This chapter:

1. (1)

   implements article 78 of CRD;

2. (2)

   contains the rules that exercise the discretion afforded to the FCA as competent authority under articles 115, 119(5), 124(2), 125(3), 126(2), 178(1)(b), 244(2), 245(2),2 286(2), 298(4) and 380 of the UK CRR3; and

3. (3)

   contains the guidance in relation to the IRB approach, securitisation, counterparty credit risk and credit risk mitigation.

Where the FCA has published evidence showing that a well-developed and long-established residential property market is present in that territory with loss rates which do not exceed the limits in article 125(3) of the UK CRR4 (Exposures fully and completely secured by mortgages on residential property), a firm does not need to meet the condition in article 125(2)(b) of the UK CRR4 in order to consider an exposure, or any part of an exposure, as fully and completely secured for the purposes of article 125(1) of the UK CRR4.

The FCA confirms that, in relation to the concessionary treatment set out in article 119(5) of the UK CRR4, there are no financial institutions currently authorised and supervised by it (other than those to which the UK CRR4 applies directly) that are subject to prudential requirements that it considers to be comparable in terms of robustness to those applied to institutions under the UK CRR4.

[Note: article 119(5) of the UK CRR4]

Where an exposure is denominated in a currency other than the euro, the FCA expects a firm to use appropriate and consistent exchange rates to determine compliance with relevant thresholds in the UK CRR3. Accordingly, a firm should calculate the euro equivalent value of the exposure for the purposes of establishing compliance with the aggregate monetary limit of €1 million for retail exposures using a set of exchange rates the firm considers to be appropriate. The FCA expects a firm's choice of exchange rate to have no obvious bias and to be derived on the basis of a consistent approach (see article 123(c) of the UK CRR3).

The FCA considers an Ijara mortgage to be an example of an exposure to a tenant under a property leasing transaction concerning residential property under which the firm is the lessor and the tenant has an option to purchase. Accordingly, the FCA expects exposures to Ijara mortgages to be subject to all of the requirements that apply to exposures secured by mortgages on residential property, including in respect of periodic property revaluation (see articles 124 and 125 of the UK CRR4).

The FCA expects a firm with exposure to a lifetime mortgage to inform the FCA of the difference in the own funds requirements on those exposures under the UK CRR4 and the credit risk capital requirement that would have applied under BIPRU 3.4.56A R.The FCA will use this information in its consideration of relevant risks in its supervisory assessment of the firm (see articles 124, 125 and 208 of the UK CRR4).

When determining the portion of a past due item that is secured, the FCA expects the secured portion of an exposure covered by a mortgage indemnity product that is eligible for credit risk mitigation purposes under Part Three, Title II, Chapter 4 of the UK CRR4 (Credit risk mitigation) to qualify as an eligible guarantee (see article 129(2) of the UK CRR4).

When determining whether exposures in the form of units or shares in a CIU are associated with particularly high risk, the FCA expects the following features would be likely to give rise to such risk:

1. (1)

   an absence of external credit assessment of such CIU from an ECAI recognised under article 132(2) of the UK CRR4 (Items representing securitisation positions) and where such CIU has specific features (such as high levels of leverage or lack of transparency) that prevent it from meeting the eligibility criteria in article 132(3) of the UK CRR4 (Items associated with particular high risk); or

2. (2)

   a substantial element of the CIU's property is made up of items that would be subject to a risk weight of more than 100%, or the mandate of a CIU would permit it to invest in a substantial amount of such items.

The FCA expects a firm's assessment of whether types of exposure referred to in article 128(3) of the UK CRR4 are associated with particularly high risk to include consideration of exposures arising out of a venture capital business (whether the firm itself carries on the venture capital business or not) . The FCA considers "venture capital business" to include the business of carrying on any of the following:

1. (1)

   advising on investments, managing investments, arranging (bringing about) deals in investments in or making arrangements with a view to transactions in investments in venture capital investments;

2. (2)

   advising on investments or managing investments in relation to portfolios, or establishing, operating or winding up a collective investment scheme, where the portfolios or collective investment schemes (apart from funds awaiting investment) invest only in venture capital investments;

3. (3)

   any custody activities provided in connection with the activities in (1) or (2); and

4. (4)

   any related ancillary activities.

Responsibility for ensuring that internal models are appropriately conservative and that approaches are compliant with the UK CRR3 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 UK CRR3 (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 UK CRR2 states that, where the IRB approach is used on a unified basis by those entities which fall within the scope of article 20(6)2, 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 UK CRR2 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 UK CRR3 (Internal ratings based approach) is immaterial under article 146(b) of the UK CRR3 (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 UK CRR2, the FCA considers that the governance requirements in article 189 of the UK CRR2 can only be met if the subsidiaries have delegated to the governing body or designated committee of the UK parent institution, UK parent financial holding company or UK parent mixed financial holding company2 responsibility for approval of the firm's rating systems.

2. (2)

   The FCA expects an appropriate individual in a designated senior management function4 role to provide to the FCA on an annual basis written attestation that the rating system permissions required by the UK CRR2 have been carried out appropriately.

   [Note: see articles 189 and 20(6) of the UK CRR2 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 UK CRR3 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 UK CRR3 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 UK CRR3, 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 be2 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 UK2 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 UK2 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 UK2 and part of a wider third-country group subject to equivalent supervision by a regulatory authority outside of the UK2, 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 UK2 and is part of a wider third-country group that is not subject to equivalent supervision by a regulatory authority outside of the UK2, 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 GENPRU 3.2 (Third-country groups).2 (See article 150(1)(c) of the UK CRR2.)

Where a firm wishes to permanently apply the Standardised Approach to exposures to connected counterparties in accordance with article 150(1)(e) of the UK CRR3, 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 UK CRR3).

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 UK CRR3).

1. (1)

   Article 154(4)(d) of the UK CRR3 (Risk-weighted1 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.

   1
2. (2)

   Article 154(4)(e) of the UK CRR3 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 UK CRR3 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 UK CRR3 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.

In order to be able to determine that the requirements in article 144(1) of the UK CRR1 have been met, the FCA would typically have the high-level expectations set out in this section.

The information that a firm produces or uses for the IRB approach should be reliable and take proper account of the different users of the information produced (customers, shareholders, regulators and other market participants).

A firm should establish quantified and documented targets and standards, against which it should test the accuracy of data used in its rating systems. Such tests should cover:

1. (1)

   a report and accounts reconciliation, including whether every exposure has a PD, LGD and, if applicable, conversion factor for reporting purposes;

2. (2)

   whether the firm's risk control environment has key risk indicators for the purpose of monitoring and ensuring data accuracy;

3. (3)

   whether the firm has an adequate business and information technology infrastructure with fully documented processes;

4. (4)

   whether the firm has clear and documented standards on ownership of data (including inputs and manipulation) and timeliness of current data (daily, monthly, real time); and

5. (5)

   whether the firm has a comprehensive quantitative audit programme.

In respect of data inputs, the testing for accuracy of data (including the reconciliation referred to above) should be sufficiently detailed so that, together with other available evidence, it gives reasonable assurance that data input into the rating system is accurate, complete and appropriate. The FCA considers that input data fails to meet the required standard if it gives rise to a serious risk of material misstatement in the own funds requirement either immediately or subsequently.

In respect of data outputs, a firm (as part of the reconciliation referred to above) should be able to identify and explain material differences between the outputs produced under accounting standards and those produced under the requirements of the IRB approach, including in relation to areas that address similar concepts in different ways (eg, expected loss and accounting provisions).

A firm should have clear and documented standards and policies about the use of data in practice (including information technology standards) which should, in particular, cover the firm's approach to the following:

1. (1)

   data access and security;

2. (2)

   data integrity, including the accuracy, completeness, appropriateness and testing of data; and

3. (3)

   data availability.

[Note: article 144(1)(a) of the UK CRR1)

For the FCA to be satisfied that a firm documents its ratings systems appropriately, in accordance with article 144(1)(e) of the UK CRR1, it would expect a firm to be able to demonstrate that it has an appropriate policy for any ratings system in relation to:

1. (1)

   any deficiencies caused by its not being sensitive to movements in fundamental risk drivers or for any other reason;

2. (2)

   the periodic review and action in the light of such review;

3. (3)

   providing appropriate internal guidance to staff to ensure consistency in the use of the rating system, including the assignment of exposures or facilities to pools or grades;

4. (4)

   dealing with potential weaknesses of the rating system;

5. (5)

   identifying appropriate and inappropriate uses of the rating system and acting on that identification;

6. (6)

   novel or narrow rating approaches; and

7. (7)

   ensuring the appropriate level of stability over time of the rating system.

[Note: article 144(1)(a) and (e) of the UK CRR1)

To be satisfied that the requirements in article 179(1) of the UK CRR1 are met, the FCA expects a firm to collect data on what it considers to be the main drivers of the risk parameters of probability of default (PD), loss given default (LGD), conversion factors (CFs) and expected loss (EL) for each group of obligors or facilities, to document the identification of the main drivers of risk parameters, and be able to demonstrate that the process of identification is reasonable and appropriate.

In its processes for identifying the main drivers of risk parameters, the FCA expects that a firm should set out its reasons for concluding that the data sources chosen provide in themselves sufficient discriminative power and accuracy and why additional potential data sources do not provide relevant and reliable information that would be expected materially to improve the discriminative power and accuracy of its estimates of the risk parameter in question. This process need not necessarily require an intensive analysis of all factors.

[Note: article 179(1)(a), (d) and (e) of the UK CRR1)

To demonstrate that rating systems provide for meaningful assessment, the FCA expects that a firm's documentation relating to data should include clear identification of responsibility for data quality. A firm should set standards for data quality, aim to improve them over time and measure its performance against those standards. Furthermore, a firm should ensure that its data is of high enough quality to support its risk management processes and the calculation of its own funds requirements (see article 175(1) of the UK CRR1).

Further detail of standards that the FCA would expect a firm to meet when it assesses compliance with article 174 of UK CRR1 are set out in the sections on probability of default (PD), loss given default (LGD) and exposure at default (EAD).

In assessing whether the external data used by a firm to build models is representative of its actual obligors or exposures, the FCA expects a firm to consider whether this data is appropriate to its own experience and whether adjustments are necessary (see article 174 of the UK CRR1).

