Minimum Capital Requirements for Credit Risk

Under the advanced approach, banks must assign an estimate of EAD for each eligible facility. It must be an estimate of the long-run default-weighted average EAD for similar facilities and borrowers over a sufficiently long period of time, but with a margin of conservatism appropriate to the likely range of errors in the estimate. If a positive correlation can reasonably be expected between the default frequency and the magnitude of EAD, the EAD estimate must incorporate a larger margin of conservatism. Moreover, for exposures for which EAD estimates are volatile over the economic cycle, the bank must use EAD estimates that are appropriate for an economic downturn, if these are more conservative than the long-run average. For banks that have been able to develop their own EAD models, this could be achieved by considering the cyclical nature, if any, of the drivers of such models. Other banks may have sufficient internal data to examine the impact of previous recession(s). However, some banks may only have the option of making conservative use of external data. Moreover, where a bank bases its estimates on alternative measures of central tendency (such as the median or a higher percentile estimate) or only on ‘downturn’ data, it should explicitly confirm that the basic downturn requirement of the framework is met, ie the bank’s estimates do not fall below a (conservative) estimate of the long-run default- weighted average EAD for similar facilities. 16.90 The criteria by which estimates of EAD are derived must be plausible and intuitive, and represent what the bank believes to be the material drivers of EAD. The choices must be supported by credible internal analysis by the bank. The bank must be able to provide a breakdown of its EAD experience by the factors it sees as the drivers of EAD. A bank must use all relevant and material information in its derivation of EAD estimates. Across facility types, a bank must review its estimates of EAD when material new information comes to light and at least on an annual basis. 16.91 Due consideration must be paid by the bank to its specific policies and strategies adopted in respect of account monitoring and payment processing. The bank must also consider its ability and willingness to prevent further drawings in circumstances short of payment default, such as covenant violations or other technical default events. Banks must also have adequate systems and procedures in place to monitor facility amounts, current outstandings against committed lines and changes in outstandings per borrower and per grade. The bank must be able to monitor outstanding balances on a daily basis. 16.92 Banks’ EAD estimates must be developed using a 12-month fixed-horizon approach; i.e. for each observation in the reference data set, default outcomes must be linked to relevant obligor and facility characteristics twelve months prior to default.