Response to cP on Guidelines on Credit Risk Mitigation for institutions applying the IRB approach with own estimates of LGDs
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With reference to the Substitution Approach, we understand the rationale of not allowing the migration of the guaranteed part of the exposure class towards the guarantor asset class for modelling purpose (e.g. large corporate with banks guarantee, the covered part would not migrate on banks but it remains as large corporate although with banks PD and LGD). In order to avoid potential misunderstanding, we would suggest to clarify, as done in the context of the Public Hearing held in Paris on April 15th 2019, that for regulatory reporting purposes the relevant migration is admitted consistently with the principle behind the following extract of paragraph 29 (a) (ii):
“when direct exposures to the guarantor are, or would be, treated under the IRB approach, substitution of both the PD and LGD risk parameters of the underlying exposure with the corresponding PD and LGD of a comparable direct exposure to the guarantor in accordance with paragraph 36.b of these Guidelines (i.e. ‘substitution approach’); […]”
Furthermore we would suggest to clarify that, even in the presence of the migration of the exposure class for regulatory reporting, in case of mismatch of the default classification between the guaranteed obligor and the guarantor (the former in default and the latter in performing status) the default classification should remain the guaranteed obligor’s one. This clarification would better explain the treatment required in the following extract of paragraph (29) (a) (ii):
“[…] in particular, in case the institutions have not received the permission of the competent authority to use own LGD estimates in accordance with Article 143(2) of Regulation (EU) No 575/2013 for direct exposures to the guarantor, institutions should substitute the LGD of the underlying exposure with the LGD value specified according to Article 161(1) of that Regulation; under this approach the following applies to defaulted exposures:
- the ELBE should be the expected loss which would have been assigned to the guaranteed part of the exposure after the substitution of the PD and LGD parameters in case the obligor was in a non-defaulted status;
- the LGD in-default should be such that the risk weight assigned to the guaranteed part of the exposure is the same as the risk weight which would have been assigned to the guaranteed part of the exposure after the substitution of the PD and LGD parameters in case the obligor was in a non-defaulted status;”.
Finally, to make comparable ELBE and EL for the guaranteed obligor in default and the guarantor in performing status, the removal of the Margin of Conservatism (as foreseen by EBA GL) in adopting the EL of the guarantor as ELBE should be considered. For the same reason the EL of performing should be adjusted in order to reflect the current economic condition as required for ELBE (and also to ensure consistency with IFRS9). This would represent the main challenge in applying the approach as it would entail an extension of the approaches currently required for ELBE also to EL for performing assets.
For the recognition of unfunded credit protection, UniCredit is currently adopting both the Substitution Approach and the LGD modelling approach, according to the type of UFCP.
As to the four listed issues (see box page 36) related to the eligibility and treatment of unfunded credit protection we deem the ones which would warrant an improvement are the following two:
i) treatment of unfunded credit protection provided by guarantor, when the direct exposures to the guarantor are treated under the foundation approach (FIRB). Indeed, the implementation of the new Basel framework foresees the dismissal of the advanced IRB approach for specific asset classes: as a result, banks with supervisory approval will use the foundation IRB (F-IRB) approach for banks, other financial institutions and large and mid-sized corporates (consolidated revenues > €500m) and the same treatment will be foreseen for unfunded credit protection provided by guarantor, when the guarantor falls within the abovementioned asset classes.
