Unsecured IRB: Fresh start or status quo?

To submit or not to submit…?

At a macro-level, the key question firms are asking is ‘when will the PRA start reviewing unsecured models, and what regulatory requirements will they assess them against?’. Given the current delays with mortgage model submissions, it is relatively clear that the PRA will expect firms to align any new model submissions with the Basel 3.1 requirements - final policy rules for credit risk are expected to be published in May/ June this year, which should provide a backdrop for further clarity on submission timelines.

When commencing development work on unsecured portfolios, firms should align approaches to the Basel 3.1 draft rules, and be prepared to respond to any updates once the final rules are published, before submitting to the PRA. The experience of enforcing the ‘wave’ approach to stagger model change applications has historically impacted the quality of submissions to the PRA; the regulator has therefore also indicated that they may be open to being ‘industry-led’ in determining appropriate timelines for the submission of unsecured models.

Where models are already compliant with the Basel 3.1 requirements, there is a discussion over whether submission to the PRA is even required - given there is no fundamental regulatory update specifically in relation to unsecured models (bar the changes for EAD models - see below), and the (relatively lower) materiality of unsecured portfolios to UK credit RWAs. Against this backdrop, the PRA may look to take a proportionate approach to submissions and approvals. This is in contrast to other asset classes, such as wholesale portfolios, where the PRA is challenging firms on previously accepted approaches.

If it ain’t broke, don’t fix it

As noted above, firms should be thinking about the Basel 3.1 requirements when assessing model compliance. Given the materiality of the unsecured models (particularly in comparison to mortgage portfolios), we expect firms to be adopting a proportionate approach to redevelopment activity, ensuring compliance with any new requirements.

One of the key focus areas we have been discussing with firms is the use of “point in time plus buffer” approaches for unsecured PD models. This approach is conceptually “non-compliant” with regulation, given the requirement for PDs to reflect long run averages of one-year default rates^[1], but has continued to be the industry-standard rating philosophy for these portfolios. We are aware of recently approved models adopting this framework and current expectations are for it to remain common practice - changes firms are making have been focused on new requirements being proposed through Basel 3.1.

One of the more material changes being proposed through the Basel 3.1 draft rules are the requirements for the structure of EAD models. Practices across firms have historically been mixed on this topic, with some firms taking a ‘fixed-horizon’ approach, whereas others applied a ‘cohort-based’ approach. The proposed Basel 3.1 rules require firms to adopt a ‘fixed-horizon’ approach, which may bring some alignment between IFRS 9 and IRB models. Under the Basel 3.1 proposals, a formal definition of what constitutes a commitment has also been streamlined across the IRB and standardised approaches.

Same stuff, different models…

Firms should bear in mind other regulatory expectations which have emerged throughout the mortgage hybrid model reviews, which may also be applicable to unsecured models. In particular, the use of bureau scores within scorecards - firms must ensure these are not dominant risk drivers and that sufficient internal information is used to support the risk ranking of exposures.