EBA final draft technical standards on the specification of an economic downturn

On 16^th November 2018 the European Banking Authority published final draft Regulatory Technical Standards (RTS) on the specification of the nature, severity and duration of an economic downturn in accordance with Articles 181(3)(a) and 182(4)(a) of Regulation (EU) No 575/2013.

The Basel formula for IRB (Internal Ratings Based) approach capital requirement requires that loss given default (LGD) and conversion factor (CF) estimates should reflect downturn conditions if these estimates are more conservative than the long-run averages. However, the identification of LGDs appropriate for such downturn conditions (LGD DT) and similarly CFs (CF DT) has proven challenging.

A precondition to limiting unjustified variability stemming from LGD DT estimation is a common specification of ‘economic downturn’ conditions as referred to in the relevant CRR articles. After intensive debates, the approach that has been chosen in the final draft regulatory technical standards (RTS) aims to specify the identification of an economic downturn independent of the applied LGD or CF estimation methodology. The guidelines on LGD DT estimation will be elaborated separately.

There are three features defined in the RTS:

• The nature of the economic downturn is a set of economic factors relevant for the type of exposures under consideration.
• The severity of an economic downturn is the set of the most severe values of economic factors observed over a given historical period on the relevant.
• The duration of an economic downturn is the set of durations of the downturn periods constituting the economic downturn under consideration.

A downturn period is defined as a period of time of at least 12 months during which the most severe values (i.e. the severities) of several correlated relevant economic factors are reached simultaneously or shortly after each other. The identification of an economic downturn has to be reviewed annually and updated in case a new downturn period is identified.