This treatment will entail the application of a fixed LGD value and predefined haircut penalizing above all unfunded credit protections provided by guarantors with better quality. Therefore, as already stated in question 4, we reiterate the need to align (in addition to Standardized Approach versus IRB in light of the Output Floor adoption) Advanced and Foundation IRB framework with respect to the collateral eligibility in order to mitigate the impact of the adoption of the FIRB haircuts on the input floor. Additionally, in case of substitution with guarantors under FIRB approach, for the covered part, unless an overlapping coverage is provided also with a funded credit protection, the LGD Unsecured to be applied would be equal to 40% (in the presence of Large Corporate guarantors) or 45% (in the presence of banks or other guarantors different from large corporate under the FIRB approach), whereas under the AIRB an LGD equal to 25% (as per para. 85 of the Finalised Basel III standards) input floor for fully unsecured part would be applied. Therefore, in the presence of FIRB guarantors under the substitution approach, the LGD for the covered part of the exposure would lead to a LGD sensibly higher than the input floor applied for fully unsecured exposure thus potentially hindering the mitigation effect both for the substitution and modelling approaches. More specifically:
- for the substitution, even in the presence of a guarantor with a lower PD compared to the guaranteed obligor (that is something to be expected ,), the LGD might potentially be higher than the LGD estimated by the model for unsecured exposures (that is another expected result considering the lower input floor for AIRB set at 25%) thus potentially offsetting the lower PD of the guarantor and removing all the mitigation effect;
- for the modelling approach, the same effect on substitution will apply also on the RW floor, thus removing the mitigation effect determined by the modelling approach on internal LGD estimates.
As a consequence, in order to avoid the unwarranted effect of not incentivizing the collection of high quality guarantees and protections thus ultimately worsening the asset quality of the banks portfolio, and ensuring the adoption of FIRB estimates as required by Finalised Basel III standards an alternative approach should be thought.
In order to recognize a mitigation effect specifically for large corporate and banks guarantors in case the underlying guaranteed exposures are treated at AIRB, a possible solution might be the adoption of an approach “secured-unsecured-like” (thus within the Modelling approach) envisaging the computation of a “LGD Secured” on the tranche of the AIRB exposure covered by large corporate or banks guarantors equal to the Expected Loss resulting from the adoption of internal PD and FIRB LGD (40%-45%). Indeed if the guarantor will pay the guarantees, the resulting LGD on the covered tranche of the exposure would be 0 otherwise, in case it fails in meeting its obligation thus going to default, the LGD would be equal to the LGD of the guarantor itself. This LGD secured value would contribute together with the guaranteed obligor’s PD at customer level and the internal LGD estimates on the other tranches of the AIRB exposures not covered by that large corporate / banks guarantor, to the computation of the RWA. In this way the mitigation effect would be at least recognized in proportion to the quality of the guarantor creditworthiness (the lower its PD the lower the EL; realizing therefore what we referred to as the “LGD Secured” for the part of the AIRB exposure covered by large corporate or banks guarantor). Clearly the LGD attributed to the LGD part not covered by the guarantees should be estimated without the inclusion of the cash flows stemming from the guarantors (or at least not recognizing the mitigation effects of the Unfunded Credit Protection estimated by the LGD model).
Example
Overall AIRB Exposure = 100
Unsecured part = 50 (LGD applicable 35%)
Part covered by FIRB banks guarantor = 50
PD of the customer = 1,25%
PD bank guarantor = 0,8%
LGD bank guarantor = FIRB Value = 45%
LGD will be calculated as the combination of Secured / Unsecured (weighted by 50:50 unsecured: covered exposures) with an LGD Secured equal to 0,8%*45%=0,36%
LGD* = (LGDU * 50 + LGDS * 50) / 100 = 35% * 0,5 + 0,36% * 0,5 = 17,68%
The LGD* equal to 17,68% would be used together with the guaranteed customer PD equal to 1,25% for RWA computation. Clearly the application of the Basel input floor would be relevant for all the tranches not covered by the large corporate or banks FIRB guarantor, since for the latter the LGD Secured will be computed using an internal IRB PD that in turn will be subject to the Basel PD input floor - equal to 0,05% - and a Regulatory set LGD for Foundation. This would be equivalent to say that the LGD secured for large corporate / banks guarantors in the context of an IRB approach is subject to an input floor equal to 0,05% * 40% or 45% for large corporate and banks guarantor.
ii)On the use of an appropriate risk weight function for the purposes of computing the risk weight under the substitution approach, in our opinion it is important to ensure, for Regulatory Reporting purposes, the adoption of the risk weight function related to the guarantor.
