculating own funds requirements for credit risk where its exposures are material in absolute terms and where it has at the same time a large number of material counterparties. This provision is without prejudice to the fulfilment of criteria laid down in Part Three, Title I, Chapter 3, Section 1 of the EU CRR (IRB approach).

[Note: article 77(1) of CRD]

The FCA will, taking into account the nature, scale and complexity of a firm's activities, monitor that it does not solely or mechanistically rely on external credit ratings for assessing the creditworthiness of an entity or financial instrument.

[Note: article 77(2) of CRD]

Article 20(6) of the EU CRR states that, where the IRB approach is used on a unified basis by those entities which fall within the scope of article 20(6) (EEA group), the FCA is required to permit certain IRB requirements to be met on a collective basis by members of that group. In particular, the FCA considers that, where a firm is reliant upon a rating system or data provided by another member of its group, it will not meet the condition that it is using the IRB approach on a unified basis unless:

1. (1)

   the firm only does so to the extent that it is appropriate, given the nature and scale of the firm's business and portfolios and the firm's position within the group;

2. (2)

   the integrity of the firm's systems and controls is not adversely affected;

3. (3)

   the outsourcing of these functions meets the requirements of SYSC; and

4. (4)

   the abilities of the FCA and the consolidating supervisor of the group to carry out their responsibilities under the EU CRR are not adversely affected.

Prior to reliance being placed by a firm on a rating system or data provided by another member of the group, the FCA expects the proposed arrangements to have been explicitly considered, and found to be appropriate, by the governing body of the firm.

If a firm uses a rating system or data provided by another group member, the FCA would expect the firm'sgoverning body to delegate those functions formally to the persons or bodies that are to carry them out.

Where a firm seeks to demonstrate to the FCA that the effect of its non-compliance with the requirements of Part Three, Title II Chapter 3 of the EU CRR (Internal ratings based approach) is immaterial under article 146(b) of the EU CRR (Measures to be taken where the requirements cease to be met), the FCA expects the firm to have taken into account all instances of non-compliance with the requirements of the IRB approach and to have demonstrated that the overall effect of non-compliance is immaterial.

1. (1)

   Where the firm's rating systems are used on a unified basis under article 20(6) of the EU CRR, the FCA considers that the governance requirements in article 189 of the EU CRR can only be met if the subsidiaries have delegated to the governing body or designated committee of the EEA parent institution, EEA parent financial holding company or EEA parent mixed financial holding company responsibility for approval of the firm's rating systems.

2. (2)

   The FCA expects an appropriate individual in a significant-influence function role to provide to the FCA on an annual basis written attestation that the rating system permissions required by the EU CRR have been carried out appropriately.

   [Note: see articles 189 and 20(6) of the EU CRR and article 3(1)(7) of CRD]

The FCA expects a firm seeking to apply the Standardised Approach on a permanent basis to certain exposures to have a well-documented policy explaining the basis on which exposures are to be selected for permanent exemption from the IRB approach. This policy should be provided to the FCA when the firm applies for permission to use the IRB approach and maintained thereafter. Where a firm also wishes to undertake sequential implementation, the FCA expects the firm's roll-out plan to provide for the continuing application of that policy on a consistent basis over time.

1. (1)

   The FCA may permit the exemption of exposures to sovereigns and institutions under article 150(1)(a) and (b) of the EU CRR respectively only if the number of material counterparties is limited and it would be unduly burdensome to implement a rating system for such counterparties.

2. (2)

   The FCA considers that the 'limited number of material counterparties' test is unlikely to be met if for the UK group total outstandings to 'higher risk' sovereigns and institutions exceed either £1bn or 5% of total assets (other than for temporary fluctuations above these levels). For these purposes, 'higher risk' sovereigns and institutions are considered to be those that are unrated or carry ratings of BBB+ (or equivalent) or lower. In determining whether to grant this exemption, the FCA will also consider whether a firm incurs exposures to 'higher risk' counterparties which are below the levels set out but are outside the scope of its core activities.

3. (3)

   In respect of the 'unduly burdensome' condition, the FCA considers that an adequate, but not perfect, proxy for the likely level of expertise available to a firm is whether its group has a trading book. Accordingly, if a firm's group does not have a trading book, the FCA is likely to accept the argument that it would be unduly burdensome to implement a rating system.

