The European Banking Authority (EBA) published today its final Guidelines specifying how institutions should quantify the estimation of loss given default (LGD) appropriate for conditions of an economic downturn. In particular, the Guidelines focus on requirements for the quantification of the calibration target used for downturn LGD estimation. The Guidelines complete the EBA's broader work on the review of the IRB approach aiming at reducing the unjustified variability in the outcomes of internal models, while preserving the risk sensitivity of capital requirements.

Starting from the relevant downturn period(s) identified in accordance with the related Regulatory Technical Standard (RTS), the final Guidelines set out requirements for the appropriate quantification of the calibration target used for downturn LGD estimates and include three types of approaches:

• Type-1 approaches can be applied when banks have sufficient loss data for the identified downturn period. In this case, institutions are allowed some modelling flexibility, but subject to a harmonised and prescriptive impact assessment;
• Type-2 approaches can be applied when banks do not have sufficient loss data for the identified downturn period. In this case, institutions are given the choice between two approaches, the so-called haircut or extrapolation approaches This will harmonise the approaches used by banks.
• Type-3 approaches can be applied in rare cases, where neither type-1 nor type-2 approaches can be used. In this case, banks have to apply a minimum margin of conservatism (MoC) requirement of 15 percentage points on LGD estimates.

Finally a reference value is put in place that acts as a non-binding challenger to the final downturn LGD estimation.

Legal basis, implementation and next steps

The EBA has developed these Guidelines on its own initiative in accordance with Article 16 of its founding Regulation, which mandates the Authority to issue guidelines and recommendations addressed to competent authorities or financial institutions with a view to establishing consistent, efficient and effective supervisory practices within the ESFS, and to ensuring the common, uniform and consistent application of Union law.

The Guidelines will apply as of 1 January 2021, at the latest, but earlier implementation is encouraged. Institutions should engage with their competent authorities at an early stage in order to determine an adequate implementation plan, including the timeline for the supervisory assessment and approval of material model changes, where necessary.

These Guidelines are an amendment to the Guidelines on PD, LGD estimation and treatment of defaulted assets (EBA/GL/2017/16) published on 20 November 2017.