New Definition of Default: Insight on Challenges to Implementation

By Mahdi Ghazala, Senior Consultant and

Kristian Lajkep, Regulatory Compliance Officer

In September 2016, the European Banking Authority published its final guidelines related to the definition of default. The objective of the Regulator was to harmonize the definition of default among European financial institutions. The differences in understanding default throughout the Europe so far have led to a significant variety of capital requirements.

The NDoD  is expected to increase the comparability of risk parameters and own funds requirements, particularly for those financial institutions already applying the IRB  method. It will also impact the own funds requirements under both the IRB Approach and the Standardized Approach. Depending on the high gaps between the institutions’ current definition and the new one, the effect may be considerable. 

Given the magnitude of effort banks are expected to put into integrating the new rules of default identification and exit into their internal procedures and IT systems, the deadline of 1st January 2021 is challenging. 
 

• Past due criterion in the identification of default
  • When obligor is past due more than 90 days on material credit obligation
  • What counts as “Material Obligation” is defined in a special RTS

• Indications of unlikeliness to pay
  • Subject to some exceptions, the exposures classed as stage 3 under IFRS 9 are considered defaulted
  • Other indications of unlikeliness to pay could be restructuring or forbearance
  • Institutions are encouraged to look for other indications of unlikeliness to pay

• Conditions for a return to non-defaulted status and treatment
  • Probation period of 3 months at least
  • The definition of default in external data

To find out more about the new definition of default, please consult our previous expert input  "The new definition of default – how is it going to affect you?"

In order to implement the definition of default in the right way, the institutions should consult the following list of regulatory pieces:

• Guidelines on the application of the default definition: published on 28/09/2016, clarify important elements concerning the past due criterion, the indications of unlikeliness to pay (UTP), the criteria for the exit from default, etc. The application deadline for these guidelines is 01/01/2021.
• RTS on materiality threshold of past due credit obligations: published on 19/10/2017, this document specifies the conditions that competent authorities (CAs) shall apply when setting the materiality threshold for credit obligations. The national authorities are free to influence the application deadline for the requirements following from this RTS, but the deadline for the institutions that use the Standardised Approach must be no later than 31/12/2020.

The regulation allows national supervisory authorities considerable discretion regarding specific points, like setting absolute and relative materiality thresholds. 

Banks will have to accommodate significant changes by 1st January 2021, and these changes will have to be implemented on different levels:

As a starting point, the institutions have to perform a significant gap analysis so as to compare the “as is situation” with the new requirements and identify the gaps to be filled and that are subject to internal policies amendments. This is invaluable as indication of the workload necessary to fill those gaps as they will start emerging. In addition, the gaps identified during this analysis provide an early indication on what the quantitative impact will look like. For example: if an institution does not apply any materiality threshold for days past due counting, a small decrease in simulated PD should be expected to follow the introduction of a materiality threshold on historical data. Contrarily, if an institution identifies a weak application of contagion principle, a slight increase in the defaulted counterparties portfolio should be expected. 

Additionally, the new methodology for the detection and management of defaulted exposures and its  scope must be documented, and all criteria used in detecting both entry and exit from default clearly specified. A good practice to strengthen compliance with this point is to set a Permanent control procedure that will periodically check whether all changes to the approved methodology are documented, approved by the relevant body and kept in a change log / register.

Once the NDoD is implemented, another recommended practice to help with proper identification and management of entries and exit from default consists in putting in place mechanisms to control the use of the relevant information in the default detection process as soon as this information has been provided.

Last but not least, institutions that apply the IRB approach will have to adapt their process of identification of the payment default and most probably the associated IT systems, and recalibrate their internal rating systems accordingly. 
 

The key concept of this is “Sound Governance”. The bank should take all necessary actions to ensure that:

• The new default definition is interpreted properly;
• The Management has approved the new default definition;
• The implementation team sets up a project planning and that there is a robust organisation to handle all data and system changes;
• The definition of default is used consistently especially in bigger institutions where all subsidiaries do not always use a single IT system;
• The robustness, effectiveness and timeliness of the identification of default is periodically reviewed by an independent internal audit unit.
• There is a strict compliance with audit recommendations if any; Involvement of Senior Management is critical; it is crucial that this is perceived as a priority.
• The changes to the internal models for IRB banks are submitted to the approval of the national competent authority.
   

