Prudential Regulation Authority Rulebook

2.1

[First sentence moved to 2.4B] Matching Adjustment 7.2(1) states that internal credit assessments must have considered all possible sources of credit risk relevant to the exposure. This is particularly important when internal credit assessments are used as part of the process to determine the FS, because the FS should reflect the risks retained by the firm as per regulation 5(4) of the IRPR regulations.

2.2

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2.3

The overarching aim of the FS is to determine how much of the spread on an eligible asset should be taken to reflect the risks retained by the firm on the assumption that the asset is held until maturity (other than where it proves necessary to sell it, as part of rebalancing the MA portfolio, for the purpose of restoring the overall matching position where the asset and/or liability cash flows of the portfolio have materially changed). Retained risks include both qualitative and quantitative risks. Qualitative risks may include the strength of the terms and conditions in the loan agreement or a lack of default data. Quantitative risks may include economic or market stresses. Internal credit assessments must also consider how these risks may interact (as per Matching Adjustment 7.2(1)). The examples of risks listed in this paragraph are not exhaustive.

2.3A

Regulation 4(4) of the IRPR regulations states that the credit quality of all MA portfolio assets must be capable of being assessed through either a credit rating or the firm’s internal credit assessment of a comparable standard. For assets with highly predictable cash flows this will provide some assurance on the appropriateness of the features and structure of the assets for backing liabilities in firms’ MA portfolios.

2.4

[First sentence moved to 2.4B] As part of demonstrating that internal credit assessments are of a comparable standard to a credit rating as per Matching Adjustment 7.1(1), Matching Adjustment 7.2(2) requires that internal credit assessment outcomes lie within the plausible range of issue ratings that could have resulted from a CRA. Matching Adjustment 7.2(3) also requires broad consistency and no bias within the plausible range between firms’ internal credit assessment outcomes and CRA issue ratings at an asset type and the portfolio level. These requirements will help to give the PRA some assurance that the basic FS is appropriate. Having sample assets assessed by a CRA will additionally help demonstrate broad consistency between a firm’s internal credit assessment outcomes and comparable CRA issue ratings. Nevertheless, firms should not solely or mechanistically rely on credit ratings for assessing the creditworthiness of an entity or financial instrument.^[12]

2.4A

[First sentence moved to 2.4B] The PRA’s expectations for internal credit assessments are expanded on in paragraphs 2.8A to 2.8N below.

2.4B

An internal credit assessment outcome will need to be mapped onto a CQS. Firms are reminded that performing an internal credit assessment and mapping an asset onto a CQS are two distinct processes. The PRA notes that the mappings of CRA credit ratings to CQSs are set out in the Annexes to Commission Implementing Regulations 2016/1799 and 2016/1800. For each internally rated asset type, a firm should consider how it has met the credit rating comparability requirements referred to in paragraph 2.4 above, when selecting appropriate CQS mapping scales from those applicable to different CRAs.

2.5

Once a CQS and asset class have been assigned, firms are required to use the corresponding basic FS set out in the technical information published by the PRA as a starting point for the calculation of the MA (see the definition of matching adjustment in the Glossary Part of the PRA Rulebook, and Chapter 4 generally of the Matching Adjustment Part). Firms should not alter the CQS mapping of an asset on the grounds that they disagree with the technical information published by the PRA, eg if a firm’s opinion on the appropriate recovery rate for that asset differs from that specified in regulation 6(6)(a) of the IRPR regulations.

2.5A

Firms must then further adjust the basic FS to allow for differences in credit quality by rating notch for the purposes of calculating the MA as per Chapter 6 of the Matching Adjustment Part. The PRA expects firms to consider their internal credit assessment outcomes by rating notch when determining whether they meet the ‘broad consistency and no bias’ requirement, and when assessing whether their internal credit assessment would exceed any rating caps from CRAs in meeting the ‘plausible range’ requirement (see paragraph 2.7B below for further detail).

