How should exposures to unrated institutions be treated under Article 121 CRR in the cases where these institutions are located in a Member State or in a third country that does apply supervisory and regulatory arrangements at least equivalent to those applied in the Union and the exposures to the central government and central bank denominated and funded in domestic currency are assigned a risk weight according to Articles 114(4) to (7)?

According to Article 121 CRR, exposures to institutions for which a credit assessment by a nominated ECAI is not available shall be assigned a risk weight according to the credit quality step to which exposures to the central government of the jurisdiction in which the institution is incorporated are assigned.

Article 121 CRR does not specify the treatment to be applied to exposures to unrated institutions in a Member State or in a third country in those cases where the RW corresponding to the central government is determined according to Articles 114(4) and (7) CRR. In this case, the main doubt to be clarified is the meaning of “credit quality step to witch central government is assigned” in Article 121(1), table 5.

Consider an institution located in a Member State where according to Article 114(4) the exposures to this Member States' central government and central bank denominated and funded in the domestic currency of that central government and central bank shall be assigned a risk weight of 0 %. Does this mean that the “credit quality step to which central government is assigned” is 1, independently of the external rating of the central government?

In this regard, and in spite of the fact of not being an explicit reference in the regulation, our understanding is that the CRR should follow the Basel provisions, which establish that the applicable risk weight for unrated institutions should be one category less favourable than that assigned to claims on the sovereign (Paragraphs 60 to 64 of the Basel Committee Accord (2006)).

Consider an exposure to a public sector entity for which a credit assesment by a nominated ECAI is not available.

The central government of the jurisdiction in which the public sector entity is incorporated has a credit quality step equal 2 and does apply supervisory and regulatory arrangements equivalent to those applied in the Union.

Under Article 114 CRR direct exposures to that central government are assigned a

W=0% (Article 114.7 CRR). If we analyse table 1 in Article 114.2 CRR the RW=0% corresponds to a credit quality step = 1

In this regard, when we do apply 116.1 CRR which credit assessment should be used as a reference for the central government? The original credit quality step of the jurisdiction (Credit quality step=2) that does not account for the equivalence or the credit quality step that corresponds once applied Article 114 CRR (Credit quality step=1)?

Article 114(1) CRR provides that the fall-back risk weights applied to exposures to central governments is 100%. It provides for several exceptions in paragraphs (2) to (7), including:

• paragraph (2), whereby exposures to central governments and central banks for which a credit assessment by an ECAI nominated by the institution is available shall be assigned a risk weight according to Table 1.
• paragraph (4), whereby exposures to Member States' central governments, and central banks denominated and funded in the domestic currency of that central government and central bank shall be assigned a risk weight of 0 %.

Article 114(4) bypasses Article 114(2) for EU Member States under specific conditions. It allows institutions to apply a risk weight independently from the country’s credit quality step. This does not mean, however, that the credit quality step of all EU countries remains “1” independently from the country’s external rating. It simply means that exposures to central governments and banks in the EU benefit from a special treatment which allow banks to bypass EU countries’ external ratings. Article 114(7) extends this preferential treatment under stricter conditions pertaining to regulations to countries outside the EU.

Article 121(1) CRR specifies that “exposures to institutions for which a credit assessment by a nominated ECAI is not available shall be assigned a risk weight according to the credit quality step to which exposures to the central government of the jurisdiction in which the institution is incorporated.” This occurs independently from the currency of the exposure and its funding’s currency and it does not imply that risk weights are the same for an exposure to the government and an exposure to the institution localised in the same country.

It follows that exposures to unrated institutions, where these institutions are located in a Member State or in a third country that does apply supervisory and regulatory arrangements at least equivalent to those applied in the Union and the exposures to the central government and central bank denominated and funded in domestic currency are assigned a risk weight according to Articles 114 (4) to (7), can receive two types of treatments:

• Either ECAIs nominated by the institution gave the central government of the jurisdiction in which the institution is incorporated an external rating, in which case Article 121(1) applies;
• Or central government does not have any rating from an ECAI nominated by an institution and therefore RW is 100%, according to Article 121(2).

Update 26.03.2021: This Q&A has been reviewed in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR) and continues to be relevant.