INSIGHTS ¦ Credit risk: the definition of default

PRA Paper and policy statement

Summary

The consultation paper “CP17/18: Credit risk: the definition of default” from July 2018, outlines the Prudential Regulation Authority’s (PRA) proposed changes to the definition of default in the Capital Requirements Regulation (CRR). The changes aim to align UK practices with the European Banking Authority’s (EBA) guidelines and address variability in the risk-weighted assets calculated by banks using their internal ratings-based (IRB) approaches.

Key Points

  1. The consultation seeks to update the PRA’s expectations in Supervisory Statement 11/13 for the IRB approaches and to amend the Credit Risk Part of the PRA Rulebook.
  2. The proposals are relevant to UK banks, building societies, and PRA-designated investment firms.
  3. The changes follow the EBA’s regulatory products, including the Regulatory Technical Standards and Guidelines on the definition of default.
  4. A significant change includes setting new materiality thresholds for past due credit obligations, which determine when a credit obligation is considered defaulted.
  5. The PRA proposes a zero relative and absolute materiality threshold for retail exposures and a 1% relative and €500 absolute threshold for non-retail exposures.
  6. Another key proposal is the removal of the discretion to use 180 days instead of 90 days for past due exposures in certain cases, aligning default recognition across all exposures.
  7. The PRA intends to implement these changes by 31 December 2020.
  8. Stakeholders are invited to provide feedback on the proposals, especially regarding their impact on operations and capital requirements.
  9. The consultation addresses the need for consistency in default definitions across the UK and EU, enhancing comparability and reliability of risk assessments.
  10. It also discusses the benefits of standardising the recognition of default to reduce unnecessary variability and promote a stable financial environment.
  11. The consultation includes an extensive cost-benefit analysis, weighing the operational impacts against the potential benefits of more accurate default recognition.
  12. The PRA will also review these policies in response to changes in the UK’s regulatory framework post-Brexit.
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Key Statistics

  • 0% materiality threshold: Proposed for retail exposures to quickly identify defaults.
  • 1% relative materiality threshold: Proposed for non-retail exposures with a €500 absolute threshold.
  • 90 days past due: Standardising the period for default recognition across exposure classes, eliminating the 180 days option.
  • 2020 implementation: Target date for all proposed changes to take effect.
  • Feedback deadline: Responses to the consultation are requested by 29 October 2018.

Key Take Aways

  • The PRA is aligning its default definition with European standards to ensure consistency and comparability across borders.
  • New materiality thresholds aim to simplify and standardise how defaults are recognised, particularly in non-retail exposures.
  • Removing the option to extend the past due period to 180 days for certain exposures will likely increase the number of defaults recognised sooner, impacting capital requirements and operational processes.
  • Stakeholder feedback is crucial to refine the proposals, particularly concerning their practical impacts on financial institutions.
  • The PRA’s adaptations are part of broader efforts to enhance the stability and reliability of the financial sector through better risk management and regulatory practices.
  • These changes are expected to impact all UK financial institutions subject to the CRR, necessitating adjustments in their risk assessment and management systems.
  • Firms need to prepare for the implementation of these rules by the end of 2020, considering potential adjustments in their operational and financial strategies.
  • The consultation also serves as a preparatory step for potential post-Brexit regulatory adjustments, ensuring that UK financial practices remain robust and in line with international standards.


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