Furthermore, in case of not eligible collaterals, the LGD estimation can be computed:
• separating secured cash flows related to not eligible collaterals, and considering them in the LGD calculation as unsecured cash flows;
• otherwise, if the separation between eligible and not eligible cash flows is not possible, all the recoveries are to be treated as unsecured. When the ineligible collaterals exclusion would drive to a biased LGD estimation, a dummy variable (presence of such collateral) and/or coverage variable (e.g. VtL) can be added to sterilize the effect. This would equally ensure that an LGD estimate not inclusive of the UCP mitigation would be recognized on the part of the exposures not supported by the UCP.
In general, we deem relevant to assess if the presence of both ineligible UFCP and FCP in the historical data drives to statistically significant mitigation effects. This would indeed be an objective criteria in order to understand if the presence of cash flows from ineligible credit protections might introduce a bias in the estimates and deserve appropriate treatment.
As an additional comment, we would suggest to clarify whether the substitution approach can be applied only if the execution costs are expected to be negligible, or if it is necessary to shift to the modelling approach should the costs be significant. With respect to this, we suggest in particular to clarify the following sentence of the Guidelines: “the institution may reasonably expect that the direct costs of exercising the unfunded credit protection are negligible with respect to the amount covered by the unfunded credit protection.”.
We deem important to establish which is the appropriate criteria to choose which unfunded credit protection to use for the purposes of substituting the risk parameter in case of multiple unfunded credit protections that cover the same part of the original exposure. For the same situation, we would equally have some concerns on the possibility to satisfy the requirement foreseen by paragraph 37 (c), related to the calculation of the risk weight floor as the criteria to be used for the calculation of each risk weight direct exposures to the guarantor in case of multiple unfunded credit protection on the same part of the exposure is not clear. In particular, we wonder whether the effect of the other existing unfunded credit protections on the same part of the exposure (in accordance with paragraph 40) should even be considered or not.
Finally, we would recommend to add more details in the final guideline on how to consider the effect of credit mitigation in case of an exposure that includes an unsecured portion, although more collaterals (funded and unfunded) cover the whole exposure (see Figure 4).
a) in case the guarantee is provided to a single loan, the guarantee
isk mitigation is no longer active and it terminates its coverage effect;
b) whereas, when the guarantee is provided to a portfolio of loans, the occurred loss of a single loan does not lead to the termination of the risk mitigation effects because the contractual guarantee continues to be effective until its legal maturity (that shall not be shorter than the covered portfolio Weighted Average Life). This is a specific characteristic of all securitization transactions.
As a matter of fact, article 4(61) of the CRR states that a securitization is “a transaction or scheme, whereby the credit risk associated with an exposure or pool of exposures is tranched, having both of the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or pool of exposures; (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme”.
UniCredit considers the portfolio guarantees eligible as Unfunded Credit Protection based on the rules defined under Chapter 4 of the CRR for own synthetic transactions portfolio.
In particular, the applicable guarantee scheme for synthetic securitizations is the third case described in the explanatory box, i.e.: guarantee provided both in a form of “guarantee rate” covering only a part of credit losses on each loan, and “guarantee cap rate” up to a certain percentage of the portfolio”. In these transactions the risk of loans is divided in one or more tranches, the risk is transferred to third party; therefore the credit risk parameter applied on the part retained by a bank fully reflects the CRM effects of the UFCP. In order to recognize the CRM effects of the guarantee in these transactions, UniCredit adjusts the risk parameters leveraging on the “Substitution Approach” or applying the SA risk weight of the guarantor that UniCredit would assign to direct comparable exposure.
With regard to the treatment of portfolio guarantees, we consider that the effect of the UFCP should be independent of the eligibility rules applicable on the guarantor, and we recommend to allow the adjustment of the relevant parameters in case of both SA and IRB underlying portfolios. As a consequence, the UFCP schemes described in the draft guidelines shall operate and be used on both SA and A-IRB portfolios.
Question 1: Do you agree with the proposed clarifications on eligibility requirements in accordance with Article 181(1)(f) of the CRR?
NoQuestion 2: Do you agree with the proposed clarifications on the assessment of legal certainty of movable physical collateral? How do you currently perform the assessment of legal effectiveness and enforceability for movable physical collateral?
