Default Definition is the specification of the precise criteria by which a Legal Entity (the Counterparty to a contract) is deemed to be "in credit default". The term is particularly relevant in the regulatory context of Basel II and the accounting context of IFRS 9 / CECL.
The need for a precise credit default definition arises from the variety of possible "states" and paths when a borrower enters repayment difficulties.
In Basel II context the definition of default is important for the purpose of measuring and validating rating performance and is standardized at 90 days past due
IFRS 9 Definition
The IFRS 9 Standard does not define default
Credit Default Swap Credit Events
In credit risk derivatives context the definition of default is recorded in product documentation as a Credit Event, typically one of the following:
Issues and Challenges
- Legal ambiguity given the many stages of Non-Performing Exposure
- The default definition may be different between different banks and even within a bank and different business lines.
- The default definition in External Risk Data used to support building a risk model may differ (see ECB TRIM below)
- Technical (documentation) difficulties
ECB TRIM Requirements
Institutions that use external data that are not in themselves consistent with the definition of default laid down in regulation must make appropriate adjustments to achieve broad equivalence with the definition of default. To comply with this requirement, institutions should ensure that when they make use of external data or pooled data they have a complete understanding of the definition of default applied to these data and perform a comparison between the definition of default used and regulatory requirements.
If there are differences between the definition of default applied in the external or pooled data and the institution’s own definition of default, the institution should assess the differences and describe the adjustments made to the risk estimates, in order to achieve the required level of consistency with the internal definition of default. It should also include an appropriate MoC to account for the adjustments included.
These adjustments should be appropriately documented and justified, in particular by providing reasonable assurance that they do not undermine the validity of the approach for the purposes of risk differentiation and risk quantification.
- ECB guide to internal models - Credit Risk, Sep 2018