Where a firm wishes permanently to apply the Standardised Approach to certain business units on the grounds that they are non-significant and/or certain exposure classes or types of exposures on the grounds that they are immaterial in terms of size and perceived risk profile, the FCA expects to permit a firm to make use of this exemption only to the extent that the risk-weighted exposure amount calculated under article 92(3)(a) and (f) of the EU CRR that are based on the Standardised Approach (insofar as they are attributable to the exposures to which the Standardised Approach is permanently applied) would be no more than 15% of the risk-weighted exposure amount calculated under article 92(3)(a) and (f) of the EU CRR, based on whichever of the Standardised Approach and the IRB Approach would apply to the exposures at the time when the calculation is being made.

The following points set out the level at which the FCA expects the 15% test to applied for a firm that is a member of a group:

1. (1)

   if a firm is part of a group subject to consolidated supervision in the EEA and for which the FCA is the consolidating supervisor, the calculations in (1) are carried out with respect to the wider group;

2. (2)

   if a firm is part of a group subject to consolidated supervision in the EEA and for which the FCA is not the consolidating supervisor the calculation in (1) would not apply but the requirements of the consolidating supervisor relating to materiality will need to be met for the wider group;

3. (3)

   if the firm is part of a sub-group subject to consolidated supervision in the EEA and part of a wider third-country group subject to equivalent supervision by a regulatory authority outside of the EEA, the calculation in (1) would not apply but the requirements of the consolidating or lead regulator relating to materiality would need to be met for both the sub-group and the wider group; and

4. (4)

   if the firm is part of a sub-group subject to consolidated supervision in the EEA and is part of a wider third-country group that is not subject to equivalent supervision by a regulatory authority outside of the EEA, then the calculation in (1) would apply for the wider group if supervision by analogy is applied and for the sub-group if other alternative supervisory techniques are applied.

Whether a third-country group is subject to equivalent supervision, whether it is subject to supervision by analogy or whether other alternative supervisory techniques apply, is decided in accordance with article 127 of CRD (Assessment of equivalence of third countries' consolidated supervision). (See article 150(1)(c) of the EU CRR.)

Where a firm wishes to permanently apply the Standardised Approach to exposures to connected counterparties in accordance with article 150(1)(e) of the EU CRR, the FCA would normally expect to grant permission to do so only if the firm had a policy that provided for the identification of connected counterparties exposures that would be permanently exempted from the IRB approach and also identified connected counterparty exposures (if any) that would not be permanently exempted from the IRB approach. The FCA expects a firm to use the IRB approach either for all of its intra-group exposures or none of them (see article 150(1)(e) of the EU CRR).

In the event that a firm with IRB permission acquires a significant new business, it should discuss with the FCA whether sequential roll-out of the firm's IRB approach to these exposures would be appropriate. In addition, the FCA would expect to review any existing time period and conditions for sequential roll-out and determine whether these remain appropriate (see article 148 of the EU CRR).

1. (1)

   Article 154(4)(d) of the EU CRR (Risk weighted exposure amounts for retail exposures) specifies that, for an exposure to be treated as a qualifying revolving retail exposure (QRRE), it needs to exhibit relatively low volatility of loss rates. A firm should assess the volatility of loss rates for the QRRE portfolio relative to the volatilities of loss rates of other relevant types of retail exposures for these purposes. Low volatility should be demonstrated 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.

2. (2)

   Article 154(4)(e) of the EU CRR specifies that, for an exposure to be treated as a QRRE, this treatment should be consistent with the underlying risk characteristic of the sub-portfolio. The FCA considers that a sub-portfolio consisting of credit card or overdraft obligations will usually meet this condition and that it is unlikely that any other type of retail exposure will do so. If a firm wishes to apply the treatment in article 154 (4) of the EU CRR to product types other than credit card or overdraft obligations, the FCA expects it to discuss this with the FCA before doing so.

The FCA expects a firm to ensure that all documentation relating to its rating systems (including any documentation referenced in this chapter or required by the EU CRR that relate to the IRB approach) is stored, arranged and indexed in such a way that it could make them all, or any subset thereof, available to the FCA immediately on demand or within a short time thereafter.