Credit risk: the definition of default

credit risk definition

4.173 The PRA also proposes to introduce a requirement that firms submit an annual model inventory to the PRA. This proposal would replace existing requirements to submit model inventories where these have been applied to individual firms under s55M FSMA. 4.166 UK firms are currently subject to a five-year minimum data requirement for all parameters, including LGD and EAD for non-retail portfolios, which can be met with internal, external, or pooled data.

  • In calculating credit risk, lenders are gauging the likelihood that they will recover all of their interest and principal when giving a loan.
  • In some cases, these floors consist of recalibrated values of floors in the existing Basel standards.
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  • This can be aggregated at the borrower level to determine likely disposable income and potential shocks under various scenarios.
  • Creating a longer horizon of predictability is no simple task, but it can help to break performance down into groups of significant drivers and assess relevant trends both at portfolio and obligor levels.
  • 4.286 The PRA considers that it is typically challenging for firms to model EAD robustly for slotted exposures because of a lack of relevant data.

4.270 The proposed removal of the PRA’s LGD wholesale framework reflects the proposed introduction of three new constraints on LGD modelling. The PRA considers that these proposed measures, on balance, would result in an appropriate degree of conservatism. 4.253 As noted in Chapter 5, while the PRA proposes to withdraw the option of adjusting PD to reflect UFCP, it proposes to continue to permit firms to recognise support arrangements through the adjustment of obligor grades in some circumstances. The PRA notes that both the CRR and the Basel 3.1 standards are open to interpretation about whether firms can combine the LGD adjustment method with adjustments to obligor grades. 4.230 The PRA considers that the Basel 3.1 standards are open to interpretation in respect of the interaction of obligor grade adjustment with CRM techniques, for example PD substitution (which the PRA proposes to retain) and PD adjustment (which the PRA proposes to withdraw).

What you need to know about credit risk…

The PRA also proposes to introduce an explicit expectation that firms submitting applications and notifications relating to the IRB approach should provide the PRA with a self-assessment of whether it complies with relevant CRR requirements, PRA rules, and SS expectations. EAD is based on the idea that risk exposure depends on outstanding balances that can accrue before default. For example, for loans with credit limits, such as credit cards or lines of credit, risk exposure estimates should include not just current balances, but also the potential increase in the account balances that might happen before the borrower defaults.

  • 4.230 The PRA considers that the Basel 3.1 standards are open to interpretation in respect of the interaction of obligor grade adjustment with CRM techniques, for example PD substitution (which the PRA proposes to retain) and PD adjustment (which the PRA proposes to withdraw).
  • The PRA also considers that to remove the wholesale LGD framework would prevent an excessively complex regime.
  • Firms currently using the IRB approach for IPRE exposures would instead be required to risk weight the exposures using the slotting approach.footnote [26] The PRA proposes that this restriction would also apply to exposures that would be newly allocated to the HVCRE category.
  • 4.112 However, the PRA considers that one-off costs that relate to implementing the proposed requirements set out in this CP could occur and that, as a result, mandating firms to remain on either the FIRB approach or the AIRB approach could be unduly burdensome.
  • Risk appetite framework refers to a set of principles and guidelines that define a financial institution’s willingness to take on credit risk.
  • In personal lending, creditors will want to know the borrower’s financial situation – do they have other assets, other liabilities, what is their income (relative to all of their obligations), and how does their credit history look?

The PRA also proposes to align the scope of the remainder of the ‘equity’ exposure class with those exposures that are treated as equity under the SA. 4.32 Under the CRR, the PRA approves applications for IRB permissions if, and only if, it considers that all the requirements in the IRB chapter of the CRR are fully met. As a result, firms must remediate any CRR non-compliance in an IRB model application before an IRB permission can be granted by the PRA, even if the effect of the non-compliance is immaterial. Credit risk is a particular problem when a large proportion of sales on credit are concentrated with a small number of customers, since the failure of any one of these customers could seriously impair the cash flows of the seller. A similar risk arises when there is a large proportion of sales on credit to customers within a particular country, and that country suffers disruptions that interfere with payments coming from that area.

Credit Risk Management Techniques

4.158 As set out in Chapter 13, the PRA has proposed a methodology for redenominating certain references to Euros (EUR) and US Dollars (USD) into Pound Sterling (GBP) in the PRA rules proposed in this CP. 4.39 The PRA considers that this proposed change would be beneficial as it would enable IRB model improvements to be implemented sooner by firms. However, the PRA continues to consider it important that firms seek to promptly remediate non-compliance and would retain the right to take supervisory action in respect of remaining non-compliance, in cases where it grants approval for a materially non-compliant IRB application, for a material model change. 4.12 This section sets out the PRA’s proposed timelines for implementing the changes to the IRB approach proposed in this chapter.

The Basel Accords are a set of international banking regulations developed by the Basel Committee on Banking Supervision (BCBS) to enhance the stability of the global financial system. Additionally, they can stay informed about changes in debt recovery laws and regulations, which can impact the recovery process.

Credit Derivatives

4.51 The PRA has reviewed the existing IRB exposure classes and proposes a small number of definitional changes. The PRA also proposes to introduce new exposure sub-classes in some cases to bring greater clarity to the regulatory framework. There are instances where firms are required to apply different treatments to different categories of exposures within an exposure class. The introduction of exposure sub-classes would enable these requirements to be set out more clearly. 4.1 This chapter sets out the Prudential Regulation Authority’s (PRA) proposals to implement the Basel 3.1 standards for the internal ratings based (IRB) approach to credit risk.

Financial institutions can use various tools, such as credit scoring models and collateral requirements, to minimize their exposure to default risk. For example, a mortgage applicant with a superior credit rating and steady income is likely to be perceived as a low credit risk, so they will likely receive a low-interest rate on their mortgage. In contrast, an applicant with a poor credit history may have to work with a subprime lender to get financing. For large individual obligors, it can make sense to go further, modeling revenues and costs under various scenarios and shocks to create cash flow curves and understand debt service coverage.