To estimate PDs that are long run averages of one-year default rates for obligor grades or pools, the FCA expects a firm to estimate expected default rates for the grade/pool over a representative mix of good and bad economic periods, rather than simply taking the historic average of default rates actually incurred by the firm over a period of years. The FCA expects that a long run estimate would be changed when there is reason to believe that the existing long run estimate is no longer accurate, but that it would not be automatically updated to incorporate the experience of additional years as these may not be representative of the long run average (see article 180 of the UK CRR1).

To demonstrate compliance with article 144(1) of the UK CRR1, the FCA expects a firm to take into account the following factors in understanding differences between their historic default rates and their PD estimates, and in adjusting the calibration of their estimates as appropriate:

1. (1)

   the rating philosophy of the system and the economic conditions in the period over which the defaults have been observed;

2. (2)

   the number of defaults, as a low number is less likely to be representative of a long run average. Moreover, where the number of internal defaults is low, there is likely to be a greater need to base PDs on external default data as opposed to purely internal data;

3. (3)

   the potential for under-recording of actual defaults; and

4. (4)

   the level of conservatism applied.

The FCA expects a firm that is unable to produce a long run estimate, as described above, to consider what action it would be appropriate for it to take to comply with article 180(1)(a) of the UK CRR1. In some circumstances, it may be appropriate for a firm to need to amend its rating system so that the PD used as an input into the IRB own funds requirement is an appropriately conservative estimate of the actual default rate expected over the next year. However, such an approach is not likely to be appropriate where default rates are dependent on the performance of volatile collateral. (See articles 179(1)(f) and 180(1)(a) of the UK CRR1).

In accordance with articles 181(1)(b) and 182(1)(b) of the UK CRR1, where the estimates appropriate for an economic downturn are more conservative than the long run average, the FCA expects the estimate for each of these parameters to represent the LGD or CF expected, weighted by the number of defaults, over the downturn period. Where this is not the case, the FCA expects the estimate to be used to be the expected LGD or CF, weighted by the number of defaults, over a representative mix of good and bad economic periods (see articles 179, 181 and 182 of the UK CRR1).

To demonstrate that a rating system provides for a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk, the FCA expects a firm would have regard to the sensitivity of the rating to movements in fundamental risk drivers, in assigning exposures to grades or pools within a rating system (see article 171 of the UK CRR1).

The FCA expects that if a firm ordinarily assigns exposures in the corporate, institution or central government and central bank exposure classes to a member of a group, substantially on the basis of membership of that group and a common group rating, and the firm does so in the case of a particular obligor group, the firm should consider whether members of that group should be treated as a single obligor for the purpose of the definition of default in article 178(1) of the UK CRR2.

The FCA would not expect a firm to treat an obligor as part of a single obligor under IFPRU 4.5.1 G if the firm rates its exposures on a standalone basis or if its rating is notched. (For these purposes, a rating is notched if it takes into account individual risk factors or otherwise reflects risk factors that are not applied on a common group basis.) Accordingly, if a group has two members which are separately rated, the FCA will not expect that the default of one will necessarily imply the default of the other.

Under article 178(1)(b)1 of the UK CRR2, the FCA is empowered to replace 90 days with 180 days in the days past due component of the definition of default for exposures secured by residential or SME commercial real estate in the retail exposure class, as well as exposures to public sector entities (PSEs).

The FCA would expect to replace 90 days with 180 days in the days past due component of the definition of default for exposures secured by residential real estate in the retail exposure class, and/or for exposures to PSEs,1 where this was requested by the firm. Where this occurred, it would be specified in the firm's IRB permission.

The FCA expects that a credit obligation be considered as a distressed restructuring if an independent third party, with expertise in the relevant area, would not be prepared to provide financing on substantially the same terms and conditions (see article 178(2)(d) of the UK CRR2).

To be satisfied that a firm complies with the documentation requirements in article 175(3) of the UK CRR2, the FCA expects a firm should have a clear and documented policy for determining whether an exposure that has been in default should subsequently be returned to performing status (see article 175(3) of the UK CRR2).

'Rating philosophy' describes the point at which a rating system sits on the spectrum between the stylised extremes of a point in time (PiT) rating system and a through-the-cycle (TTC) rating system. To explain these concepts:

1. (1)

   PiT: a firm seeks to explicitly estimate default risk over a fixed period, typically one year. Under such an approach, the increase in default risk in a downturn results in a general tendency for migration to lower grades. When combined with the fixed estimate of the long-run default rate for the grade, the result is a higher own funds requirement. Where data are sufficient, grade level default rates tend to be stable and relatively close to the PD estimates; and

2. (2)

   TTC: a firm seeks to remove cyclical volatility from the estimation of default risk, by assessing borrowers' performance across the economic cycle. TTC ratings do not react to changes in the cycle, so there is no consequent volatility in capital requirements. Actual default rates in each grade diverge from the PD estimate for the grade, with actual default rates relatively higher at weak points in the cycle and relatively lower at strong points.

Most rating systems sit between these two extremes. Rating philosophy is determined by the cyclicality of the drivers/criteria used in the rating assessment and should not be confused with the requirement for grade level PDs to be "long run". The calibration of even the most PiT rating system needs to be targeted at the long run default rates for its grades; the use of long run default rates does not convert such a system into one producing TTC ratings or PDs

A firm should understand where its rating systems lie on the PiT/TTC spectrum to enable it to estimate how changes in economic conditions will affect its IRB own funds requirements and it should be able to compare the actual default rates incurred against the default rate expected over the same period given the economic conditions pertaining, as implied by its PD estimate.

The term "variable scalar" is used to describe approaches in which the outputs of an underlying, relatively PiT, rating system are transformed to produce final PD estimates used for regulatory capital requirements that are relatively non-cyclical. Typically, this involves basing the resulting requirement on the long run default rate of the portfolio or its segments.

Article 169(3) of the UK CRR1 allows the use of direct estimates of PDs, although such a measure could be assessed over a variety of different time horizons which the EU CRR does not specify. Accordingly, the FCA considers that it acceptable in principle to use methodologies of this type in lieu of estimation of long-run averages for the grade/pool/score of the underlying rating system, where the following conditions are met. Meeting these conditions requires a firm using the variable scalar approach to have a deep understanding of how and why its default rates vary over time:

1. (1)

   a firm meets the following four principles which address the considerable conceptual and technical challenges to be overcome in order to carry out variable scalar adjustments in an appropriate way:

   Principle 1: both the initial calculations of, and subsequent changes to, the scalar must be able to take account of changes in default risk that are not purely related to the changes in the cycle;

   Principle 2: a firm must be able accurately to measure the long-run default risk of its portfolio; this must include an assumption that there are no changes in the business written;

   Principle 3: a firm must use a data series of appropriate length in order to provide a reasonable estimate of the long-run default rate in IFPRU 4.4.13 G (Calculation of long averages PD, LGD and EAD); and

   Principle 4: a firm must be able to demonstrate the appropriateness of the scaling factor being used across a portfolio;

2. (2)

   stress testing includes a stress test covering the downturn scenario outlined in IFPRU 2.2 (Internal capital adequacy assessment process)] based on the PDs of the underlying PiT rating system, in addition to the stress test based on the parameters used in the Pillar 1 own funds requirements calculation (ie, the portfolio level average long-run default rates); and

3. (3)

   a firm is able to understand and articulate upfront how the scaling factor would vary over time in order to achieve the intended effect.

The FCA will not permit a firm using a variable scalar approach to revert to using a PiT approach during more benign economic conditions.

Principle 1 (in IFPRU 4.6.5 G) is the most important and challenging to achieve as it requires an ability to be able to distinguish movements not related to the economic cycle, from changes purely related to the economic cycle, and not to average these away. This is because a variable scalar approach removes the ability of a rating system to take account automatically of changes in risk through migration between its grades.

Accordingly, the FCA expects a firm using a variable scalar approach should adopt a PD that is the long-run default rate expected over a representative mix of good and bad economic periods, assuming that the current lending conditions including borrower mix and attitudes and the firm's lending policies remain unchanged. If the relevant lending conditions or policies change, then the FCA would expect the long-run default rate to change (see article 180(1)(a), (b) and (2)(a) of the UK CRR1).

The FCA considers that, until more promising account level arrears data is collected, enabling firms to better explain the movement in their arrears rate over time, the likelihood of firms being able to develop a compliant variable scalar approach for non-mortgage retail portfolios is low. This is because of the difficulty that firms have in distinguishing between movements in default rates that result from cyclical factors and those that result from non-cyclical reasons for these portfolios. In practice, the rest of this section applies to residential mortgage portfolios.

For the purposes of this subsection 'non-mortgage retail portfolios' refers to non-mortgage lending to individuals (eg, credit cards, unsecured personal loans, auto-finance) but does not include portfolio of exposures to small and medium-sized entities (SMEs in the retail exposure class).

The FCA considers that one variable scalar approach, potentially compliant with the four principles in IFPRU 4.6.5 G, could involve:

1. (1)

   segmenting a portfolio by its underlying drivers of default risk; and

2. (2)

   estimating separate long-run default rates for each of these segmented pools.

A firm that applied the segmentation approach properly could satisfy both Principle 1 and Principle 4 (IFPRU 4.6.5 G). The choice of the basis of segmentation and the calibration of the estimated long-run default rate for the segments would both be of critical importance.

Segmentation should be done on the basis of the main drivers of both willingness and ability to pay. In the context of residential mortgages, an example of the former is the amount of equity in the property and an example of the latter is the ratio of debt to income. The FCA expects a firm to:

1. (1)

   incorporate an appropriate number of drivers of risk within the segmentation to maximise the accuracy of the system;

2. (2)

   provide detailed explanations supporting its choices of drivers, including an explanation of the drivers it has considered and chosen not to use; and

3. (3)

   ensure that the drivers reflect its risk processes and lending policy, and is therefore not chosen using only statistical criteria (ie a judgemental assessment of the drivers chosen must be applied).

