Default Definition

From Open Risk Manual

Definition

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", signalling a Default Event. The need for a precise credit default definition arises from the variety of possible "states" and paths when a borrower enters repayment difficulties and is complicated by the large number of different types of obligors, contracts and jurisdictions. [1]

Usage

  • The term is particularly relevant for financial intermediaries in the regulatory context of Basel II/Basel III and the accounting context of IFRS 9.
  • In market context it plays a particularly important role in the context of the Credit Default Swap market

Regulatory Definitions

In Basel II/III context the definition of default is important for the purpose of measuring and validating rating performance and is standardized at 90 days past due. The definition of default influences own funds requirements both under the IRB Approach and under the Standardised Approach. In the case of the IRB Approach it is the basis for estimation of risk parameters and therefore influences risk weights and expected loss calculation for both defaulted and non-defaulted exposures. In the case of the Standardised Approach the definition of default is the basis for the assignment of exposures to the class of exposures in default.

European Union Context

The definition of default of an obligor specified in Article 178 of the Capital Requirements Directive (CRR) includes:

  • the days Past Due criterion for default identification
  • indications of unlikeliness to pay
  • conditions for a return to non-defaulted status and
  • treatment of the definition of default in external data.

EBA Guidelines

In the absence of specific rules on these and other aspects of the application of the definition of default various approaches have been adopted across institutions and jurisdictions. EBA/GL/2016/07[2] specifies the following specific choices (in summary):

  • Past due criterion in the identification of default
    • Counting of Days Past Due: For the purposes of the application of point (b) of Article 178(1) of Regulation (EU) No 575/2013, where any amount of principal, interest or fee has not been paid at the date it was due, institutions should recognise this as the credit obligation past due. Where there are modifications of the schedule of credit obligations, as referred to in point (e) of Article 178(2) of Regulation (EU) No 575/2013, the institution’s policies should clarify that the counting of days past due should be based on the modified schedule of payments.
    • Technical past due situation: The guidelines specify the definition and treatment of situations where recognition of default results from technical issues.
    • Exposures to central governments, local authorities and public sector entities: If the delay in payments results only from administrative procedures and there are no other indications of a diminished financial situation of the obligor or unlikeliness to pay, default may not be recognised until any material credit obligation of such obligors to an institution is, at the maximum, 180 days past due
    • Factoring and purchased receivables: where individual receivables are recognised on the balance sheet, the risk weight will apply to these individual receivables; where the receivables are not actually purchased and only the exposure to the client is recorded on the balance sheet, the appropriate risk weight will apply to this exposure.
    • Materiality threshold:
  • Indications of unlikeliness to pay
    • Specific credit risk adjustments (SCRA): All SCRA should be considered to be a result of a significant perceived decline in the credit quality of an obligation and hence should be treated as an indication of unlikeliness to pay.
    • Sale of credit obligations: If the loss on the sale of credit obligations is not related to credit risk and the institution does not perceive the credit quality of those obligations as declined, the sale should not be considered an indication of default even if the non-credit-risk-related loss is material.
    • Distressed restructuring: the assessment of whether the financial obligation has diminished should be based on a comparison between the present value of expected cash flows before the changes in the terms and conditions of the contract and the present value of expected cash flows based on the new arrangement, both discounted using the original effective interest rate.
    • Bankruptcy:
  • Application of the definition of default in external data
  • Criteria for a return to non-defaulted status
  • Retail exposures

ECB TRIM Requirements

In the context of the Targeted Review of Internal Models 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[3].

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 Margin of Conservatism 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.

IFRS 9 Definition

The IFRS 9 Standard notably does not offer a precise definition of default

Market Definitions

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 section)
  • Technical (documentation) difficulties

See Also

References

  1. BCBS D403, Prudential treatment of problem assets - definitions of non-performing exposures and forbearance
  2. EBA Guidelines on the application of the definition of default under Article 178 of Regulation (EU) No 575/2013, EBA/GL/2016/07
  3. ECB guide to internal models - Credit Risk, Sep 2018

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