Assessment of inherent credit risk

Competent authorities should assess credit risk from both a current and forward-looking perspective, integrating the analysis of the current portfolio’s credit risk with the assessment of the institution’s credit risk strategy, risk appetite and risk limits (potentially as part of the wider assessment of strategy carried out as part of the BMA). Competent authorities should also consider how the expected, as well as the stressed, macro-economic developments could affect those elements.

To assess the inherent credit risk of an institution, competent authorities should first identify its credit risk exposure. To achieve this and ensure consistent identification of the sources of credit risk the institution is or might be exposed to, they should consider the following sources of information:

Competent authorities should focus their assessment primarily on the most significant identified sources of credit risk, evaluating their materiality for the institution from a prudential perspective. To conduct this assessment, they should consider the following elements:

Competent authorities should assess the materiality of the risk in relation to the current portfolio, as well as with an historical and forward-looking perspective (previous change in these figures and forecasts, where available).

As additional source of information for the materiality assessment, competent authorities should – where available and appropriate – consider the internal credit risk parameters used by the institution. This includes assessing their adequacy in accurately quantifying credit risk exposures across different portfolios, with particular attention to evidence from the yearly report produced by the validation function of the institution, and more specifically on backtesting outcomes – that is, comparing estimated parameters with observed outcomes as conducted by the institution. Competent authorities should place emphasis on portfolios where the estimated parameters have underestimated the observed outcomes.

Competent authorities should also consider the results of stress tests performed by the institution to identify any previously unidentified sources of credit risk, such as those emerging from changes in credit quality, credit concentrations, collateral value and credit exposure during a stressed period.

Based on the materiality assessment performed in the previous paragraphs, as well as the size and complexity of the institution’s credit risk and credit portfolio, competent authorities should choose the relevant level of details for the assessment.

Competent authorities should assess the nature of the credit exposures (i.e. the types of borrowers and exposures) and analyse the composition of the institution’s credit portfolio. In performing this assessment, competent authorities should also consider how the nature of credit risk exposure can affect the size of exposure (e.g. credit lines/undrawn commitments drawn down by borrowers, foreign currency denomination), taking into consideration the institution’s legal capacity to unilaterally cancel undrawn amounts of committed credit facilities.

To assess the nature of credit risk, competent authorities should consider at least the following subcategories of credit risk by carrying out a more detailed assessment of those subcategories which are considered most relevant for the institution⁽³⁷⁾:

Where specialised lending exposures are deemed material, competent authorities should assess such exposures separately from other lending activities, given that the risk of such exposures lies in the profitability of the asset or project financed (e.g. commercial real estate, energy plant, shipping, commodities) rather than the borrower (which is generally a special purpose vehicle). In conducting this assessment, competent authorities should consider:

When assessing portfolio credit quality, competent authorities should pay particular attention to the adequacy of the classification of credit exposures and assess the impact of potential misclassification, with the subsequent delay in the provisioning and recognition of losses by the institution.

Competent authorities should carry out an analysis to distinguish between performing, non-performing and forborne exposure categories, considering both the number of obligors and the relevant amounts/volumes. Competent authorities should assess the overall credit quality at portfolio level and the different quality grades within each of the above categories to determine the institution’s overall credit risk. As part of this assessment, competent authorities should analyse default and migration risk by exposure classes, taking into account trends in the credit quality over time, and they should consider whether the actual portfolio credit quality is consistent with the stated risk appetite and establish reasons for any deviations.

This should result in an overall assessment on the end-to-end credit cycle of the institution, from origination through the monitoring and management of each exposure categories. In conducting these analysis, competent authorities should employ peer comparison and use benchmark portfolios (i.e. portfolios of borrowers common to groups of institutions) where appropriate and possible. This analysis should be carried out taking into account:

Competent authorities should assess whether the level of loan loss provisions and credit valuation adjustments are appropriate for the quality of the exposures and, where relevant, for the level of collateral, assessing in particular whether the level of loan loss provisions is consistent with the level of risk in different portfolios, over time and compared with the institution’s relevant peers as well as relevant macro-economic developments and whether the credit valuation adjustments to derivatives’ market values reflect the creditworthiness of relevant counterparties. Where deemed necessary, competent authorities should use on-site inspections or other appropriate supervisory actions to assess whether or not the level of loan loss provisioning and risk coverage is adequate, by assessing a sample of loans, for example. When conducting such assessment, competent authorities should also consider any findings raised by internal and external auditors, where available.

When evaluating the inherent credit risk of an institution, competent authorities should also take into account the results of stress tests performed by the institution to identify any previously unidentified sources of credit risk, such as those emerging from changes in credit quality, credit concentrations, collateral value and credit exposure during a stressed period.

Competent authorities should consider the level and quality of guarantees (including credit derivatives) and of available collateral that would mitigate credit losses where credit events occur, including those not accepted as eligible credit risk mitigation techniques for own funds calculations. In performing such assessment, competent authorities should consider:

Competent authorities should also assess the materiality of the residual risk (as referred to in Article 80 of Directive 2013/36/EU) and in particular the adequacy and enforceability of collateral agreements and of guarantees, the timing and the ability to realise collateral and execute guarantees under the national legal framework, the liquidity and volatility in asset values for collateral and the recoverable value of collateral under any credit enforcement actions. Competent authorities should also assess the concentration of guarantors and collateral, as well as the correlation with borrowers’ creditworthiness (i.e. wrong-way risk) and the potential impact in terms of the effectiveness of protection.