   [Note: article 179(1)(d) of the UK CRR1]

To the extent that the basis of segmentation is not sufficient completely to explain movements in non-cyclical default risk, the long-run default rate for that segment will not be stable (eg, a change in the mix of the portfolio within the segment could change the long-run default rate). In such cases, the FCA would expect a firm to make a conservative compensating adjustment to the calibration of the long-run average PD for the affected segments and be able to demonstrate that the amount of judgement required to make such adjustments is not excessive. Where judgement is used, considerable conservatism may be required. The FCA expects conservatism applied for this reason not to be removed as the cycle changes.

The FCA expects a firm to review and amend as necessary the long run default rate to be applied to each segment on a regular (at least an annual) basis. When reviewing the long run default rate to be applied to each segment, the FCA expects a firm to consider the extent to which:

1. (1)

   realised default rates are changing due to cyclical factors and the scaling factors needs to be changed;

2. (2)

   new information suggests that both the PiT PDs and the long run PDs should be changed; and

3. (3)

   new information suggests that the basis of segmentation should be amended.

The FCA expects that, over time, the actual default rates incurred in each segment would form the basis of PD estimates for the segments. However, at the outset, the key calibration issue is likely to be the setting of the initial long-run default rate for each segment, as this will underpin the PD of the entire portfolio for some years to come. A firm should apply conservatism in this area and this is something on which the FCA is likely to focus on in model reviews.

A firm should put in place a governance process to provide a judgemental overlay to assess its choices of segments, PD estimates and scalars, both initially and on a continuing basis. Moreover, where the basis of its estimation is a formulaic approach, the FCA considers that the act of either accepting or adjusting the estimate suggested by the formula would represent the exercise of judgement.

A firm should consider what use it can make of industry information. However, the firm should be seeking to measure the absolute level of, and changes to, its own default risk, rather than changes in default risk relative to the industry. Given the potential for conditions to change across in the market as a whole, a firm should not draw undue comfort from the observation that its default risk is changing in the same way as the industry as a whole. Doing so would not allow it to meet Principle 1 in IFPRU 4.6.5 G.

The FCA expects a firm to consider the following issues when seeking to apply a variable scalar approach for UK mortgages:

1. (1)

   in respect of Principle 2 (IFPRU 4.6.5 G), the commonly used Council for Mortgage Lenders database was based on arrears data and not defaults during a period, and the use of these data without further analysis and adjustment can undermine the accuracy of any calculations; and

2. (2)

   in respect of Principle 3 (IFPRU 4.6.5 G), the historical data time period chosen for use in the calculations will vary the long-run PDs, and thus own funds requirements, when there is no change in the underlying risk.

The FCA expects a firm that is including mortgage arrears data as a proxy for default data to:

1. (1)

   carry out sensitivity analysis identifying the circumstances in which the assumption that arrears may be used as a proxy for default would produce inaccuracy in long-run PD estimates;

2. (2)

   set a standard for what might constitute a potentially significant level of inaccuracy, and demonstrate why, in practice, the use of this proxy would not result in any significant inaccuracy;

3. (3)

   establish a process for assessing the ongoing potential for inaccuracy, including thresholds beyond which the level of inaccuracy may no longer be insignificant; and

4. (4)

   consider the use of conservative adjustments to address the potential inaccuracy.

When using historical mortgage data as a key input into variable scalar models, the FCA expects a firm to:

1. (1)

   carry out sensitivity analysis identifying the implications of using different cut-off dates for the start of the reference data set; and

2. (2)

   justify the appropriateness of its choice of cut-off date.

Where a firm has not chosen to apply the definition of default at the level of an individual credit facility in accordance with article 178(1) of the UK CRR1, the FCA expects it to ensure that the PD associated with unsecured exposures is not understated as a result of the presence of any collateralised exposures.

The FCA expects the PD of a residential mortgage would typically be lower than the PD of an unsecured loan to the same borrower (see article 178(1) of the UK CRR1).

Where a firm chooses to apply the definition of default at the level of an individual credit facility, in accordance with article 178(1) of the UK CRR1, and a customer has defaulted on a facility, then default on that facility is likely to influence the PD assigned to that customer on other facilities. The FCA expects a firm to take this into account in its estimates of PD (see article 178(1) of the UK CRR1).

To ensure that a rating system provides a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk, the FCA expects a firm to develop country-specific mid-market PD models. Where a firm develops multi-country mid-market PD models, the FCA expects the firm to be able to demonstrate that the model rank orders risk and predicts default rates for each country where it is to be used for own funds requirements calculation.

The FCA expects a firm to have challenging standards in place to meaningfully assess whether a model rank orders risk and accurately predict default rates. These standards should specify the number of defaults that are needed for a meaningful assessment to be done.

The FCA expects a firm to assess the model's ability to predict default rates using a time series of data (ie, not only based on one year of default data).

In the FCA's view, a model is not likely to be compliant where the firm cannot demonstrate that it rank orders risk and predicts default rates for each country, regardless of any apparent conservatism in the model.

The FCA expects a firm using a rating agency grades as the primary driver in its IRB models to be able to demonstrate (and document) compliance with the following criteria:

1. (1)

   the firm has its own internal rating scale;

2. (2)

   the firm has a system and processes in place that allow it to continuously collect and analyse all relevant information, and the 'other relevant information' considered by the firm in accordance with article 171(2) of the UK CRR1 reflects the information collected and analysed by the firm when extending credit to new or existing obligors;

3. (3)

   the 'other relevant information' considered by the firm is included in an IRB model in a transparent and objective way and is subject to challenge. The FCA expects the firm to be able to demonstrate what information was used and why, how it was included and, if no additional information is included, to be able to document what information was discarded and why;

4. (4)

   the development of final grades includes the following steps:

   1. (a)

      the firm takes into account all available information (eg,external agency grades and any 'other relevant information') prior to allocating obligors to internal grades and does not automatically assign obligors to grades based on the rating agency grade;

   2. (b)

      any overrides are applied to these grades; and

   3. (c)

      the firm has a system and processes in place that allows it to continuously collect and analyse final rating overrides;

5. (5)

   the grades to which obligors are assigned is reassessed at least annually. The firm is able to demonstrate how the grades are reassessed on a more frequent than annual basis when new relevant information becomes available;

6. (6)

   the firm can demonstrate that a modelling approach is being applied, both in terms of the choice of the rating agency grade as the primary driver and, where information is found materially and consistently to add to the internal rating grade, that they have incorporated this information as an additional driver. The FCA expects this work to be analytical (rather than entirely subjective) and could form part of the annual independent review of the model.

In the FCA's view, if a firm does not have any additional information to add to the external ratings for the significant part of its portfolio then it will not be meeting the requirements for using an IRB approach.

The FCA expects a firm to estimate PD for a rating system in line with this section where the firm's internal experience of defaults for that rating system was 20 defaults or fewer, and reliable estimates of PD cannot be derived from external sources of default data, including the use of market price-related data. In PD estimation for all exposures covered by the rating system, the FCA expects the firm to:

1. (1)

   use a statistical technique to derive the distribution of defaults implied by the firm's experience, estimating PDs (the "statistical PD") from the upper bound of a confidence interval set by the firm to produce conservative estimates of PDs in accordance with article 179(f) of the UK CRR1;

2. (2)

   use a statistical techniques to derive the distribution of default which takes account, as a minimum, of the following modelling issues:

   1. (a)

      the number of defaults and number of obligor years in the sample;

   2. (b)

      the number of years from which the sample was drawn;

   3. (c)

      the interdependence between default events for individual obligors;

   4. (d)

      the interdependence between default rates for different years; and

   5. (e)

      the choice of the statistical estimators and the associated distributions and confidence intervals;

3. (3)

   further adjust the statistical PD to the extent necessary to take account of the following:

   1. (a)

      any likely differences between the observed default rates over the period covered by the firm's default experience and the long-run PD for each grade required by article 180(1)(a) and (2)(a) of the UK CRR1; and

   2. (b)

      any other information that indicates (taking into account the robustness and cogency of that information) that the statistical PD is likely to be an inaccurate estimate of PD.

The FCA expects a firm to take into account only defaults that occurred during periods that are relevant to the validation under the UK CRR1 of the model or other rating system in question when determining whether there are 20 defaults or fewer.

The FCA expects a firm to assign exposures to the risk weight category for specialised lending exposures based on the criteria set out in the tables in IFPRU 4 Annex 1G(Slotting criteria).

The FCA expects a firm to ensure that no LGD estimate is less than zero.

The FCA does not expect a firm to be using zero LGD estimates in cases other than where it had cash collateral supporting the exposures.

The FCA expects a firm to justify any low LGD estimates using analysis on volatility of sources of recovery, notably on collateral, and cures (see IFPRU 4.7.5 G). This includes:

1. (1)

   recognising that the impact of collateral volatility on low LGDs is asymmetric, as surpluses over amounts owed need to be returned to borrowers and that this effect may be more pronounced when estimating downturn, rather than normal period LGDs; and

2. (2)

   recognising the costs and discount rate associated with realisations and the requirements of article 181(1)(e) of the UK CRR2.

To ensure that the impact of collateral volatility is taken into account, the FCA expects a firm's LGD framework to include non-zero LGD floors which are not solely related to administration costs (see article 179(1)(f) of the UK CRR2).

Where a firm wishes to include cures in its LGD estimates, the FCA expects it to do this on a cautious basis, with reference to both its current experience and how this is expected to change in downturn conditions. In particular, this involves being able to articulate clearly both the precise course of events that will allow such cures to take place and any consequences of such actions for other elements of its risk quantification. For example:

1. (1)

   where cures are driven by the firm's own policies, the FCA expects the firm to consider whether this is likely to result in longer realisation periods and larger forced sale discounts for those exposures that do not cure, and higher default rates on the book as a whole, relative to those that might be expected to result from a less accommodating attitude. To the extent feasible, the FCA expects cure assumptions in a downturn to be supported by relevant historical data;

2. (2)

   the FCA expects a firm to be aware of, and properly account for, the link between cures and subsequent defaults. In particular, an earlier cure definition is, other things being equal, likely to result in a higher level of subsequent defaults.

   [Note: article 5(2) of the UK CRR2]

To ensure that estimates of LGDs take into account the most up-to-date experience, the FCA expects a firm to take account of data for relevant incomplete workouts (ie, defaulted exposures for which the recovery process is still in progress, with the result that the final realised losses in respect of those exposures are not yet certain) (see article 179(1)(c) of the UK CRR2).

