Commission Delegated Regulation (EU) 2023/1578 of 20 April 2023 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards specifying the requirements for the internal methodology or external sources used under the internal default risk model for estimating default probabilities and losses given default (Text with EEA relevance)

New Commission Delegated Regulation (EU) 2023/1578 specifying Regulatory Technical Standards (RTS) on probabilities of default (PDs) and losses given default (LGDs) for default risk model for institutions using the new Internal Model Approach (IMA) under the Fundamental Review of the Trading Book (FRTB) has been published in the Official Journal (OJ) of the EU. Specifically, the regulation „clarifies the requirements that an institution’s internal methodology or external sources are to fulfill for estimating default probabilities and losses given default“. The primary aim of the RTS is to ensure a level playing field among institutions using an internal ratings based approach (IRB) and those that are not for purposes of computing market risk, while addressing situations where institutions can’t rely on external sources or feasible models for determining PDs or LGDs.
#### Background
Institutions using an IMA for calculating their own funds requirements related to holdings of traded debt and equity instruments in the trading book and thus to market risk need to calculate an extra default risk capital (DRC) requirement. This means they must allocate additional funds internally to cover potential default risks. To meet this requirement, institutions must have the ability to model the default of individual issuers and the collective default of multiple issuers. Furthermore, they need to assess how these defaults would affect the market values of the positions included in the model’s scope.
In order to simulate issuer defaults within the IMA, institutions must estimate the PDs for these issuers. Institutions without permission to estimate PDs via the IRB approach must create an internal method or use external sources to estimate PDs for DRC purposes. Similarly, if institutions using the IRB approach lack an available PD estimate for a specific issuer, they can also employ an internal method or external sources for estimation. Basically the same holds true for the estimate of LGD.
#### Content of the regulation
Among others, the regulation specifies
(1) requirements for the internal methodology for estimating default probabilities including the requirement that an institution’s internal default probability estimation methodology must meet the same criteria as methodologies used by institutions permitted to estimate default probabilities under an IRB unless certain conditions are met (no external data source available, a calculation is unfeasible).
(2) requirements for external sources for estimating default probabilities including the requirement that the data source is sound and periodically reevaluated. In case multiple external data sources are used, a hierarchy must be developed. Furthermore, certain requirements on the methodology must be met.
(3) requirements for the internal methodology for estimating losses given default including the requirement that an institution’s loss given default estimation methodology must meet the same criteria as methodologies used by institutions permitted to estimate LGD under an IRB unless certain conditions are met (no external data source available, a calculation is unfeasible). Additionally, it specifies the minimum LGD values to be assigned to debt positions.
(4) Requirements for external sources for estimating losses given default including the requirement to „validate the estimates of losses given default on a periodic basis for their use in the internal default risk model“ and to – again – develop a hierarchy of external sources.
(5) Documentation obligations including the obligation to document the absence of suitable external sources for estimating default probabilities for issuers and losses given default for positions (if so), reasons for not using internal methodologies (if so), certain calculation requirements pertaining to the exceptional status of a position’s LGD and PD calculation (m-value) and an updated inventory of external data sources.