On 22 July 2020, the European Banking Authority (EBA) issued a consultation paper on draft regulatory technical standards on default probabilities (PDs) and loss given default (LGD) for default risk model for institutions using the new Internal Model Approach (IMA) under the Fundamental Review of the Trading Book (FRTB).

Institutions using an alternative internal model to compute own funds requirements for market risk and holding positions in traded debt and equity instruments in trading desks covered by the IMA permission, are required to additionally compute an own funds requirement using an internal default risk model (DRC). One of the requirements to be met under the internal default risk model consists for institutions to be capable of modelling the default of individual issuers, as well as the simultaneous default of multiple issuers, and computing the impact of those defaults on the market values of the positions that are included in the scope of that model.

In order to simulate the default of issuers under the DRC, institutions need to estimate the PDs of those issuers in accordance with the requirements set out in paragraph 5 of Article 325bp of the Capital Requirements Regulation 2 (CRR2). In particular, institutions that have been granted  permission to estimate default probabilities in accordance with Section 1 of Chapter 3 of Title II (Permission to use the IRB approach) are required to use the methodology set out therein to calculate default probabilities, while institutions that have not been granted that permission are required to develop an internal methodology or use external sources to estimate default probabilities.

In order to simulate the default of issuers under the DRC, institutions need to estimate the relevant LGD in accordance with the requirements set in paragraph 6 of Article 325bp of the CRR2. Institutions that have been granted permission to estimate LGD in accordance with Section 1 of Chapter 3 of Title II (Permission to use the IRB approach) are required to use the methodology set out therein to calculate LGD estimates, while institutions that have not been granted that permission are required to develop an internal methodology or use external sources to estimate LGD.

The draft regulatory standards in the consultation paper specify the requirements that an institution’s internal methodology or external sources are to fulfil for estimating default probabilities and losses given default in accordance with point (e) of Article 325bp(5) and point (d) of Article 325bp(6).

The deadline for comments on the consultation paper is 22 October 2020.