To ensure that sovereign LGD models are sufficiently conservative in view of the estimation error that may arise from the lack of data on losses to sovereigns, the FCA expects a firm to apply a 45% LGD floor to each unsecured exposure in the sovereign asset class (see article 179(1)(a) of the UK CRR2).

The FCA believes that an average reduction in property sales prices of 40% from their peak price, prior to the market downturn, forms an appropriate reference point when assessing downturn LGD for UK mortgage portfolios. This reduction captures both a fall in the value of the property due to house price deflation, as well as a distressed forced sale discount.

Where a firm adjusts assumed house price values within its LGD models to take account of current market conditions (for example, appropriate house price indices), the FCA recognises that realised falls in market values may be captured automatically. A firm adopting such approaches may remove observed house price falls from its downturn house price adjustment so as not to double count. A firm wishing to apply such an approach must seek the consent of the FCA and be able to demonstrate that the following criteria are met:

1. (1)

   the adjustment applied to the market value decline element of a firm's LGD model is explicitly derived from the decrease in indexed property prices (ie, the process is formulaic, not judgemental);

2. (2)

   the output from the adjusted model has been assessed against the 40% peak-to-trough property sales prices decrease reference point (after inclusion of a forced sale discount);

3. (3)

   a minimum 5% market value decline applies at all times in the LGD model; and

4. (4)

   the firm has set a level for reassessment of the property market price decline from its peak. For example, if a firm had initially assumed a peak-to-trough market decline of 15%, then it will have set a level of market value decline where this assumption will be reassessed (see article 181(1)(b) of the UK CRR2).

To ensure that its LGD estimates are oriented towards downturn conditions, the FCA expects a firm to have a process through which it:

1. (1)

   identifies appropriate downturn conditions for each IRB exposure class within each jurisdiction;

2. (2)

   identifies adverse dependencies, if any, between default rates and recovery rates; and

3. (3)

   incorporates adverse dependencies, if identified, between default rates and recovery rates in the firm's estimates of LGD in a manner that meets the requirements relating to an economic downturn (see article 181(1)(b) of the UK CRR2).

To ensure that its LGD estimates incorporate material discount effects, the FCA expects a firm's methods for discounting cash flows to take account of the uncertainties associated with the receipt of recoveries for a defaulted exposure. For example, by adjusting cash flows to certainty-equivalents or by using a discount rate that embodies an appropriate risk premium; or by a combination of the two.

If a firm intends to use a discount rate that does not take full account of the uncertainty in recoveries, the FCA expects it to be able to explain how it has otherwise taken into account that uncertainty for the purposes of calculating LGDs. This can be addressed by adjusting cash flows to certainty-equivalents or by using a discount rate that embodies an appropriate risk premium for defaulted assets, or by a combination of the two (see article 5(2) of the UK CRR2).

The FCA expects a firm using advanced IRB approaches to have done the following in respect of wholesale LGD estimates:

1. (1)

   applied LGD estimates at transaction level;

2. (2)

   ensured that all LGD estimates (both downturn and non-downturn) are cautious, conservative and justifiable, given the paucity of observations. Under article 179(1)(a) of the UK CRR2, estimates must be derived using both historical experience and empirical evidence, and not be based purely on judgemental consideration. The FCA expects the justification as to why the firm thinks the estimates are conservative to be documented;

3. (3)

   identified and explained at a granular level how each estimate has been derived. This should include an explanation of how internal data, external data, expert judgement or a combination of these has been used to produce the estimate;

4. (4)

   clearly documented the process for determining and reviewing estimates, and the parties involved in this process in cases where expert judgement has been used;

5. (5)

   demonstrated an understanding of the impact of the economic cycle on collateral values and be able to use that understanding in deriving their downturn LGD estimates;

6. (6)

   demonstrated sufficient understanding of any external benchmarks used and identified the extent of their relevance and suitability to the extent that the firm can satisfy itself that they are fit for purpose;

7. (7)

   evidenced that it is aware of any weaknesses in its estimation process and have set standards, for example related to accuracy, that their estimates are designed to meet;

8. (8)

   demonstrated that it has sought and utilised relevant and appropriate external data, including through identifying all relevant drivers of LGD and how these will be affected by a downturn;

9. (9)

   ensured, in most cases, estimates incorporate effective discrimination on the basis of at least security-type and geography. In cases where these drivers are not incorporated into LGD estimates, the FCA expects the firm to be able to demonstrate why they are not relevant;

10. (10)

    have an ongoing data collection framework to collect all relevant internal loss and exposure data required for estimating LGD and a framework to start using these data as soon as any meaningful information becomes available;

11. (11)

    ensure it can articulate the data the firm intends to use from any industry-wide data collection exercises that it is participating in, and how the data will be used.

The FCA uses a framework for assessing the conservatism of a firm's wholesale LGD models for which there are a low number of defaults. This framework is set out in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework) and does not apply to sovereign LGD estimates which are floored at 45%. This framework is also in the process of being used to assess the calibration of a firm's material LGD-models for low-default portfolios.

In the following cases, the FCA expects a firm to determine the effect of applying the framework in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework) to models which include LGD values that are based on fewer than 20 'relevant' data points (as defined in IFPRU 4 Annex 2G):

1. (1)

   the model is identified for review by the FCA; or

2. (2)

   the firm submits a request for approval for a material change to its LGD model.

The FCA considers that both of the following approaches in relation to calculating unexpected loss of defaulted assets are acceptable in principle:

1. (1)

   the independent calculation approach; and

   1
2. (2)

   subtraction of the best estimate of expected loss from post-default LGD.

Where an independent calculation approach is adopted for the calculation of unexpected loss on defaulted assets, the FCA expects a firm to ensure that estimates are at least equal, at a portfolio level, to a 100% risk weight, ie,1 8% capital requirement on the amount outstanding net of provisions (see article 181(1)(h) of the UK CRR2).

The extent to which a borrower's assets are already given as collateral will clearly affect the recoveries available to unsecured creditors. If the degree to which assets are pledged is substantial, this will be a material driver of LGDs on such exposures. Although potentially present in all transactions, the FCA expects a firm to be particularly aware of this driver in situations in which borrowing on a secured basis is the normal form of financing, leaving relatively few assets available for the unsecured debt. Specialist lending (including property), hedge fund, and some SME/mid-market lending can be considered such cases.

The FCA expects a firm to take into account the effect of assets being substantially used as collateral for other obligations estimating LGDs for borrowers for which this is the case. The FCA expects a firm not to use unadjusted data sets that ignore this impact, and note that it is an estimate for downturn conditions that is normally required. In the absence of relevant data to estimate this effect, conservative LGDs potentially of 100% are expected to be used (see articles 171(2) and 179(1)(a) of the UK CRR2).

The FCA considers that a firm may provide own estimates of exposure at default (EAD) in place of the own estimates of conversion factors (CFs) that it is permitted or required to provide under article 151 of the UK CRR2.

For the purpose of this section, references to EAD refer to both direct estimates of EAD and CFs, unless specified otherwise (see article 151 of the UK CRR2).

The FCA expects that EAD estimates should not be less than current drawings (including interest accrued to date). Consequently, CF estimates should not be less than zero.

The EAD required for IRB purposes is the exposure expected to be outstanding under a borrower's current facilities should it go into default in the next year, assuming that economic downturn conditions occur in the next year and a firm's policies and practices for controlling exposures remain unchanged other than changes that result for the economic downturn conditions.

To achieve sufficient coverage of the EAD, the FCA expects firms to take into account all facility types that may result in an exposure when an obligor defaults, including uncommitted facilities.

To the extent that a firm makes available multiple facilities, the FCA expects the firm to be able to demonstrate:

1. (1)

   how they deal with the fact that exposures on one facility may become exposures under another on which the losses are ultimately incurred; and

2. (2)

   the impact of its approach on its own funds requirements.

The FCA expects firms using own estimates of EAD to have done the following in respect of EAD estimates:

1. (1)

   applied EAD estimates at the level of the individual facility;

2. (2)

   where there is a paucity of observations, ensured that all EAD estimates are cautious, conservative and justifiable. In accordance with article 179(1)(a) of the UK CRR2, estimates must be derived using both historical experience and empirical evidence, and must not be based purely on judgemental consideration. The FCA expects the justification as to why the firm thinks the estimates are conservative to be documented;

3. (3)

   identified and explained at a granular level how each estimate has been derived. This should include an explanation of how internal data, any external data, expert judgement or a combination of these has been used to produce the estimate;

4. (4)

   ensured that where expert judgement has been used there is clear communication of the process for arriving at and reviewing the estimates, and identifying the parties involved;

5. (5)

   demonstrated an understanding of the impact of the economic cycle on exposure values and be able to use that understanding in deriving downturn EAD estimates;

6. (6)

   demonstrated sufficient understanding of any external benchmarks used and identified the extent of their relevance and suitability to the extent that the firm can satisfy itself that they are fit for purpose;

7. (7)

   evidenced that they are aware of any weaknesses in their estimation process and have set standards that their estimates are designed to meet (eg, related to accuracy);

8. (8)

   ensured, in most cases, that estimates incorporate effective discrimination on the basis of at least product features and customer type. In cases where these drivers are not incorporated into EAD estimates, the FCA expects the firm to be able to demonstrate why they are not relevant;

9. (9)

   have an ongoing data collection framework to collect all relevant internal exposure data required for estimating EAD and a framework to start using this data as soon as any meaningful information becomes available;

10. (10)

    made use of the data they are collecting to identify all relevant drivers of EAD and to understand how these drivers will be affected by a downturn; and

11. (11)

    identified dependencies between default rates and conversion factors for various products and markets when estimating downturn EADs. Firms are expected to consider how they expect their own policies regarding exposure management to evolve in a downturn.

The FCA uses a framework for assessing the conservatism of firms' wholesale EAD models for which there are a low number of defaults. This framework is set out in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework). This framework is in the process of being used to assess the calibration of firms' material EAD models for low-default portfolios.

In the following cases, the FCA expects firms to determine the effect of applying the framework in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework) to models which include EAD values that are based on fewer than 20 'relevant' data points (as defined in IFPRU 4 Annex 2G):

1. (1)

   the model is identified for review by the FCA; or

2. (2)

   the firm submits a request for approval for a material change to its EAD model.

