1

To: CRSG Date: 26 August 2008

From: Credit Risk Policy cc:

Subject: THE IRB REQUIREMENT FOR UNEXPECTED LOSS FOR DEFAULTED

ASSETS

Introduction and summary

1. The purpose of this note is to advise industry members of the approach being taken by
the FSA’s Decision Making Committee (DMC) on the above topic. In particular it
advises IRB firms of a precedential decision made by the DMC in respect of one
approach for estimation of UL and which is described in this paper, following a
CRDTG question, as the “independent calculation” approach.

2. The decision effectively floors the UL at a 100% risk weight of amount

outstanding net of provisions – which is the across-the-board treatment used by
the US and Swiss supervisors – where the “independent calculation” approach is
being used for some or all exposures. Any affected firms will be expected to
move into compliance with this decision as soon as is practicable. Any firms who
have problems in this regard should raise this issue with their supervisors in the
first instance.

3. We should stress that:-

a) This floor only applies where the independent calculation approach is being
used which we understand is relatively rare;

b) This treatment is not at all relevant where the Foundation IRB approach is
being used, as UL is deemed to be embedded within the supervisory estimates
of LGD.

Background

4. UL on defaulted assets is a topic that has that has received very little attention in the
development of the IRB approach, international or domestic discussions on
implementation, or the FSA’s model approval process. Although the EU have a
published Q&A through the CRD Transposition Group process on this topic, neither
the text of the answer nor follow-up discussions with the Commission have been of
much assistance in progressing to an answer on the issues raised in this note.

5. As we see it the Basel text and consequently the CRD and BIPRU contain two
different philosophical approaches to UL on defaulted assets. These result from the
way in which certain aspects of the IRB approach were developed.

6. As far as defaulted assets are concerned IRB clearly has the notion of an Expected
Loss charge (known as Best Estimate of Expected Loss, or BEEL). However an
Unexpected Loss charge is also needed because of the risk that losses will be higher

1/4
 2

than expected over the recovery period. This was the initial consideration in Basel,
and is reflected in their text. This approach with a UL specifically added on to the
BEEL is known as the “independent calculation” approach in the CRDTG question.
However in its purest form, because it relates to volatility over the recovery period of
the presently defaulted assets, there is no necessary relation between that and a
downturn calibration. The question of how much the add-on should be is the central
general question. However, one feature of this approach is that we would expect it to
produce a total LGD (BEEL plus UL) that is relatively cyclical as BEEL will vary
with the cycle and the UL will always be positive.

7. The second approach was developed in 2003/4 following the package of changes to
Basel which reinforced the primacy of downturn LGD as the necessary calibration.
This allows a simple method of

a) Working out a downturn (or default weighted average if downturn agreed not
be relevant) LGD on defaulted assets;

b) Working out a BEEL on the same assets;

c) The difference between the two is the UL charge, and may be known as the
“difference between LGD and BEEL” approach.

8. With very few exceptions, all of the approaches that we have explicitly assessed in the
approval process are what we would characterise as being of the “difference between
LGD and BEEL” variety. A feature of the difference approach is that it should not be
very cyclical as the UL decreases, possibly to zero, as the BEEL approaches the
downturn LGD; whereas in an upturn reductions in do not impact the total LGD.

9. The CRDTG answer suggests that both of these approaches are acceptable in
principle. However it did not address the consequent issue of how much divergence
between the answers produced by the two approaches are acceptable. Given that we
believe the difference approach produces an answer that is logically “correct” within
the calibration principles of the IRB framework, we might characterise this as “by
how much can an independent calculation approach diverge from the difference
approach”.

10. The DMC had to consider this issue recently in an amendment proposal by a bank that
incorporated moving from what we characterised as a difference approach to an
independent calculation approach. It noted the following:-

a) There was no accepted settled answer to the question of consistency between

difference and independent calculation approaches and little real prospect of
one emerging in the foreseeable future;

b) Pursuing the rationale for differences in the case in question was leading us
into unanticipated complexity and protracted discussions;

c) Certain major supervisors had sidestepped the complexity of the issues around
UL on defaulted assets by mandating that the UL should be an across-the-
board 100% risk weight of the amount outstanding.

2/4
 3

11. The DMC accordingly agreed that it would make a pragmatic precedential
decision in that particular case – i.e. that it should be applied to all other cases
where any firm is using the independent calculation approach for UL as part of
own estimates of UL.

12. Where a firm is adopting the independent calculation approach, the FSA would
accept their UL estimates provided they are at least equal, at a portfolio level, to
a 100% risk weight/ 8% capital requirement on the amount outstanding net of
provisions. In effect this sets a 100% risk weight as a floor.

3/4