NoQuestion 2: Do you agree with the proposed clarifications on the assessment of legal certainty of movable physical collateral? How do you currently perform the assessment of legal effectiveness and enforceability for movable physical collateral?
NoQuestion 4: Do you have specific concerns related to the recognition of collateral in the modelling of LGD? How do you currently recognise collateral in your LGD estimates?
NoQuestion 5: What approaches for the recognition of the unfunded credit protection do you currently use? What challenges would there be in applying approaches listed above for the recognition of unfunded credit protection?
We welcome a clear definition of handling collaterals to be eligible also for an assignment to multiple partners/obligors, as this it is a standard procedure in many countries, e.g. in Germany . It represents an important clarification with respect to the current TRIM guideline, where the collateral should be only assigned to a facility or at facility level.With reference to the Substitution Approach, we understand the rationale of not allowing the migration of the guaranteed part of the exposure class towards the guarantor asset class for modelling purpose (e.g. large corporate with banks guarantee, the covered part would not migrate on banks but it remains as large corporate although with banks PD and LGD). In order to avoid potential misunderstanding, we would suggest to clarify, as done in the context of the Public Hearing held in Paris on April 15th 2019, that for regulatory reporting purposes the relevant migration is admitted consistently with the principle behind the following extract of paragraph 29 (a) (ii):
“when direct exposures to the guarantor are, or would be, treated under the IRB approach, substitution of both the PD and LGD risk parameters of the underlying exposure with the corresponding PD and LGD of a comparable direct exposure to the guarantor in accordance with paragraph 36.b of these Guidelines (i.e. ‘substitution approach’); […]”
Furthermore we would suggest to clarify that, even in the presence of the migration of the exposure class for regulatory reporting, in case of mismatch of the default classification between the guaranteed obligor and the guarantor (the former in default and the latter in performing status) the default classification should remain the guaranteed obligor’s one. This clarification would better explain the treatment required in the following extract of paragraph (29) (a) (ii):
“[…] in particular, in case the institutions have not received the permission of the competent authority to use own LGD estimates in accordance with Article 143(2) of Regulation (EU) No 575/2013 for direct exposures to the guarantor, institutions should substitute the LGD of the underlying exposure with the LGD value specified according to Article 161(1) of that Regulation; under this approach the following applies to defaulted exposures:
- the ELBE should be the expected loss which would have been assigned to the guaranteed part of the exposure after the substitution of the PD and LGD parameters in case the obligor was in a non-defaulted status;
- the LGD in-default should be such that the risk weight assigned to the guaranteed part of the exposure is the same as the risk weight which would have been assigned to the guaranteed part of the exposure after the substitution of the PD and LGD parameters in case the obligor was in a non-defaulted status;”.
Finally, to make comparable ELBE and EL for the guaranteed obligor in default and the guarantor in performing status, the removal of the Margin of Conservatism (as foreseen by EBA GL) in adopting the EL of the guarantor as ELBE should be considered. For the same reason the EL of performing should be adjusted in order to reflect the current economic condition as required for ELBE (and also to ensure consistency with IFRS9). This would represent the main challenge in applying the approach as it would entail an extension of the approaches currently required for ELBE also to EL for performing assets.
For the recognition of unfunded credit protection, UniCredit is currently adopting both the Substitution Approach and the LGD modelling approach, according to the type of UFCP.
Question 6: Do you have any specific concerns related to the issues excluded from the scope of the Guidelines?
We already highlighted in Question 4 the interconnection envisaged between the Guidelines and the implementation of the finalised Basel III standards regarding the input and output floors application, and the related need to foresee an alignment of the eligibility criteria between the Standardized and IRB Approaches on the AIRB perimeters where these floors are adopted. In our opinion both of them are extremely relevant elements that will need to be addressed in addition to the four listed issues (see box page 36) related to the eligibility and treatment of unfunded credit protection once the EU will implement the finalised Basel III framework .As to the four listed issues (see box page 36) related to the eligibility and treatment of unfunded credit protection we deem the ones which would warrant an improvement are the following two:
i) treatment of unfunded credit protection provided by guarantor, when the direct exposures to the guarantor are treated under the foundation approach (FIRB). Indeed, the implementation of the new Basel framework foresees the dismissal of the advanced IRB approach for specific asset classes: as a result, banks with supervisory approval will use the foundation IRB (F-IRB) approach for banks, other financial institutions and large and mid-sized corporates (consolidated revenues > €500m) and the same treatment will be foreseen for unfunded credit protection provided by guarantor, when the guarantor falls within the abovementioned asset classes.
