The European Banking Authority (EBA) published today its final draft Regulatory Technical Standards (RTS) specifying the nature, severity and duration of an economic downturn. These RTS complete the EBA’s regulatory review of the internal ratings-based (IRB) Approach, with the objective of restoring market participants’ trust in internal models by reducing the unjustified variability in resulting risk weighted exposure amounts. The EBA is currently finalising the related Guidelines on the estimation of loss given default (LGD) appropriate for conditions of an economic downturn.
The final draft RTS set out the notion of economic downturn to be taken into account when estimating the LGD and the conversion factors (CF). Given the specificities of the types of exposures covered by a rating system, the economic downturn should be identified separately for each rating system. However, as a rating system may cover exposures from different businesses, sectors and geographical areas, the notion of an economic downturn included in these RTS may comprise several disjunctive downturn periods (e.g. where a rating system covers two sectors which experienced downturn conditions in different periods of time).
In addition, the final draft RTS specify the nature of an economic downturn via macroeconomic or credit-related factors (‘economic factors’) that are explanatory variables or indicators for the business cycle of the considered type of exposure. The severity of an economic downturn is specified by the set of the most severe observations on the economic factors constituting the nature of an economic downturn, based on historical values of these factors over the last 20 years. The duration of an economic downturn is determined by the duration of the identified downturn periods and is generally specified as the 12-month period where the most severe values are observed. However, some flexibility is embedded in the draft policy to ensure that the severity and duration are appropriately specified.