Credit risk: internal ratings based approaches - Bank of England

Consultation Paper |CP4/13 Credit risk: internal ratings based approaches March 2013 Consultation Paper |CP4/13 Credit risk: internal ratings based approaches March 2013 Adoption of legacy FSA material Along with a number of other pieces of legacy FSA material relevant to its objectives, it is intended that the material in this consultation paper will be adopted by the Prudential Regulation Authority (PRA) as a Supervisory Statement. This paper restates material which was originally communicated to firms in various forms by the FSA but does not represent a substantive change of policy. The PRA expects to review the content of this publication in due course. In particular, we will revisit the contents in the light of the forthcoming implementation of the Capital

Requirements Regulation (part of the CRD IV package) in the EEA to determine whether any changes are necessary. Loss given default (LGD) floor for retail mortgages In addition to material previously communicated by the FSA this consultation proposes that firms should maintain a 10% exposure weighted average residential mortgage LGD floor. This floor was initially set out in Section 264 of the Basel Accord to apply on a transitional basis for three years from implementation. In December 2009 the Basel Committee on Banking Supervision agreed to extend the floor indefinitely in the light of the volatility of some mortgage portfolios during the financial crisis. (1) Within EU law the floor was mandated by Article 154(4) of the Banking Consolidation Directive (2006/48/EC) until 31 December 2010 and this end date was subsequently extended until December 2012 by Directive (2010/76/EU). The floor and its extension were transposed in the United Kingdom through BIPRU TP 11.6. Article 160 of the Commission’s Proposal for the Capital Requirements Regulation (CRR) requires the floor to be applied. It is expected that the floor will be in force on a permanent basis following implementation of the CRR. There are currently nine firms that use the IRB approach for retail mortgages and consequently use mortgage LGD models to calculate capital requirements in the United Kingdom. Mortgage LGD models aim to predict losses in the event of a default in an economic downturn. Model uncertainty can arise from issues such as the price of properties being difficult to evaluate accurately in advance, or the possibility of a sudden unexpected change in the weighted average mortgage LGD of a firm, eg from a crash in the housing market. Therefore we consider that firms should continue to apply the LGD floor in advance of the implementation of the CRR as this would mitigate this risk of insufficient capital being held due to over-reliance on banks’ internal models, and hence mitigate risks to the PRA’s safety and soundness objective. (1) www.bis.org/publ/bcbs_nl14.htm. Equality and diversity issues The PRA has considered equality and diversity issues but has not identified any impacts arising from these proposals. Accordingly, the PRA has concluded that these proposals do not give rise to any equality and diversity issues. Consultation questions The PRA welcomes responses to the following questions: 1. Do you consider that the draft Supervisory Statement is presented in an appropriately clear manner? 2. Do you have any...

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