2.5B

The PRA also requires firms to validate their internal credit assessment processes used for assets within the MA portfolio as per Matching Adjustment 7.2(4) and obtain proportionate independent external assurance on the internal credit assessment outcomes as per Matching Adjustment 7.2(5).

2.6

The PRA expects proportionate independent external assurance on a firm’s internal credit assessment outcomes to focus on the exposures that, in the firm’s view, present the greatest risk and potential for an inappropriately large MA benefit. In assessing the risk of an exposure to a particular asset type, the PRA expects firms to consider both the proportion and the absolute amount of the spread that is being claimed as MA, as well as the materiality of the exposure. Specifically, the PRA expects firms to focus on assets that present some or all of the following features:

• they are more complex (eg because they have been restructured);
• the absolute amount of MA benefit derived from the asset is material to the firm; or
• the MA benefit (expressed as a proportion of the total spread on the asset) is high either in its own right or when compared to the benefit from a comparable reference instrument.

2.7

The PRA will calibrate thresholds around these features using data on firms’ asset exposures. For assets that exceed these thresholds, the PRA may request a firm to provide the results of any independent external assurance on its internal credit assessment outcomes, and seek further assurance where appropriate.

2.7A

The PRA expects firms to develop a validation framework, including validation frequencies, coverage sample size, and risk tolerance thresholds for the credit rating comparability requirements that are referred to in paragraph 2.4 above. A firm should select the validation frequency and coverage sample size according to the complexity and materiality of its internally-rated assets. Firms should ensure that they have sufficient confidence that these requirements will still be met as market conditions change.

2.7B

When establishing risk tolerance thresholds within the validation framework, for all assets, firms could determine the plausible range of issue ratings that could be achieved if the asset were rated by different CRAs (having regard to the requirements of Matching Adjustment 7.2(2)), taking into account any credit rating caps that may be applied by the CRAs. Risk tolerance thresholds for the ‘broad consistency and no bias’ requirement could be based on: (i) the proportions of the sampled assets that have higher versus lower notched internal credit assessment outcomes relative to the outcome of independent external assurance; (ii) the notch difference, across the sampled assets, between an appropriately weighted average internal credit assessment outcome compared to an appropriately weighted average outcome of independent external assurance; and/or (iii) any other reasonable methods that consider the distribution of notch differentials.

2.7C

The PRA expects firms to resolve any validation failures that result in a lower basic FS being applied than is merited based on any internal validation and/or independent external assurance on the sampled assets. The PRA expects a firm to amend its internal credit assessment methodology, assumptions and/or processes, in order to resolve any validation failures. Where it takes time to eliminate such validation failures, a firm can apply an FS addition (as per Matching Adjustment 4.17) to compensate for the extent of any breaches of the plausible range, and any bias at an asset type or portfolio level, in order to ensure that the FS covers all risks retained by the firm.

2.7D

If, as a result of either its internal validation or independent external assurance sought, a firm makes an adjustment to its internal credit assessment for one or more assets then the PRA expects any updated internal credit assessment outcomes to be used for the purposes of calculating the MA and any other relevant purposes, for example as an input to the Solvency Capital Requirement (SCR) calculation. Similarly, if a firm finds any potential weakness or issue with its internal credit assessment, and addresses it, but in such a way that it does not fully flow through to the MA calculation and/or any other relevant purposes, then the PRA expects the firm to take this into account when considering the appropriateness of its FS and MA as part of the attestation process and the adequacy of its SCR.

2.8

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2.8A

In order for a firm to evidence the robustness of its internal credit assessments, and hence provide assurance in respect of the assigned CQS and basic FS, the PRA expects the following areas to be implemented and documented.^[13] This is not an exhaustive list.