The FCA expects firms to use a time horizon of one year for EAD estimates, unless they can demonstrate that another period would be more conservative.

EAD estimates can be undertaken on the basis that default occurs at any time during the time horizon (the 'cohort approach') or at the end of the time horizon (the 'fixed-horizon approach'). The FCA considers that either approach is acceptable in principle.

The FCA expects the time horizon for additional drawings to be the same as the time horizon for defaults. This means that EAD estimation need cover only additional drawings that might take place in the next year, such that:

1. (1)

   no own funds requirements need be held against facilities, or proportions of facilities that cannot be drawn down within the next year; and

2. (2)

   where facilities can be drawn down within the next year, firms may, in principle, reduce their estimates to the extent that they can demonstrate that they are able and willing, based on a combination of empirical evidence, current policies, and documentary protection to prevent further drawings (see article 182 of the UK CRR2).

There are a range of approaches that focus on the total amount that will be drawn down at the time of default and directly estimate EAD. Typically, but not in all cases, these will estimate EAD as a percentage of total limit. These approaches can be described collectively as 'momentum' approaches.

A 'momentum' approach can be used either:

1. (1)

   by using the drawings/limit percentage to formulaically derive a conversion factor on the undrawn portion of the limit; or

2. (2)

   by using the higher of percentage of the limit and the current balance as the EAD.

The FCA considers that the use of momentum approaches in both of the ways outlined above is acceptable in principle as an alternative to direct estimation of conversion factors (see article 4(56) of the UK CRR2).

In cases where firms estimate conversion factors (CFs) directly using a reference data set that includes a significant number of high CFs as a result of very low undrawn limits at the observation date, the FCA expects firms to:

1. (1)

   investigate the distribution of realised CFs in the reference data set;

2. (2)

   base the estimated CF on an appropriate point along that distribution, that results in the choice of a CF appropriate for the exposures to which it is being applied and consistent with the requirement in article 179 of the UK CRR2 for estimates to include a margin of conservatism related to errors; and

3. (3)

   be cognisant that, while the median of the distribution might be a starting point, they should not assume without analysis that the median represents a reasonable unbiased estimate. The FCA expects firms to consider whether the pattern of distribution in realised CFs means that some further segmentation is needed (eg, treating facilities that are close to full utilisations differently) (see article 182(1)(a) of the UK CRR2).

The FCA expects firms to treat a facility as an exposure from the earliest date at which a customer is able to make drawings under it.

Where the facility is of the type that it is customary not to advise the borrower of its availability, the FCA expects an EAD/CF to be applied from the time that the existence of the facility is recorded on the firm's systems in a way that would allow the borrower to make a drawing.

If the availability of a facility is subject to a further credit assessment by the firm, an EAD/CF may not be required. However, the FCA expects this to be the case only if the subsequent credit assessment was of substantially equivalent rigour to that of the initial credit approval and if this includes a re-rating or a confirmation of the rating of the borrower.

Firms are not expected to include in their EAD/CF estimates the probability of increases in limits between observation and default date. If the reference data set includes the impact of such increases, the FCA expects firms to be able to adjust their estimates accordingly with the aim of assessing what the exposure would have been at default if the limit had not been increased.

The FCA expects firms to investigate the incidence of exposures existing at default that arise from products or relationships that are not intended to result in a credit exposure and, consequently, have no credit limit established against them and are not reflected in their estimates of EAD. Unless such exposures are immaterial, the FCA expects firms to estimate a Pillar 1 own funds requirement on a portfolio basis to such exposures.

The FCA expects firms to investigate how their EAD estimates are impacted by exposures that are in excess of limits at either the observation date (if in the reference data set) or at the current reporting date (for the existing book to which estimates need to be applied). Unless a momentum approach is being used, exposures in excess of limit should be excluded from the reference data set (as the undrawn limit is negative and nonsensical answers would result from their inclusion). The FCA expects firms to ensure that their EAD estimation includes the risk of further drawings on accounts that are in excess of their limits (see article 4(56) of the UK CRR2).

Exposures include not only principal amounts borrowed under facilities but also interest accrued which will fluctuate between payment dates. To ensure proper coverage of interest, the FCA expects firms to take the following approach:

1. (1)

   accrued interest to date should be included in current exposure for performing exposures;

2. (2)

   firms may choose whether estimated increases in accrued interest up to the time of default should be included in LGD or EAD;

3. (3)

   in the estimation of EAD, increases in accrued interest may be offset against reductions in other outstandings;

4. (4)

   estimation of changes in accrued interest needs to take account of changes in the contractual interest rate over the time horizon up to default and in a way consistent with the scenario envisaged in the calculation of the downturn/default weighted average;

5. (5)

   inclusion of estimates of future post-default interest is not necessary in either EAD or LGD; and

6. (6)

   firms' accounting policies will determine the extent to which interest accrued to date is reflected in current exposure as opposed to LGD for defaulted exposures (see article 166(1) of the UK CRR2).

The FCA considers that there is scope within the UK CRR2 for a firm to recognise on-balance sheet netting (including in respect of cross-currency balances) through EAD as an alternative to LGD1 in cases where a firm meets the general conditions for on-balance1 sheet netting, as set out in article 205 of1 the UK CRR2.

For the CF on undrawn limits, this may be applied on the basis of the net limit, provided the conditions in the UK CRR2 for the use of net limits are met. However, firms are reminded that the purpose of the measure is to estimate the amount that would be outstanding in the event of a default. This implies that their ability, in practice, to constrain the drawdown of credit balances will be particularly tested. Moreover, the FCA expects the appropriate conversion factor to be higher as a percentage of a net limit than of a gross limit.

The lower the net limit as a percentage of gross limits or exposures, the greater will be the need on the part of the firm to ensure that it is restricting exposures below net limits in practice and that it will be able to continue to do so should borrowers encounter difficulties. The application of a zero net limit is acceptable in principle but there is, consequently, a very high obligation on the firm to ensure that breaches of this are not tolerated (see article 166(3) of the UK CRR2).

Estimation of CFs on underwritten facilities in the course of primary market syndication may take account of anticipated sell down to other parties.

Firms are reminded that, since the basis of EAD estimation is that default by the borrower is expected to take place in a one-year time horizon and quite possibly in downturn conditions, the FCA expects any reduction in their CF in anticipation of syndication to take account of this scenario (see article 4(56) of the UK CRR2).

To be satisfied that the credit risk stress test undertaken by a firm under article 177(2) of the UK CRR1 is meaningful and considers the effects of severe, but plausible, recession scenarios, the FCA would expect the stress test to be based on an economic cycle that is consistent with IFPRU 2.2.73G(1)(b) (see article 177(2) of the UK CRR1)

The FCA expects a firm to have a validation process that includes the following:

1. (1)

   standards of objectivity, accuracy, stability and conservatism that it designs its ratings systems to meet and processes that establish whether its rating systems meet those standards;

2. (2)

   standards of accuracy of calibration (ie, whether outcomes are consistent with estimates) and discriminative power (ie, the ability to rank-order risk) that it designs its rating systems to meet and processes that establish whether its rating systems meet those standards;

3. (3)

   policies and standards that specify the actions to be taken when a rating system fails to meet its specified standards of accuracy and discriminative power;

4. (4)

   a mix of developmental evidence, benchmarking and process verification and policies on how this mixture varies between different rating systems;

5. (5)

   use of both quantitative and qualitative techniques;

6. (6)

   policies on how validation procedures are expected to vary over time; and

7. (7)

   ensuring independent input into, and review of, its rating systems (see article 188 of the UK CRR2).

In IFPRU 4.10.1 G:

1. (1)

   developmental evidence means evidence that substantiates whether the logic and quality of a rating system (including the quantification process) adequately discriminates between different levels of, and delivers accurate estimates of, PD, EL, LGD and conversion factors (as applicable); and

2. (2)

   process verification means the process of establishing whether the methods used in a rating system to discriminate between different levels of risk and to quantify PD, EL, LGD and conversion factors are being used, monitored and updated in the way intended in the design of the rating system (see article 188 of the UK CRR2).

The FCA expects a firm to be able to explain the performance of its rating systems against its chosen measure (or measures) of discriminative power. In making this comparison, a firm should rely primarily on actual historic default experience where this is available. In particular, the FCA expects a firm to be able to explain the extent of any potential inaccuracy in these measures, caused, in particular, by small sample size and the potential for divergence in the future, whether caused by changing economic conditions or other factors. Firms' assessment of discriminative power should include appropriate use of external benchmarks where available.

The FCA will take into consideration the sophistication of the measure of discrimination chosen when assessing the adequacy of a rating system's performance.

In the case of a portfolio for which there is insufficient default experience to provide any confidence in statistical measures of discriminative power, the FCA expects a firm to use other methods. For example, analysis of whether the firm's rating systems and an external measurement approach (eg, external ratings) rank common obligors in broadly similar ways. Where such an approach is used, the FCA would expect a firm to ensure it does not systematically adjust its individual ratings with the objective of making them closer to the external ratings as this would be counter to the philosophy of an internal rating approach.1 The FCA expects a firm to be able to explain the methodology it uses and the rationale for its use.

The FCA considers that income-producing real estate (IPRE) is a particularly difficult asset class for which to build effective rating systems that are compliant with the requirements of the internal ratings based (IRB) approach.

As with all asset classes, firms should assess whether their IPRE model is UK CRR2 compliant and not whether it is the nearest they can get to compliance given the constraints imposed on their model development (eg, lack of data or resource constraints).

Where material non-compliance is identified and cannot be remediated in a timely fashion, firms should adopt a compliant approach for calculating own funds requirements. In most cases, this is likely to be the slotting approach (see article 144(1) of the UK CRR2).

Firms should be able to demonstrate that the model drivers selected offer sufficient discriminatory power and to justify why other potential data sources are not expected to materially improve the discriminatory power and accuracy of estimates.

