credit risk definition

Changes in interest rates can impact borrowers’ debt servicing capacity, which may, in turn, affect their credit risk. Macroeconomic factors, such as economic conditions, interest rates, and the regulatory environment, can also influence credit risk. Borrower-specific factors, such as creditworthiness, financial performance, and industry sector, play a significant role in determining credit risk.

4.331 Given that the PRA has not observed any strong evidence to suggest that firms can build effective rating systems for IPRE exposures, the PRA proposes that the option for firms to apply the AIRB or FIRB approaches for IPRE exposures would no longer be permitted. 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. 4.319 The PRA considers that HVCRE exposures typically exhibit higher loss rate volatility compared to other types of specialised lending and that HVCRE exposures should therefore receive higher risk weights than IPRE exposures for a given slotting assignment. While the proposal could increase RWAs for some exposures, the PRA would not expect the increase to be material in aggregate as the PRA assesses that HVCRE is unlikely to be a significant exposure class for most firms.

Table 2: Proposed unsecured and retail residential mortgage LGD floors

The PRA therefore proposes to clarify that firms applying the LGD adjustment method would not be permitted to also reflect the effect of the guarantee by adjusting obligor grades. 4.222 The PRA does not consider that similar prudential concerns Differences Between For-Profit & Nonprofit Accounting arise from the use of continuous rating scales for LGD and EAD models because the IRB risk weight formula is linear in LGD and EAD. The PRA therefore does not propose to restrict the use of continuous rating scales for LGD and EAD.

credit risk definition

4.182 This section sets out the PRA’s proposals relating to the definition of default and is relevant to firms using the SA and the IRB approach. 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. Firms are also expected to use data from a representative mix of good and bad economic periods to calibrate PD and data from downturn periods to calibrate LGD and EAD. 4.165 The Basel 3.1 standards set minimum data requirements for firms to adopt the IRB approach. These state that firms should use at least five years of data from at least one source to estimate all parameters, with the exception of LGD and EAD for non-retail portfolios where seven years of data is required.

Input floors

4.277 The PRA also proposes to introduce an ‘unrecognised exposure adjustment’ to RWAs in order to reflect risks falling outside the scope of IRB approaches for EAD. This proposal is discussed in section ‘Calculation of risk-weighted assets (RWA) and expected loss (EL)’ above. 4.247 The proposed formula is in line with that proposed for firms applying the foundation collateral method, as set out in Chapter 5 (an analogous formula would be applied where multiple collateral types are recognised).

Supervisory expectations for the credit risk management approach used by individual banks should be commensurate with the scope and sophistication of the bank’s activities. For smaller or less sophisticated banks, supervisors need to determine that the credit risk management approach used is sufficient for their activities and that they have instilled sufficient risk-return discipline in their credit risk management processes. 4.320 The PRA considers that the proposed introduction of HVCRE would enhance the risk-sensitivity of the slotting approach and would help ensure that a greater degree of risk-sensitivity is retained relative to the proposed specialised lending treatment in the SA. The PRA considers this would result in RWAs for specialised lending being more reflective of the risk of a firm’s exposures. The PRA considers that the introduction of the HVCRE category would therefore promote the safety and soundness of firms. 4.301 The PRA has assessed whether the proposals on EAD modelling would facilitate effective competition.

– Introduction to Credit Risk

Overall, effective credit risk management is essential to maintaining a healthy and stable financial system. The Committee stipulates in Sections II through VI of the paper, principles for banking supervisory authorities to apply in assessing bank’s credit risk management systems. Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences.

4.272 The PRA considers that the different changes proposed in this section would potentially have different impacts on competition but it does not expect that the proposals to adversely impact the facilitation of effective competition overall. 4.209 The PRA proposes to remove the existing 10% exposure-weighted average portfolio LGD floor for residential mortgages in the retail How to do bookkeeping for a nonprofit exposure class and the existing 15% exposure-weighted average portfolio LGD floor for commercial mortgages in the retail exposure class. The PRA considers these floors are not required given the proposed retention of a 10% portfolio risk weight floor for retail residential mortgages, the relative low materiality of retail commercial mortgages, and the proposed input floors.

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