2.8B

There should be an identification of all the risks affecting each asset and an assessment of how the firm has satisfied itself that it has considered all potential sources of systemic and idiosyncratic risk in its internal credit assessment. This should include consideration of the following factors at a minimum:

• external market factors;
• cash flow predictability;
• collateral;
• loan characteristics (eg refinancing risk);
• risks arising from third parties (eg sponsors, parties involved in the servicing and managing of the loan);
• legal, political and regulatory risks; and
• potential future risks eg impacts arising from climate change risks.

2.8C

In addition, where a firm uses an internal model, the PRA expects the same underlying risk identification exercise to be used as a starting consideration for both the internal model and internal credit assessment process. However, a firm may justify why only a subset of the identified risks is then selected for inclusion in the internal model or credit assessment. This subset of risks may differ between the internal model and credit assessment.

2.8D

The PRA expects firms’ internal credit assessment methodology and criteria to:

• set out the overall credit assessment philosophy and the ratings process;
• set out the scope of types of loans or entities to which the methodology applies;
• set out the scope of risks covered and define the credit and other relevant risks being measured;
• where a CRA has a published credit rating methodology for an asset type, have in scope at least the same range of risks, qualitative and quantitative factors and risk mitigating considerations, or justify any difference in the scope;
• describe how different loan features, risks, cash flow variability due to any non-default events and other relevant factors are assessed;
• set out the key assumptions and judgements underlying the assessment, including the treatment of assumed risk mitigating actions that rely on the firm’s own or outsourced processes involved in managing assets through their lifecycles;
• define whether the credit assessment is calibrated to a point-in-time or through-the-cycle;
• use both qualitative and quantitative factors; and
• explain the limitations of the internal credit assessment, for example, risks that are not covered, and when it would not be appropriate to allow for these limitations by overriding judgements.

2.8E

The PRA expects a firm to justify its internal credit assessment methodology and to recognise any limitations.

2.8F

Where a firm has decided that its internal credit assessment methodology for a particular asset type should be based on a CRA’s published credit rating methodology that is applicable for that asset type, the PRA also expects the firm to apply that methodology in full in the manner applied by the CRA.

2.8G

Regardless of the choice of a firm’s internal credit assessment methodology, the firm should also describe how it has maintained broad consistency between its internal credit assessment outcomes and comparable issue ratings given by a CRA.

2.8H

The PRA expects firms to consider the availability, appropriateness, and quality of the data over the credit cycle on which their internal risk assessments and calibrations are based, and should clearly document how they have allowed for incomplete or missing data in the internal credit assessment. This includes consideration of whether the data is sufficient to support the proposed internal credit assessment and any adjustments to reflect differences in credit quality by rating notch.

2.8I

The PRA expects expert judgements made in the determination of the internal credit assessment to be transparent, justified and documented, and consideration to have been given to the circumstances in which judgements on the rating would be considered false. Furthermore, the history of judgements applied to deviate from the result of the internal credit rating methodology should be well documented, as should any other end-of-process overriding adjustments to the internal credit ratings themselves. The key judgements should be subject to the appropriate level of governance within the overall credit assessment process.

2.8J

The PRA expects to see evidence that the credit rating methodology and criteria development and approval, credit assessment and CQS mapping have been performed by individuals with relevant asset-specific credit risk expertise, competency and sufficient access to resources, who are independent and with minimised conflicts of interest. The PRA expects the individual with responsibility for the internal credit assessment function to be someone with appropriate experience and, where justified by the nature, scale and complexity of assets held by the firm, whose appointment to the role is approved by the management body and who has access to the management body on an ongoing basis. In particular, firms must ensure the independence of the internal credit assessment function and that effective controls are in place to manage any potential conflicts of interest as per Matching Adjustment 7.2(6), for example, between different stakeholders involved in the overall acquisition, origination and/or management of the assets.

2.8K

The PRA expects that, as part of the requirement for a firm to have an internal credit assessment process that is subject to appropriate validation as per Matching Adjustment 7.2(4), the firm will have validated its internal credit assessment methodology and criteria, including how it has identified and allowed for all sources of credit risk, whether qualitatively or quantitatively. In addition, the PRA expects the firm’s validation to ensure that the internal credit assessment outcomes have satisfied the points in paragraph 2.4 above.