The FCA expects that an IPRE rating system will only be compliant if a firm is able to demonstrate the following in respect of its treatment of cash flows (except where the firm can demonstrate that this is not an appropriate risk driver):

1. (1)

   the difference in deal ratings when tenant ratings are altered is intuitive;

2. (2)

   the transformation of ratings into non-rent payment probability is intuitive. Even where tenants are rated by the firm the PD will not usually represent a direct read across to probability of non-payment due to, for example, model philosophy issues. Addressing this is likely to be a key area since many firms struggle with defining what divergence is expected between observed default rate and PD in different economic conditions in the mid corporate space;

3. (3)

   the selection of parameter values and/or distributions, and their impact on deal ratings, is well supported and intuitive;

4. (4)

   the impact on the deal rating is intuitive for such features as type of building, geographical location and building quality; and

5. (5)

   where data are missing or unavailable the treatment is conservative.

The FCA expects that an IPRE rating system will only be compliant if a firm is able to demonstrate the following in respect of its treatment of interest-rate risk (IRR):

1. (1)

   IRR is included as a relevant risk driver (unless the portfolio is exclusively hedged);

2. (2)

   the way in which IRR is included in the deal rating is intuitive with respect to model philosophy. For example, a 'point in time' rating should consider the current interest rate and likely change over a one-year time horizon, whereas a 'through-the-cycle' model needs to consider the IRR averaged over an economic cycle; and

3. (3)

   the model rates deals where IRR is hedged by the firm differently from deals where IRR is unhedged and the magnitude of the difference in these ratings is intuitive.

The FCA expects that an IPRE rating system will only be compliant if a firm is able to demonstrate the following in respect of its treatment of refinance risk:

1. (1)

   refinance risk is included as a relevant risk driver (unless the portfolio contains only amortising loans);

2. (2)

   the model rates interest only and amortising deals differently in the final year and that the magnitude of the difference in these ratings is intuitive;

3. (3)

   given the time horizon associated with IRB estimates (ie 12 months), the refinance risk could have a zero weight until the deal enters its final year for point-in-time models. In these cases, the risk should be captured in stress testing and Pillar 2; and

4. (4)

   the firm is able to report by borrowers that have previously had a distressed restructuring unlikeliness to pay indicator (even if they are now performing) by number, EAD and risk weighted exposure amounts.

The FCA expects that firms will not be compliant with the calibration requirements relating to use of a long-run default rate, unless it can demonstrate that:

1. (1)

   the internal data series is the longest relevant and accurate data series, on a UK CRR2 compliant definition of default, that is available;

2. (2)

   the determination of long-run default rate includes reference to an appropriate source of downturn data (this may require the use of external data);

3. (3)

   the relevance of any external data used is analysed, and the relationship between internal default data and the external data used is considered over a multi-year period; and

4. (4)

   where uncertainty is introduced due to, for example, the quality of internal data or shortcomings in the relevance of external data, a conservative adjustment to the estimates should be made.

The FCA expects that a firm will only be compliant with the calibration requirements relating to model philosophy if it can demonstrate that:

1. (1)

   the model philosophy is clearly articulated and justified. Justification should include analysis of the performance of assets, and the corresponding ratings assigned, over a change in economic conditions (ie, as long as period as possible); and

2. (2)

   in addition to encapsulating this information in a coherent way in the calibration, the impact of capturing risks such as IRR and refinance risk is clearly documented.

Where the rating system is classed as a low default portfolio in accordance with the guidance in this section, a firm should be able to demonstrate that the framework applied adequately considers:

1. (1)

   economic environment of data used;

2. (2)

   changes in portfolio composition over time;

3. (3)

   parameter choices; and

4. (4)

   model philosophy.

Under article 144(1) of the UK CRR2, all models, including those constructed from a theoretical basis without reference to any empirical default data (such as Monte-Carlo cash-flow simulation models), must meet the IRB requirements that are set out in Title II Chapter 3 of Part Three of the UK CRR2 (IRB approach).

The FCA considers that, to meet the requirements referred to in IFPRU 4.11.1 G, it will be necessary for firms to demonstrate that a firm has a good understanding of PD models that are constructed theoretically and that the parameter estimates reflect a one-year PD. In addition, even if empirical data were not used to determine the PD estimate it should, where available, be used to back-test the estimates.

The FCA expects that, as most models of this type will be able to produce one-year estimates of PD that correspond closely to point-in-time estimates, firms should conduct robust back-testing of such estimates by comparing them with realised default rates. Firms would need to demonstrate that the results of such back-testing meet pre-defined and stringent standards in order for the FCA to be satisfied that the IRB requirements are met.

Because assumptions in the model build process are likely to materially impact the resulting PDs, the FCA would expect these choices to be clearly justified in the model documentation and to have been independently reviewed. To be satisfied that a firm is complying with article 176(1)(d) of the UK CRR2, the FCA expects a firm to support justification for all assumptions with analysis of the sensitivity of the model outputs to changes in the assumptions.

Where the firm has fewer1than 20 defaults in their internal data set, the FCA expects it to be necessary for firms to perform a statistical low default portfolio calibration, as set out in the guidance in this section.

The FCA expects that a firm will be compliant with the validation requirements only where1it can demonstrate, in respect of discriminatory power, that:

1. (1)

   appropriate minimum standards that the rating system is expected to reach are defined, together with reasoning behind the adoption of such standards and that the factors considered when determining the tests are clearly documented;

2. (2)

   an objective rank-ordering metric, measured using an appropriate time horizon (eg, using ratings one year prior to default) or cohort approach, such as Gini or Accuracy Ratio of 50% is achieved over time;

3. (3)

   where there are sufficient defaults from different time periods the discriminatory power is shown to have reached the appropriate minimum standard over an extended time period (ie, longest period possible, including most recent data); and

4. (4)

   any concentrations in ratings from the model are demonstrated to be appropriate.

The FCA expects that a firm will be compliant with the validation requirements only where1it can demonstrate in respect of the calibration that:

1. (1)

   observed default rate versus PD is considered at grade level and across a range of economic environments (ie, as long as period as possible);

2. (2)

   where the PD does not relate to a pure point-in-time estimate, either the PD or the observed default rate is transformed such that comparison between the two is meaningful. This transformation should be consistent with the model philosophy and calibration technique applied; and

3. (3)

   pre-defined tolerances for the degree of divergence, and the associated actions for what should happen when they are not met, are set.

The FCA also expects that a firm will be compliant with the validation requirements only where1it can demonstrate that:

1. (1)

   appropriate stability metrics should be considered across a range of economic environments (ie, longest period possible including most recent data);

2. (2)

   the tolerances for the degree of divergence, and associated actions for what should happen when they are not met, is pre-defined; and

3. (3)

   subsections of portfolios by characteristics affecting risk profile, and therefore potentially model performance, are investigated. Such subsections could include:

   1. (a)

      loan type (amortising/interest only);

   2. (b)

      degree of hedging;

   3. (c)

      building type; and

   4. (d)

      other factors such as non-SPV (special purpose vehicle) lending in a predominately SPV lending book or vice versa (see article 188 of the UK CRR2).

The FCA expects that a firm will1 be able to comply with certain other UK CRR2 requirements only where it can1demonstrate that:

1. (1)

   in relation to article 144(1)(e) of the UK CRR2, where more than one model is used, the rationale, and the associated boundary issues, is clearly articulated and justified and the criteria for assigning an asset to a rating model are objective and clear;

2. (2)

   in relation to article 173(1)(c) of the UK CRR2, the firm has a process in place to ensure valuations of the property are appropriate and up to date;

3. (3)

   in relation to article 171(2) of the UK CRR2, the firm makes reference to information available from the Investment Property Databank where relevant. Where this data is utilised at a broad level when more granular data is available this is fully justified with appropriate analysis;

4. (4)

   in relation to article 173(1)(b) of the UK CRR2, the rating histories demonstrate that deals are re-rated every time material information becomes available, for example where the deal enters its final year (and refinance risk becomes relevant) or a tenant defaults, is replaced or has their rating changed;

5. (5)

   in relation to article 189(3) of the UK CRR2, management information covering all aspects required by the UK CRR2 is produced and reviewed regularly by senior management and the tolerances for the degree of divergence, and associated actions for what should happen when they are not met, are pre-defined; and

6. (6)

   in relation to article 177(2) of the UK CRR2, the impact on PDs and risk-weighted exposure amounts in a firm's credit risk stress test is consistent with model philosophy (although ratings should be affected by events such as tenant defaults even if they are TTC) and impairment projections are justified with reference to past internal data.

An originator of securitisations is able to use the securitisation risk weights (and not calculate own funds requirements on the assets underlying its securitisation) in either of the following cases:

1. (1)

   the firm transfers significant credit risk associated with the securitisedexposures to third parties; or

2. (2)

   the firm deducts from common equity tier 1 capital or applies a 1250% risk weight to all positions it holds in the securitisation.

The significant risk transfer requirements in articles 2442 (Traditional securitisation) or 2452 (Synthetic securitisation) of the UK CRR3 provide three options for a firm to demonstrate how it transfers significant credit risk for any given transaction:

1. (1)

   the originator does not retain more than 50% of the risk-weighted exposure amounts of mezzanine securitisation positions (as defined in article 242(18) of the UK CRR3), where these are:

   2
   1. (a)

      securitisation positions to which a risk weight lower than 1250% and higher than 25% applies in accordance with Sub-Sections 2 and 3 of Section 3 of Chapter 5 (Securitisation) of the UK CRR3; and

      2
   2. (b)

      subordinated to the senior securitisation position and more senior than the first loss tranche2;

2. (2)

   where there is no mezzanine position, the originator does not hold more than 20% of the exposure values of securitisation positions that are subject to a deduction or 1250% risk weight and where the originator can demonstrate that the exposure value of such securitisation positions exceeds a reasoned estimate of the expected loss on the securitisedexposures by a substantial margin; and

3. (3)

   the competent authority may grant permission to an originator to make its own assessment if it is satisfied that the originator can meet certain requirements.

IFPRU 4.12.1 R requires a firm to notify the FCA of each transaction on which it seeks capital relief under the options in IFPRU 4.12.3 G (1) (option 1) and (2) (option 2).1

Where the FCA considers that the possible reduction in risk-weighted exposure amounts (RWEA) achieved via the securitisation is not justified by a commensurate transfer of credit risk to third parties, significant risk transfer will be considered to not have been achieved. Consequently, a firm will not be able to recognise any reduction in RWEA due to the transaction.

