A Financial Guarantee is contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.
Usage for Credit Rating Purposes
A financial guarantee will typically substantially alter (improve) the Credit Risk profile of the debtor. The manner by which this is reflected in accounting, risk management and regulatory frameworks varies significantly.
ECB TRIM Requirements
Third Party Support
Institutions should have a clear policy specifying the conditions under which the rating of a third party which has a contractual or organisational relationship with an obligor of the institution (third-party support) may be taken into account in the risk assessment of that obligor. This policy should meet the following criteria :
- It should specify in which situations the rating of a parent entity could be taken into account in the risk assessment of other entities of the group. In particular, the policy should specify those situations in which obligors are assigned to a better grade than their parent entities.
- It should include provisions on the use of ratings of third parties that provide contractual support to more than one obligor. As a general rule, the policy should include, but not be limited to, possible prioritisation, eligibility, and the impact on the rating of the supporting third party.
Unfunded Credit Protection
Institutions may recognise the guarantee by applying the risk weight of the guarantor under the standardised approach to the covered part of the exposure, if no own estimates of LGD and CCFs are used. This applies when an obligor is guaranteed by a third party that is not in the range of application of a PD model and the guarantee fulfils all requirements for credit risk mitigation (CRM).
In such situations, the guaranteed obligor should be included in the calculation of the one-year default rate of the grade the obligor is assigned to, before the recognition of the guarantee.
In addition, when the institution reflects substitution effects arising from CRM in the ratings assigned to a material number of exposures within a rating system, there is a risk that the process of assigning exposures to grades or pools might not provide for a meaningful differentiation of risk, as a result of the inclusion of obligors with significantly different risk levels within the same rating grade.
To mitigate this risk, institutions should verify that obligors guaranteed by a third party under the standardised approach do not carry a significantly different level of risk from those in the same rating grade without such a guarantee, and that no separate calibration segment is required
When an institution performs a rating transfer across different rating systems that do not share the same obligor rating scale, it should ensure that the mapping between rating scales is performed in such a way that the final PD estimate (including MoC) assigned to the guaranteed exposure amount is not better than the final PD estimate (including MoC) being transferred from a third party.
Information used to assign obligors and facilities to grades or pools must be current. To comply with this requirement, if a material proportion of exposures or obligors within a rating system receives a rating from another IRB rating system as a result of rating transfers, institutions should ensure that the transferred ratings are automatically updated when the rating of the third party changes or when the PDs of the rating system to which the third party belongs are re-estimated.
Estimates must be plausible and intuitive and must be based on the material drivers of the respective risk parameters. To comply with this requirement, institutions should have sufficient empirical evidence to justify situations where an obligor has an equal or better PD estimate than the third party providing support as a consequence of the treatments specified in paragraph 62(c) of the EBA GL on PD and LGD. In addition, differences between the various forms of contractual support should be considered in the PD models, unless there is sufficient empirical evidence that these differences are not relevant risk drivers. This understanding should also be taken into account if the rating of the third party is being considered as an indication for an override.
In addition where a rating of a third party is being taken into account as a indication for an override of the assignment of the relevant obligor to a grade or pool, institutions should not assign a rating to an obligor that is better than the rating of the third party as a consequence of an override resulting solely from the existence of this third-party support.
Furthermore, when third-party support is used extensively in the scope of application of a PD model, institutions should consider its existence as a potential relevant driver for risk differentiation
- ECB guide to internal models - Credit Risk, Sep 2018