This treatment will entail the application of a fixed LGD value and predefined haircut penalizing above all unfunded credit protections provided by guarantors with better quality. Therefore, as already stated in question 4, we reiterate the need to align (in addition to Standardized Approach versus IRB in light of the Output Floor adoption) Advanced and Foundation IRB framework with respect to the collateral eligibility in order to mitigate the impact of the adoption of the FIRB haircuts on the input floor. Additionally, in case of substitution with guarantors under FIRB approach, for the covered part, unless an overlapping coverage is provided also with a funded credit protection, the LGD Unsecured to be applied would be equal to 40% (in the presence of Large Corporate guarantors) or 45% (in the presence of banks or other guarantors different from large corporate under the FIRB approach), whereas under the AIRB an LGD equal to 25% (as per para. 85 of the Finalised Basel III standards) input floor for fully unsecured part would be applied. Therefore, in the presence of FIRB guarantors under the substitution approach, the LGD for the covered part of the exposure would lead to a LGD sensibly higher than the input floor applied for fully unsecured exposure thus potentially hindering the mitigation effect both for the substitution and modelling approaches. More specifically:
- for the substitution, even in the presence of a guarantor with a lower PD compared to the guaranteed obligor (that is something to be expected ,), the LGD might potentially be higher than the LGD estimated by the model for unsecured exposures (that is another expected result considering the lower input floor for AIRB set at 25%) thus potentially offsetting the lower PD of the guarantor and removing all the mitigation effect;
- for the modelling approach, the same effect on substitution will apply also on the RW floor, thus removing the mitigation effect determined by the modelling approach on internal LGD estimates.
As a consequence, in order to avoid the unwarranted effect of not incentivizing the collection of high quality guarantees and protections thus ultimately worsening the asset quality of the banks portfolio, and ensuring the adoption of FIRB estimates as required by Finalised Basel III standards an alternative approach should be thought.
In order to recognize a mitigation effect specifically for large corporate and banks guarantors in case the underlying guaranteed exposures are treated at AIRB, a possible solution might be the adoption of an approach “secured-unsecured-like” (thus within the Modelling approach) envisaging the computation of a “LGD Secured” on the tranche of the AIRB exposure covered by large corporate or banks guarantors equal to the Expected Loss resulting from the adoption of internal PD and FIRB LGD (40%-45%). Indeed if the guarantor will pay the guarantees, the resulting LGD on the covered tranche of the exposure would be 0 otherwise, in case it fails in meeting its obligation thus going to default, the LGD would be equal to the LGD of the guarantor itself. This LGD secured value would contribute together with the guaranteed obligor’s PD at customer level and the internal LGD estimates on the other tranches of the AIRB exposures not covered by that large corporate / banks guarantor, to the computation of the RWA. In this way the mitigation effect would be at least recognized in proportion to the quality of the guarantor creditworthiness (the lower its PD the lower the EL; realizing therefore what we referred to as the “LGD Secured” for the part of the AIRB exposure covered by large corporate or banks guarantor). Clearly the LGD attributed to the LGD part not covered by the guarantees should be estimated without the inclusion of the cash flows stemming from the guarantors (or at least not recognizing the mitigation effects of the Unfunded Credit Protection estimated by the LGD model).