For IFPRU 4.12.3 G (3) (option 3), the1FCA intends to grant permission for an originator to make its own assessment of significant risk transfer only where it is satisfied that:

1. (1)

   in every relevant case, the reduction in own funds requirements achieved would be justified by a commensurate transfer of risk to third parties;

2. (2)

   the firm has adequate internal risk management2 policies and methodologies 2to assess the transfer of risk; and

3. (3)

   such transfer of risk to third parties is also recognised for the purposes of the firm's internal risk management and internal capital allocation.

Where the FCA grants permission for multiple transactions, then that permission is expected to cover a defined scope of potential transactions. The permission is expected to enable a firm (within certain limits) to carry out these transactions without notifying the FCA in each individual instance.

A firm seeking to achieve capital relief by deducting or applying a 1250% risk weight where permitted under articles 244 or 2452 of the UK CRR3 does not need to make the notification in IFPRU 4.12.1 R.1 However, in such cases, a firm should consider whether the characteristics of the transaction are such that the FCA would reasonably expect prior notice of it.

Under IIFPRU 4.12.1 G, within one month of a securitisation transaction closing, a firm must notify the FCA of the transaction if it has relied on options 1 or 2 to achieve significant risk transfer.

Notification under IFPRU 4.12.1 G should include sufficient information to enable the FCA to assess whether the possible reduction in RWEA which would be achieved by the securitisation is justified by a commensurate transfer of credit risk to third parties. The FCA expects this to include the following:

1. (1)

   details of the securitisation positions, including rating, exposure value and RWEA broken down by securitisation positions sold and retained;

2. (2)

   key transaction documentation and any relevant supporting documents (eg, a summary of the transaction);

3. (3)

   details of the governance process for the transaction, including details of any committees involved in approving the transaction;

4. (4)

   a copy of the significant risk transfer policy applied to the transaction, including details of the methodology and any models used to assess risk transfer;

5. (5)

   a statement of how all relevant risks are incorporated into the significant risk transfer assessment and how the full economic substance of the transaction is taken into consideration;

6. (6)

   the significant risk transfer calculation, setting out why the firm believes the capital relief proposed is commensurate with the credit risk transferred to third parties;

7. (7)

   the UK CRR3

8. (7)

   requirements the firm is relying on;

9. (8)

   copies of investor and internal presentations on the transaction;

10. (9)

    the rationale for the transaction;

11. (10)

    details of the underlying assets (including asset class, geography, tenor, rating, spread, collateral, exposure size);

12. (11)

    details of the transaction structure;

13. (12)

    description of the risks being retained;

14. (13)

    details of the cashflow between parties involved in the transaction;

15. (14)

    details of the ratings and pricing of bonds issued in the transaction;

16. (15)

    details of any connected parties involved in the transaction;

17. (16)

    details of any termination options (for example, call options); and

18. (17)

    details of reliance on ECAIs in the significant risk transfer assessment.

The FCA's review will focus on the proportion of credit risk transferred, compared to the proportion by which RWEA are reduced in the transaction. Where the FCA judges that the reduction in RWEA is not justified by a commensurate transfer of credit risk to third parties, it will inform the firm that significant risk transfer has not been achieved by this transaction. Otherwise, the FCA will inform the firm that it does not object to the transaction.

The FCA does not intend to pre-approve transactions. The FCA will provide a view on whether it considers that commensurate risk transfer has been achieved at a point in time, which may be provided after a transaction has closed. The FCA may reassess its judgement of the achievement of commensurate risk transfer if the level of credit risk transfer in a transaction changes materially.

A firm may apply for permissions under articles 2442 (Traditional securitisation) or 2452 (Synthetic securitisation) of the UK CRR3 to consider significant risk transfer to have been achieved without needing to rely on options (1) or (2). The scope of such permission may1be defined to cover a number of transactions or an individual transaction.

Where a firm applies for such permission, the FCA would expect the scope should be defined according to a range of characteristics, including the type of asset class and the structural features of the transaction. The characteristics the FCA would expect a firm to consider when scoping a permission application include:

1. (1)

   asset class (eg, residential mortgages, commercial mortgages, credit card receivables, leasing, loans to corporates or small and medium-sized enterprises (SMEs), consumer loans, trade receivables, securitisations, private finance initiative (PFI), insurance, other assets, covered bonds);

2. (2)

   further asset class distinction (eg, geography and asset quality); and

3. (3)

   structural features (eg, by distinguishing between securitisation and re-securitisation, traditional and synthetic securitisation and non-revolving structures and revolving structures).

It is likely for it to be more straightforward for the FCA to assess relatively narrowly scoped permissions than those covering a wide range of assets and/or with complex structural features.

To assess a firm's ability to use its own policies and methodologies for assessing significant risk transfer, the FCA's permission reviews will focus on:

1. (1)

   the firm's understanding of the risk of any potential transactions within permission scope, including for potential underlying assets, securitisation structures and other relevant factors that affect the economic substance of risk transfer;

2. (2)

   the governance around significant risk transfer assessment (including sign-off procedures) and systems and controls relating to risk-transfer assessment and determination of significant risk transfer;

3. (3)

   significant risk transfer calculation policies and methodologies, including any models used;

4. (4)

   the firm's historical experience with relevant securitisation origination; and

5. (5)

   the use of third-party risk assessments (eg, ECAI ratings) and the relationship with internal assessments.

The information the FCA expects a firm to provide in a permission application includes the following:

1. (1)

   details of the firm's governance processes for significant risk transfer, including details of any relevant committees and the seniority and expertise of key persons involved in sign-off;

2. (2)

   a copy of the firm's significant risk transfer policy, including details of the significant risk transfer calculation policies, methodologies and any models used to assess risk transfer (this should set out how the firm ensures it only takes capital relief in proportion to the amount of risk transferred on any given transaction);

3. (3)

   a statement of how all relevant risks are incorporated in the significant risk transfer calculations and how the full economic substance of transactions is taken into consideration;

4. (4)

   details of the firm's systems and controls regarding risk transfer in securitisations;

5. (5)

   a copy of the firm's capital allocation strategy;

6. (6)

   details of any securitised assets that have come back on the firm's balance sheet and the reason why; and

7. (7)

   details of reliance on ECAIs in determining significant risk transfer.

The FCA intends to apply two materiality limits to the proportion of risk-weighted exposure amount (RWEA) relief that can be taken under any permission covering multiple transactions:

1. (1)

   transaction level limit any transaction that would, in principle, be within the scope of the permission, but that resulted in an RWEA reduction exceeding 1% of the firm's credit risk-related RWEAs as at the date of the firm's most recent regulatory return, will fall outside the scope of a multiple transaction permission and will require a separate permission or require notification (if the transaction would satisfy option 1 or 2); and

2. (2)

   aggregate limit once the aggregate RWEA reduction taken on all significant risk transfer transactions executed within the scope of a permission exceeds 5% of the firm's credit risk-related RWEAs as at the date of the firm's most recent regulatory return, no additional transactions may be executed within scope of the permission. In such circumstances, a firm should take one of the following actions:

   1. (a)

      reapply to renew the multiple transaction permission; or

   2. (b)

      apply for a new permission covering the specific transactions exceeding the RWEA limit; or

   3. (c)

      notify the FCA of the transaction, following the significant risk transfer notification procedure (if the transactions would satisfy option 1 or 2).

Multiple transaction permissions can be expected to be granted for a period of one year. The FCA's review of permission renewal will focus on any changes to the firm's significant risk transfer policies and methodologies since the previous review.

Permissions relating to individual transactions do not need to be granted prior to the execution of a transaction. The FCA does not intend to specify the timeframe in which a firm should submit an individual transaction permission, but the firm should note that capital relief from a specific transaction will not be available until a firm has obtained permission covering the significant risk transfer assessment and capital treatment (unless the transaction is being notified under option 1 or 2, or falls within scope of a multiple transaction permission).

The information the FCA expects to receive in an individual transaction permission includes that in IFPRU 4.12.10G (2) and IFPRU 4.12.10 G (6) to IFPRU 4.12.10 G (17), as well as that in IFPRU 4.12.17G (1) to (3).

Depending on the nature of a transaction, the FCA may grant an individual permission for the duration of the transaction, or may impose a time limit on the permission. Where a firm sought to take capital relief on a transaction beyond the expiry date of the relevant permission, the firm would need to renew the permission prior to its expiry date.

Given that significant risk transfer should be met on a continuing basis, permissions will typically include a requirement to notify the FCA of any change in circumstances from those under which the permission was granted (eg, where the amount of credit risk transfer had changed materially). Any reduction in credit risk transfer subsequent to the permission being granted will require the firm to take a commensurate reduction in RWEA relief. If a firm does not effect a commensurate reduction in the RWEA relief, the FCA may revoke the relevant permission.

An originator must transfer a significant amount of credit risk associated with securitisedexposures to third parties to be able to apply the securitisation risk weights set out in Part Three, Title II, Chapter 5 of the UK CRR3 (Securitisation), and any associated reduction in own funds requirements must be matched by a commensurate transfer of risk to third parties.

As part of the notification and permissions process, the FCA expects the firm to inform it of the methodology it intends to use to calculate securitisation capital requirements.

As part of a firm's ongoing consideration of risk transfer, the FCA expects it to consider the support it has provided to securitisation transactions.

1. (1)

   If a firm is found to have provided support to a securitisation, the expectation that the firm will provide future support to its securitisations is increased. The FCA will take account of this increased expectation in future assessments of commensurate risk transfer to that firm.

2. (2)

   The FCA expects securitisation documentation to make clear, where applicable, that repurchase of securitisation positions by the originator beyond its contractual obligations is not mandatory and may only be made at fair market value.

3. (3)

   Where a firm provides support which it is entitled, but not obliged, to provide under the contractual documentation of the securitisation, the FCA will consider the following factors in assessing if that support has been appropriately reflected in the assessment of significant risk transfer:

   1. (a)

      whether the fact that the firm may provide such support was expressly set out in the contractual and marketing documents for the securitisation;

   2. (b)

      whether the nature of the support that the firm may give is precisely described in the documentation;

   3. (c)

      whether the maximum degree of support that could be provided could be ascertained at the time of the securitisation by the firm and by a person whose only information came from the marketing documents for the securitisation;

   4. (d)

      whether the assessment of whether significant risk transfer was achieved and the amount of that risk transferred was made on the basis that the firm would provide support to the maximum degree possible; and

   5. (e)

      whether the firm'sown funds and own funds requirements were appropriately adjusted at the time of the securitisation on the basis that the firm provided support to the maximum degree possible.

