The governance of credit risk models and the estimation of credit risk parameters (probability of default, loss given default, and the Best Estimate of Expected Loss) are now subject to increasingly close scrutiny by banking supervisory authorities. That is why, in this note, we analyze the regulatory requirements regarding the governance and estimation of credit risk parameters.
The note is primarily based on the EBA guidelines (EBA/GL/2017/16¹ and EBA/GL/2019/03²) and the TRIM (Targeted Review of Internal Models) guide.
These guidelines, which take effect in January 2021, specify the requirements for estimating credit risk parameters. The TRIM Guide explains how supervisory authorities interpret European regulations on internal risk measurement models (credit, market, and counterparty) and on model governance. The TRIM exercise, which took place from 2015 to 2019, aimed to:
- Ensure the credibility of internal models and confirm their suitability for calculating regulatory capital;
- Ensure regulatory compliance of models and reduce variability in risk-weighted assets (RWA) caused by inappropriate modeling.
The purpose of this note is to analyze regulatory requirements regarding credit risk in order to highlight the key aspects of modeling that supervisors are now paying close attention to.
¹ EBA Consultation Paper on Guidelines on PD Estimation, LGD Estimation, and the Treatment of Defaulted Exposures, November 14, 2016.
² EBA Guidelines for the Estimation of LGD Appropriate for an Economic Downturn (“Downturn LGD Estimation”), March 6, 2019.