Example
Overall AIRB Exposure = 100
Unsecured part = 50 (LGD applicable 35%)
Part covered by FIRB banks guarantor = 50
PD of the customer = 1,25%
PD bank guarantor = 0,8%
LGD bank guarantor = FIRB Value = 45%
LGD will be calculated as the combination of Secured / Unsecured (weighted by 50:50 unsecured: covered exposures) with an LGD Secured equal to 0,8%*45%=0,36%
LGD* = (LGDU * 50 + LGDS * 50) / 100 = 35% * 0,5 + 0,36% * 0,5 = 17,68%
The LGD* equal to 17,68% would be used together with the guaranteed customer PD equal to 1,25% for RWA computation. Clearly the application of the Basel input floor would be relevant for all the tranches not covered by the large corporate or banks FIRB guarantor, since for the latter the LGD Secured will be computed using an internal IRB PD that in turn will be subject to the Basel PD input floor - equal to 0,05% - and a Regulatory set LGD for Foundation. This would be equivalent to say that the LGD secured for large corporate / banks guarantors in the context of an IRB approach is subject to an input floor equal to 0,05% * 40% or 45% for large corporate and banks guarantor.
ii)On the use of an appropriate risk weight function for the purposes of computing the risk weight under the substitution approach, in our opinion it is important to ensure, for Regulatory Reporting purposes, the adoption of the risk weight function related to the guarantor.
Question 7: Do you agree with the proposed clarification regarding the parallel treatment of ineligible UFCP and ineligible FCP? How do you currently monitor the cash flows related to ineligible unfunded credit protection and how do you treat such cash flows with regard to the PD and LGD estimates?
As explained above, we consider inappropriate to use the cash flows derived from ineligible UFCP for credit risk mitigation purposes. Therefore we agree with the parallel treatment of ineligible UFCP and FCP. Nevertheless, banks should define specific cash flows tracking rules aimed to recognize them within the modelling activity.Furthermore, in case of not eligible collaterals, the LGD estimation can be computed:
• separating secured cash flows related to not eligible collaterals, and considering them in the LGD calculation as unsecured cash flows;
• otherwise, if the separation between eligible and not eligible cash flows is not possible, all the recoveries are to be treated as unsecured. When the ineligible collaterals exclusion would drive to a biased LGD estimation, a dummy variable (presence of such collateral) and/or coverage variable (e.g. VtL) can be added to sterilize the effect. This would equally ensure that an LGD estimate not inclusive of the UCP mitigation would be recognized on the part of the exposures not supported by the UCP.
In general, we deem relevant to assess if the presence of both ineligible UFCP and FCP in the historical data drives to statistically significant mitigation effects. This would indeed be an objective criteria in order to understand if the presence of cash flows from ineligible credit protections might introduce a bias in the estimates and deserve appropriate treatment.
Question 8: Do you agree with the proposed rules for the application of the substitution approach? Do you see any operational limitations in excluding the guaranteed part of exposure to which substitution approach is applied from the scope of application of the LGD model for unguaranteed exposures?
We understand the rationale of the proposed rules for the application of the substitution approach; however, in case the separation of cash flows deriving from UFCP was not possible, the substitution approach application could be implemented. The guarantor presence/absence can, in fact, be managed in the estimation phase by means of a risk driver, eliminating the mitigation effect in the application phase through a dummy variable equal to zero.As an additional comment, we would suggest to clarify whether the substitution approach can be applied only if the execution costs are expected to be negligible, or if it is necessary to shift to the modelling approach should the costs be significant. With respect to this, we suggest in particular to clarify the following sentence of the Guidelines: “the institution may reasonably expect that the direct costs of exercising the unfunded credit protection are negligible with respect to the amount covered by the unfunded credit protection.”.
Question 9: Do you agree with the proposed rules for the application of the modelling approach?
We agree with the proposed rules for the application of the modelling approach, where the unfunded credit protection is considered as a risk driver in the model development, in terms of dummy variable (presence of this collateral) and/or coverage variable (e.g. VtL).Question 10: What challenges would you envisage for back-testing the substitution approach? Do you agree that the back-testing should be performed rather at Expected loss level? Do you have any approach currently in place for the back-testing of substitution approach?