Adjusting the existing IT systems to accommodate the default triggers imposed by the new definition is quite challenging and resource consuming. The success depends on:

• A common and precise understanding of the “to be” situation for all involved parties: Functional and Technical stakeholders;
• Access to expert business analysts able to translate complex regulatory requirements into functional/technical specifications towards systems or models and to figure out future impacts.
• The manner the changes are conducted: in a project mode, involving multi-disciplinary teams: 
  • Risk and Finance functions use a large amount of common data, among which the default concept. Moreover, they are part of the end to end Regulatory Reporting process and any change in the default definition will impact both. Besides, some of the processes specific to them are directly linked with the default definition, for instance, estimation and validation of the Risk parameters (PD & LGD) by the Risk function, classification of credit exposures or calculation of credit loss allowances within Finance/Accounting functions.
  • Whilst developing the lending strategy, the business department takes into account the input from the Risk management function regarding the development of the credit portfolios and the risk-related indicators on customers at risk of default or already in default.
  • Any change in the scope of criteria of classification in default would imply a need to adapt the Collection unit’s recovery procedures accordingly.
  • The IT department is significantly impacted both on system and data aspects, as the new definition of default will require enhancing core operational systems that deal with default detection as well as other satellite systems linked, like provisioning tool or reporting tools. The database will require a serious upgrade in terms of capacity in order to be able to manage the storage of daily images of credit portfolios and past due information.
  • This list is by no means exhaustive, as a number of other departments may be affected too.

In a nutshell, some of the most significant changes that IT systems would need to implement are:

Automation: the systems must allow a timely identification and automated channelling of the information on default triggers in order to treat the relevant exposure and operate the default classification of the exposure / obligor in time. The same applies for the return to non-default status.

Daily treatment of indications of default: both regarding counting the days past due and signs of Unlikeliness to Pay. Some institutions have a daily identification and follow-up of default triggers, but the flagging of the exposures as defaulted happens on the monthly basis. In some other institutions, contagion does not happen on a daily basis.

Where default is applied at obligor level, consistent obligor identification and in particular “Joint obligors” identification: the system should allow identifying a “joint obligor” as a specific set of individual obligors that have a joint obligation. The system should treat it as a different obligor, distinct from the individual obligors. This point is crucial for the correct application of materiality thresholds on joint credit obligations as well as for default contagion. 

Materiality thresholds for days past due counting: with the NDoD, systems should integrate an additional condition to trigger the counting of days past due, i.e. the exceeding of both absolute and relative thresholds. This implies the ability of the system to:

• properly value the past due amount of an obligation;
• properly value the total on-balance exposure of an obligor especially in the cases of joint obligors.

Depending on the current usage (Total or partial) of materiality thresholds, the impact from their implementation will vary. Some institutions use only absolute or only relative, some others use both (with an ‘and’ or ‘or’ clause). Besides, some institutions currently have higher and some lower thresholds. All these aspects will pre-determine the impact, depending on whether the currently applied approach is more or less conservative than in the new GL.

Contagion   
For institutions that decide to apply the definition of default for Retail exposures at the obligor level, the system should be parameterized to properly apply contagion between the exposures of a single obligor but also specific contagion rules for joint credit obligations. 

A key success factor for the last three points is the proper identification of obligors (single / joint).
 

There are other technical changes in the systems that are also necessary but may be less complicated to implement because they resemble other challenges that the banks are already familiar with.

Two illustrations: 

• The minimum probation period of 3 months before coming back to non-defaulted status. The banks already apply a similar mechanism for forborne exposures which are kept in default 12 months before assessing their eligibility to exit from defaulted status.
• The technical past dues: systems can easily identify situations of payments made before 90 days but with an account crediting having occurred after the 90 days past due.  On the other hand, this specific situation may be difficult to apply retroactively on historical data, for example in a database.
   

The changes in the systems require time for planning, development and testing. Institutions cannot afford to wait to perform a quantitative impact assessment of the NDoD application. That is the reason why, parallel to systems upgrades, another work-block needs to focus on the application of the new default definition on the stock of historical data in order to simulate the impact on the non-performing portfolio, called also “Retro-simulations”, as well as on parameters like PD, LGD, etc.

Readjusting the stock of default exposures is also important for recalibrating risk components. The latter will vary after the integration of the full set of new criteria for entry and exit from defaulted status.

It is worth reminding that there will be a critical need to move from a monthly to a daily storage of data tracking exposures, days past due, delayed payments, as well as UTP indicators. It is important for both impact simulations on the existing stock of credit and future modelling of risk parameters based on the new definition.

This move will require an increased storage capacity and overall environment enhancement.
 

Overall there is a lot of work that needs to be done before 1st January 2021, and some of the necessary processes that need to be accommodated may take a long time to implement, especially for IRB banks, where models and IT systems will have to be recalibrated and planning should account for the time necessary for approval of the new models by the competent authority.

Due to the significance and wide impact of the implementation of the new definition of default within banks’ internal procedures, documentation, governance, systems and database, the only way to prepare everything on time is to handle it in a project mode. Such complex project should involve the right skills, methodological, functional, technical as well as data-oriented profiles.

It should be noted that the simultaneity with other regulatory changes, such as IFRS 9 or others, makes the task even more challenging. Indeed, the links and impacts on parallel projects deserve to be carefully analysed and correctly handled. In such situations, having a global overview and avoiding silo thinking is key.

Stay tuned for an article about tips and advice for you to tackle necessary considerations once all of the requirements and advice provided above are met.