4. (4)

   If a firm fails to comply with article 250(1)2 of the UK CRR3, the FCA may require it to disclose publicly that it has provided non-contractual support to the transaction.

Some transactions can transfer little or no economic risk from the protection buyer to the protection seller, but may still result in a reduction in own funds requirements. A particular example of a transaction-type of concern involves protection being purchased on a junior tranche and a high premium is paid for that transaction.

Generally, the amount of premium paid will not materially affect the assessment of whether significant risk transfer has occurred. This is because either:

1. (1)

   the protection payment payable upon default from protection seller to protection buyer is significantly larger than the overall premium payable to the protection seller; or

2. (2)

   the payment of premium leads to an immediate incurred cost.

However, there comes a point at which the premium payable for the protection can reduce significantly the actual economic risk that is transferred from the protection buyer to protection seller. A premium payable of 100% of the protection amount could leave the protection buyer in a position over the life of the transaction that was no better than if protection had not been purchased.

The FCA expects originators seeking to apply the securitisation risk weights to synthetic securitisations to take into account all relevant factors to assess the amount of risk transferred. As well as the size and timing of amounts payable to the protection seller, the circumstances in which those amounts are payable can undermine the effectiveness of risk transfer. The FCA expects a firm seeking capital relief through synthetic securitisations to incorporate premiums in their assessment of significant risk transfer. In particular, the following transaction features may have a significant impact on the amount of risk transfer:

1. (1)

   premium which is guaranteed in all or almost all circumstances, for example, premium which is payable upfront or deferred; or

2. (2)

   those that could result in the amount of premium payable for protection being significantly greater than the spread income on the assets in the portfolio or similar to the size of the hedged position; or

3. (3)

   those under which the protection buyer retains the expected loss through higher transaction costs to the counterparty, in the form of premium or otherwise.

Article 238 of the UK CRR3 (Maturity of credit protection) requires maturity to be assessed in considering significant risk transfer. When considering the effective maturity of synthetic securitisations, the FCA expects a firm to consider whether the transaction contained an option to terminate the protection at the discretion of the protection buyer.

The FCA considers the following to be examples of features which generally indicate a positive incentive to call or, at least, to constitute grounds for discussion with the FCA prior to the conclusion of the transaction:

1. (1)

   the transaction contains terms, such as payments at maturity or payments upon early termination or significant premiums, which may reduce risk transfer;

2. (2)

   the transaction includes a requirement for the protection buyer to incur additional costs or obligations if they do not exercise their option to terminate the protection; and

3. (3)

   there are pre-agreed mechanisms, for example 'at-market unwinds', where the protection seller and protection buyer agree that the transaction can be terminated in the future at a 'market' value and specifies aspects of how the value is calculated.

Significant risk transfer is an ongoing requirement. Accordingly, the FCA expects firms to ensure that any reduction in own funds requirements achieved through securitisation continues to be matched by a commensurate transfer of risk throughout the life of the transaction. The FCA expects firms to take a substance over form approach to assessing significant risk transfer. Firms should be able to demonstrate that the capital relief post-transaction adequately captures the economic substance of the entire transaction, and is commensurate to retained risk.

When risk transfer transactions are structured as a group of linked transactions rather than a single transaction, the FCA expects the aggregate effect of linked transactions to comply with the UK CRR3. The FCA expects firms to ensure that analysis of risk transfer incorporates all linked transactions, particularly if certain transactions within a group of linked transactions are undertaken at off-market rates.

The FCA expects the instruments used to transfer credit risk not to contain provisions which limit the amount of risk transferred. For example, should losses or defaults on the securitised exposures occur1(ie, deterioration in the credit quality of the underlying pool) the FCA expects the originator's net cost of protection or the yield payable to investors should not increase as a result.

To ensure continued appropriateness, the FCA expects firms to update the opinions of qualified legal counsel, required by the UK CRR3, as necessary to ensure their continuing validity. For example, an opinion may need to be updated if relevant statutory provisions are amended, or where a new decision or judgment of a court has a bearing on the continuing validity of counsel's opinion.

The FCA expects relevant senior management of a firm to be appropriately engaged in the execution of securitisation transactions that lead to a reduction in RWEA where the firm is providing or purchasing structured trades.

The FCA does not operate a pre-approval process for transactions. The FCA expects a firm to discuss with its supervisor at any early stage securitisation transactions that are material or have complex features. Where a firm claims a regulatory capital reduction from securitisation transactions in its disclosures to the market, the FCA expects such disclosures to include caveats making clear the risk of full or partial re-characterisation where this risk is material in the light of the FCA's stated policy.

Although this section sets out the FCA's expectations regarding securitisations, these expectations are also relevant for other similar credit protection arrangements.

The FCA will seek to ensure that the securitisation framework is not used to undermine or arbitrage other parts of the prudential framework. For other similar credit protection arrangements (eg, those subject credit risk mitigation or trading book requirements), the impact of certain features (such as significant premiums or call options) may cast doubt on the extent of risk transferred and the resulting capital assessment. Features which result in inadequate own funds requirements compared to the risks a firm is running may result in the credit protection not being recognised or the firm being subject to extra capital charges in their ICG in Pillar 2 add-ons. Credit protection arrangements in general are subject to the same overarching principles as those in the securitisation framework.

Where a firm achieves significant risk transfer for a particular transaction, the FCA expects it to continue to monitor risks related to the transaction to which it may still be exposed. The firm should consider capital planning implications of securitised assets returning to its balance sheet. The UK CRR3 requires a firm to conduct regular stress testing of its securitisation activities and off-balance sheet exposures. The stress tests should consider the firm-wide impact of stressed market conditions on those activities and exposures and the implications for other sources of risk (eg, credit risk, concentration risk, counterparty risk, market risk, liquidity risk and reputational risk). Stress testing of securitisation activities should take into account both existing securitisations and pipeline transactions. A firm should have procedures in place to assess and respond to the results of that stress testing and these should be taken into account under the overall Pillar 2 rule.

A firm may apply to the FCA under section 138A of the Act to waiveIFPRU 4.14.2 R if it wishes to use the residual maturity of the interest-rate contract.

1. (1)

   This guidance sets out the FCA's expectations for granting permission to a firm to use its own one-sided credit valuation adjustment internal models (an "internal CVA model") for the purpose of estimating the maturity factor "M", as proposed under article 162(2)(h) of the UK CRR1 (Maturity).

2. (2)

   In the context of counterparty credit risk, the maturity factor "M" is intended to increase the own funds requirements to reflect potential higher risks associated with medium and long-term OTC derivative portfolios, more specifically when the exposure profile of these contracts is significant beyond one year. This adjustment is only applicable to a firm using the Internal Model Method for the calculation of exposure values.

3. (3)

   A firm is permitted to replace the formula for the maturity factor "M", as set out in article 162(2)(g) of the UK CRR1 with the 'effective credit duration' derived by a firm's internal CVA model, subject to permission being granted by the FCA, as the competent authority.

4. (4)

   Internal CVA models are complex by nature and modelling practises vary significantly across the industry. The FCA considers the creation of an acceptable model resulting in an appropriate credit duration to be challenging, and so would require extensive review. Accordingly, the FCA expects a firm to demonstrate a strong case for the granting of such permission.

5. (5)

   A firm that wishes to make an application under article 162(2)(h) should provide a satisfactory justification for the use of an internal CVA model for estimating the maturity factor "M". The purpose of reducing the own funds requirements for counterparty credit risk will not, on its own, be considered as a reasonable justification. The FCA will also expect highly conservative modelling assumptions within a firm's internal CVA model for the purpose of article 162(2)(h).

1. (1)

   This guidance sets out the FCA's expectations for permitting a firm with the permission to use the Internal Model Method set out in Part Three, Title II, Chapter 6, Section 6 (Internal model method) and the permission to use an internal VaR model for specific risk set out in Part Three, Title IV, Chapter 5 (Use of internal models) associated with traded debt instruments to set to 1 the maturity factor "M" defined in article 162 of the UK CRR1.

2. (2)

   In the context of counterparty credit risk, the maturity factor "M" is intended to increase the own funds requirements to reflect the potential higher risks associated with medium and long-term OTC derivative portfolios, more specifically when the exposure profile of these contracts is significant beyond one year. This adjustment is only applicable to firms using the Internal Model Method for the calculation of exposure values.

3. (3)

   Article 162(2)(i) of the UK CRR1 allows a firm to set the maturity factor "M" to 1 for a firm using the Internal Model Method provided that the firm's internal value-at-risk (VaR) model for specific risk associated with traded debt instruments reflects the effect of rating migration and subject to the permission of the FCA, as the competent authority.

4. (4)

   Internal VaR models for specific risk associated with traded debt instruments are not specifically designed to capture the effects of rating migrations. The risk captured by these models is based on a 10-day time horizon which cannot appropriately reflect the dynamics of rating migrations, which occur on an irregular, infrequent basis. This deficiency was one of the main reasons underlying the introduction of a separate risk measure for the capture of both credit default and rating migration risks, based on a one-year time horizon (the IRC models in article 372 of the UK CRR1 (Internal IRC model)).

5. (5)

   Since the challenges of appropriately capturing credit-rating migrations in an internal VaR model are high, the FCA expects a firm to demonstrate a strong case for the granting of the permission set out in article 162(2)(i) of the UK CRR1.

6. (6)

   A firm that wishes to make an application under article 162(2)(i) of the UK CRR1 should provide a satisfactory justification for use of its internal VaR model to capture the risks associated with ratings migration. The purpose of reducing the own funds requirements for counterparty credit risk will not be considered as a reasonable justification.

7. (7)

   The FCA expects highly conservative modelling assumptions for the capture of rating migrations within a firm's internal VaR models for specific risk associated with traded debt instruments under article 162(2)(i) of the UK CRR1 (Maturity).

For purposes of repurchase transactions and securities lending or borrowing transactions, the FCA does not consider that there are any core market participants apart from those entities listed in article 227(3) of the UK CRR1.