Could effective LGD (LGD*) be used both in AIRB and FIRB if the operation has an eligible financial collateral under Financial Collateral Comprehensive method?

According to Article 228 (2) CRR, when calculating risk-weighted exposure amounts under the financial collateral comprehensive method, institutions shall use the effective LGD (LGD*) as the LGD for the purposes of Chapter 3 (IRB).

It is unclear if this would apply to contracts collateralised by eligible financial collateral for which, although they are under AIRB, the number of contracts with this type of collateral is reduced so a robust LGD bucket for these kind of operations cannot be produced.

According to Article 108 Regulation (EU) No 575/2013 as amended (CRR), for an exposure to which an institution applies the IRB Approach under Chapter 3 of title 2 of part III of CRR but without using its own estimates of loss given default (LGD) and conversion factors under Article 151, the institution may use credit risk mitigation in accordance with Chapter 4 of title 2 of part III of CRR in the calculation of risk weighted exposure amounts for credit risk. On the contrary for an exposure to which an institution applies the IRB Approach by using own estimates of LGD and conversion factors under Article 151 CRR, the institution may use credit risk mitigation in accordance with Chapter 3 of title 2 of part III of CRR.

According to Article 151(7), for retail exposures institutions shall provide own estimates of LGDs. In contrast, in accordance with Article 151(8), for non-retail exposures Article 161(1) shall apply, but only where the institution has not received permission to use its own estimates of LGDs. In this regard, although Article 161(1)(c) CRR permits recognising funded and unfunded credit protection in the LGD in accordance with Chapter 4 without explicitly limiting such recognition to the IRB Approach without the use of own estimates of LGD, this provision should be read in conjunction with the previous requirement and with Article 108 CRR, which generally clarifies that institutions may only use credit risk mitigation in accordance with Chapter 4 where they apply the IRB Approach without the use of own estimates of LGD and conversion factors, unless a specific reference to Chapter 4 exists in Chapter 3. 

This is in line with Q&A 2593, according to which unfunded credit protection for an exposure for which own estimates of LGD are to be used can be recognised under Article 161(3) or (4) CRR, if applicable, while Article 161(1)(c) is not relevant where the institution applies the IRB Approach with the use of own estimates of LGD and conversion factors.

Hence the use of the Financial Collateral Comprehensive Method (FCCM) set out in Article 223 CRR for purposes of recognising, the effects of funded credit protection as specified in Article 228 CRR pursuing Article 161 (1)(c), is not permitted where the institution estimates own LGDs and conversion factors. 

Where own estimates of LGDs are used, funded credit protection, other than master netting agreements and on-balance sheet netting, may be recognised in accordance with Article 181 CRR.