In a situation where a parent institution (good rating) has issued a full encompassing guarantee for a subsidiary - bad rating, thus supporting the subsidiary before a default event, and preventing (or reducing the risk of) a default – would this constitute a substitution effect due to a credit risk mitigation under paragraph 74 of EBA Guidelines EBA/GL/2017/16?

In article 74 of EBA/GL/2017/16 it is stated that ‘when assigning the obligors or exposures to grades or pools for the purpose of the one-year default rate calculation, institutions should take overrides into account, but they should not reflect in this assignment any substitution effects due to credit risk mitigation, …’.

If we consider the following two situations:

1. A parent (good rating) has issued a full encompassing guarantee for a subsidiary (bad rating). The parent supports the subsidiary already before a default event, which prevents (or reduces the risk of) a default. Rating of the parent is transferred to the subsidiary.

2. A guarantor (good rating) has signed an obligation to pay the full amount of an obligor (bad rating) after the event of default. Rating of the guarantor is transferred to the obligor.

In situation 2, calibration using the rating before transfer would produce an unbiased estimate of the PD. In situation 1, on the contrary, using the rating before transfer would bias the PD down (the obligor with the bad rating will not default due to the support).  It is unclear whether it is correct that situation 1 can be interpreted to be not  a form of ‘substitution effect due to credit risk mitigation’ and hence the rating after transfer can be used for calibration.

For the purpose of calculating own funds requirements under the IRB Approach described in Part III, Title II, Chapter 3 of Regulation (EU) No 575/2013 as amended  by Regulation (EU) 2019/876  (CRR2), subject to specific eligibility requirements, the existence of unfunded credit risk protection (UFCP) may be recognised in the application of risk parameters using different approaches, which are described in the report on the credit risk mitigation (CRM) framework and the Guidelines on credit risk mitigation for institutions applying the IRB approach with own estimates of LGD (EBA/GL/2020/05, GL on CRM). In particular:

• The substitution approach, in the case where regulatory LGDs are used in accordance with Article 236 of the CRR, via the use of the PD of the protection provider instead of that of the obligor or, where a full substitution is not deemed to be warranted, a PD in-between and the use of the LGD for senior claims in the case of subordinated exposures and non-subordinated unfunded protection;
• The substitution of risk parameters approach, in the case where own LGD estimates are used, in accordance with Article 161(3) of the CRR, via 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;
• The substitution of Risk Weight, in the case of guarantors whose direct exposures are treated under the SA (SA guarantors), in accordance with Article 183(4) of the CRR, via the use of the SA risk weight that the institutions would assign to comparable direct exposures to the guarantor.

The first two cases of substitution relate to the risk parameters applied to grades or pools and the third to the risk weight applied to the exposure and should therefore not be additionally reflected when assigning the obligors or exposures to grades or pools, as clarified by paragraph 74 of the Guidelines on PD estimation, LGD estimation and the treatment of defaulted exposures (EBA/GL/2017/16).

By contrast, paragraph 62 of said Guidelines describes how, for purposes of PD model development, an institution may take into account in the risk assessment of an obligor a situation where a contractual or organisational relation exists between a third party and an obligor. As clarified in paragraph 16 of the GL on CRM, this situation does not qualify as unfunded credit risk mitigation as defined by Article 4(1)(59) CRR2 and therefore none of the substitution approaches described above could be used. However, the contractual support provided by a third party to the obligor (i.e. the “appropriate guarantee” referred in par 62(a) of the Guidelines), may be reflected in the rating of the obligor. In particular, in specific situations described in paragraph 62(a) of the Guidelines, the rating of a third party may be transferred to the obligor. Further information on criteria for rating transfer is provided in Q&A 4745.

In accordance with paragraph 74 of the Guidelines, for PD quantification purposes and in particular for the calculation of one-year default rates, institutions should use the grade or pool assignment of the obligor without substitution effects due to UFCP recognition. However, the contractual or organisational relations between a third party and an obligor, which are reflected in the rating of an obligor based on paragraph 62 of the Guidelines are part of the rating of an obligor and should be taken into account in assigning the obligors or exposures to grades or pools for the purpose of the one-year default rate calculation.