On October 22, 2020, ISDA submitted a response to a consultation by the European Banking Authority (EBA) on the requirements of the internal default risk model to estimate default probabilities and losses given default.
Institutions using an alternative internal model to compute own funds requirements for market risk and holding positions in traded debt and equity instruments through trading desks covered by internal models approach permission are required to additionally compute an own funds requirement using an internal default risk model.
One of the requirements under the internal default risk model is for institutions to be capable of modelling the default of individual issuers, as well as the simultaneous default of multiple issuers, and computing the impact of those defaults on the market values of the positions that are included in the scope of that model. This consultation specifies the requirements that an institution’s internal methodology or external sources are to fulfil for estimating default probabilities and losses given default.
The industry appreciates the EBA’s efforts in developing regulatory standards for the sources used to develop default probabilities and losses given default. However, there are concerns about using the internal rating-based approach, which was built and designed for banking book activities. Utilizing this approach for market risk could lead to model design inconsistencies.