Expected Loss Best Estimate

Definition

Expected Loss Best Estimate (EL_BE) is a regulatory term and risk parameter, denoting the credit loss expectation on defaulted assets^[1]. The measure is related to but distinct from the regulatory LGD In-Default, and also distinct from accounting measurements (including the upcoming IFRS 9 measure of Expected Credit Loss for Stage 3 Assets

Requirements

The EBA consultation paper provides the following requirements:

For the purpose of estimating ELBE institutions should use the same estimation methods used for estimating LGD on non-defaulted exposures as they are in fact part of the LGD model
As for non-defaulted exposures, ELBE estimates should be based on the institutions’ own experience. This may be supplemented with external data. Firms should not derive their ELBE from the market prices of financial instruments such as marketable loans, bonds or credit default instruments;
When estimating ELBE institutions should use the same RDS and the same methods for computing the long-run average LGD including, for example, the treatment of incomplete recovery processes and the historical observation period
Institutions should take into consideration all relevant post-default information in their ELBE estimates in a timely manner. In particular, where events from the recovery process invalidate the recovery expected by the most recent ELBE estimation, institutions should update immediately their EL BE estimates
The scope of data necessary for proper ELBE estimation not only includes those required for LGD for non-defaulted exposures but also all relevant operational information obtained during the recovery process and, in particular, at each reference date used in the estimation. This implies that for the purpose of the treatment of defaulted assets institutions should additionally store relevant risk drivers, including those that become relevant after default, and outstanding exposure amounts at each reference date.
For the purpose of application of the ELBE to a given defaulted exposure in the current portfolio institutions should first evaluate which reference date is relevant for the exposure under consideration
Institutions should perform back-testing and benchmarking of their ELBE

Reference Date

For the purpose of computing realised LGDs for defaulted exposures institutions should use reference points in time that will be relevant for the current outstanding obligations of defaulted exposures
The draft GL suggests that institutions should set discrete relevant reference dates at which the realised LGDs should be computed. This way it should be feasible to estimate the parameters for defaulted exposures that are appropriate for their current status
In order to ensure adequacy of the estimates institutions should set the reference dates according to the recovery pattern observed on a specific type of exposures , where such reference dates may be either event based, e.g. linked with the realisation of collateral, or may reflect certain time periods during which exposures have been in-default

Conservatism

In accordance with Article 181(1)(h) of the CRR the ELBE estimation methods should take into account all currently available and relevant information and, in particular, consider current economic circumstances and exposure status. Taking this into consideration the draft GL clarifies that the ELBE should not include any Margin of Conservatism as this would not be in line with the best estimate concept. Adding conservativeness, in fact, does not increase the accuracy of the estimates but rather covers for the risk that the estimates might be too optimistic

References

↑ EBA/CP/2016/21

[1] EBA/CP/2016/21

[1]