For the institutions that use the Internal Ratings based (IRB) approach, the new definition may have a considerable impact on the parameters of credit risk and is consequently going to influence the expected loss calculations and, by extension, risk weights. The institutions using the IRB approach are likely to be relatively more affected by the new definition of default. They will need to adjust the historical data fed in their IRB model to comply with the new definition of default. They will also need to include a new margin of conservatism to their calculations, that would offset the possibility of the past data used to calculate the requirements not using the new definition of default. Any changes to the internal models need to be approved by national competent authorities, which may add to the time costliness of the process.
The institutions that use the standardised approach are expected to be affected to a smaller degree as they are not relying on historical data. However, under CRR, the definition of default is a base on which the different exposures are assigned in default classes, so the impact of the new guidelines is still not going to be insignificant.
If the EBA’s impact assessments are to be believed, then the capital requirement is not likely to substantially increase. However, as this is ultimately meant to be a harmonization of frameworks, whilst most of the individual institutions will find their current capital reserves adequate or near-adequate, some institutions will indeed need to increase their available capital substantially. Whilst the decrease of CET1 ratio is most likely going to be negligible for institutions that make use of the standardized approach, the CET 1 ratio is expected to drop by approximately 20bp’s for the institutions that use the IRB approach. It is however notable that re-developing the internal models is going to be a far greater cost for most of the banking institutions than a potential increase in capital requirements.
Ultimately, the burden upon any institution will largely depend on the definition that a given institution has used to date, and how much it differs from the current definition. The EBA is aware that the time, effort and costs of implementation of the new definition of default can be substantial, particularly for the institutions that are using the IRB approach and those whose definition of default was very different from the newly established one. It claims that it is entirely possible that in addition to having to replace their default identification and IT processes, the rating systems will also likely need to be recalibrated. This aligns with Finalyse's experience: although a definition of default is not complex from a conceptual point of view, it is often surprisingly complicated to embed this definition into the IT systems. Moreover, the introduction of a change in the default definition will add a considerable workload on the reporting teams, since there could potentially be a large difference in the number of defaults before and after the introduction of the new definition. This difference will then have to be analysed and explained when preparing regulatory and annual reports.
As is customary with most of the regulatory pieces implemented as part of the single European framework, the EBA claims that the harmonisation of practices will not only lead to an increased comparability of risk parameters and own funds requirements (which is its primary objective), but will also reduce the costs of the institutions that operate in more than one European country and thus currently need to comply with the definitions in use in the different member states.
As a result, firms that have cross-border operations will benefit from the unified framework. It is likely that these institutions are using the IRB approach and, consequently, even if the transformation is likely to be most costly for these, they are also most likely to benefit from it.