A back-testing might be done by treating the Expected Loss of the guarantor as a sort of “LGD Secured” for the tranche of the exposure covered by the UFCP, which contributes to the overall estimated LGD (combining Secured and Unsecured) in order to compare this with the Realized LGD observed on the overall facility supported by personal guarantees. This kind of back-testing leads to consider the substitution approach similarly to the modelling approach (since it would consider the mitigation effect in the LGD modelling).Question 11: Do you agree with the proposed guidance for the estimation of the LGD of comparable direct exposure towards the guarantor? What concerns would you have about the calculation of the risk weight floor?
Overall, we agree with the proposed guidance for the estimation of the LGD of comparable direct exposure towards the guarantor. Indeed, we evaluate positively the requirement for consistency in the application of the substitution approach: “splitting the part of the exposure covered by a given unfunded credit protection in two parts and applying to one part the ‘substitution approach’ and to the other part the ‘modelling approach’ should not be allowed“.We deem important to establish which is the appropriate criteria to choose which unfunded credit protection to use for the purposes of substituting the risk parameter in case of multiple unfunded credit protections that cover the same part of the original exposure. For the same situation, we would equally have some concerns on the possibility to satisfy the requirement foreseen by paragraph 37 (c), related to the calculation of the risk weight floor as the criteria to be used for the calculation of each risk weight direct exposures to the guarantor in case of multiple unfunded credit protection on the same part of the exposure is not clear. In particular, we wonder whether the effect of the other existing unfunded credit protections on the same part of the exposure (in accordance with paragraph 40) should even be considered or not.
Finally, we would recommend to add more details in the final guideline on how to consider the effect of credit mitigation in case of an exposure that includes an unsecured portion, although more collaterals (funded and unfunded) cover the whole exposure (see Figure 4).
Question 12: Do you consider portfolio guarantees as a form of eligible UFCP? Do they include cases where the guarantee contract sets a materiality threshold on portfolio losses below or above which no payment shall be made by the guarantor? Do they include cases where two or more thresholds (caps) either expressed in percentages or in currency units are set to limit the maximum obligation under the guarantee? How do you recognise the portfolio guarantees’ credit risk mitigation effects in adjusting risk parameters?
Unfunded Credit Protection (UFCP) provided to a portfolio of loans rather than to an individual exposure is subject to a different mechanism, even in the event the credit worthiness of the guarantor remains unchanged. In particular, once the loss is realized and the guarantee activated two cases are possible:a) in case the guarantee is provided to a single loan, the guarantee
isk mitigation is no longer active and it terminates its coverage effect;
b) whereas, when the guarantee is provided to a portfolio of loans, the occurred loss of a single loan does not lead to the termination of the risk mitigation effects because the contractual guarantee continues to be effective until its legal maturity (that shall not be shorter than the covered portfolio Weighted Average Life). This is a specific characteristic of all securitization transactions.
As a matter of fact, article 4(61) of the CRR states that a securitization is “a transaction or scheme, whereby the credit risk associated with an exposure or pool of exposures is tranched, having both of the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or pool of exposures; (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme”.
UniCredit considers the portfolio guarantees eligible as Unfunded Credit Protection based on the rules defined under Chapter 4 of the CRR for own synthetic transactions portfolio.
In particular, the applicable guarantee scheme for synthetic securitizations is the third case described in the explanatory box, i.e.: guarantee provided both in a form of “guarantee rate” covering only a part of credit losses on each loan, and “guarantee cap rate” up to a certain percentage of the portfolio”. In these transactions the risk of loans is divided in one or more tranches, the risk is transferred to third party; therefore the credit risk parameter applied on the part retained by a bank fully reflects the CRM effects of the UFCP. In order to recognize the CRM effects of the guarantee in these transactions, UniCredit adjusts the risk parameters leveraging on the “Substitution Approach” or applying the SA risk weight of the guarantor that UniCredit would assign to direct comparable exposure.
With regard to the treatment of portfolio guarantees, we consider that the effect of the UFCP should be independent of the eligibility rules applicable on the guarantor, and we recommend to allow the adjustment of the relevant parameters in case of both SA and IRB underlying portfolios. As a consequence, the UFCP schemes described in the draft guidelines shall operate and be used on both SA and A-IRB portfolios.