2.8L

The PRA expects that, as part of the requirement for a firm to have an internal credit assessment process that is subject to appropriate assessment of its ongoing appropriateness as per Matching Adjustment 7.2(4), the firm has satisfied itself that its internal credit assessments will remain appropriate over the lifetime of the assets and operate robustly under a range of different market conditions and operating experience. The credit assessments and CQS mappings should be reviewed by the firm at regular intervals, as well as in response to changes in relevant external market conditions or other factors that are expected to impact the rating. In addition to this, firms should monitor how the internal credit assessment criteria are applied consistently both within and across asset types.

2.8M

The PRA expects firms to identify potential refinements needed to their methodology by monitoring their own credit experience against the internal credit rating assessments and changes made by CRAs to their methodology and criteria. This should include addressing any previously identified shortcomings in a firm’s internal credit assessment process (including any that were identified as part of the independent reviews mentioned in paragraph 2.5B above).

2.8N

Where some or all of the internal credit assessment process is outsourced, the PRA expects firms also to demonstrate the effectiveness of the systems and processes that the outsourcer has in place, including validation, in order to ensure that outsourced internal credit assessments for assets satisfy the expectations set out in paragraphs 2.8A to 2.8M above and that the requirements of Article 274 of Commission Delegated Regulation (EU) 2015/35 are also satisfied. Firms should provide evidence that appropriate oversight systems and processes including governance are in place and have been carried out effectively for outsourced credit assessments.

2.9

If the PRA judges that a firm is unable to provide satisfactory assurance using its own internal resources, it may choose to commission an independent review, which may take the form of a report commissioned from a skilled person under Section 166 of the Financial Services and Markets Act 2000 (FSMA).

2.10

The PRA expects that internal credit assessments for restructured assets will be anchored on a risk analysis of the legal documentation between all parties concerned. In the case of restructured ERMs, this includes, for example, the original loan agreement between the borrower and the lender, the contract between the originator and the insurance firm, and the legal structure of the notes issued by the special purpose vehicle (SPV).

2.11

As mentioned in paragraphs 2.1 and 2.3 above, firms should consider both qualitative and quantitative sources of risk in their credit risk assessments. The PRA expects that all of the risks to which the senior notes are exposed (including combinations of risks) will be considered in the internal credit assessment, the assigned CQS and therefore the derivation of the basic FS (including any adjustments made to it in order to take account of differences in credit quality by rating notch).

2.12

In respect of ERMs, some of the quantitative features the PRA would expect to be considered explicitly include (but are not limited to):

• underwriting terms of the underlying ERMs (eg prepayment terms, interest rate at which the loan will accrue, conditions attaching to the borrowers, conditions attaching to the property);
• exposures (eg loan to value ratios, ages of borrowers, health of borrowers);
• strength of security (eg location, state and concentration of the properties used as collateral, rights of the SPV to substitute underlying ERMs);
• leverage, including a full analysis of the cash flow waterfall between the loan receivables and the cash flows paid to the senior noteholder; and
• stress and scenario testing of the amount and timing of receivables, for instance as a result of:
  • changes in the value of the properties that collateralise the ERMs, both in the immediate and longer term, including allowance for additional costs (eg dilapidation costs, transaction costs relating to sales);
  • demographic risks relating to the borrowers under the ERMs (eg longevity trend and volatility, morbidity); and
  • prepayment risk.

2.13

Where these exposures involve a large number of homogeneous retail exposures, as would be expected in the case of most ERM securitisations, statistical approaches could be an acceptable proportionate method for assessing exposures and risks. However, the PRA notes this is unlikely to be acceptable for wholesale exposures (corporate lending and specialised lending) which tend to be large and heterogeneous.

2.14

Where a firm has restructured an asset, eg an ERM portfolio, into a range of tranches, the spread on a given tranche should be commensurate with the level of risk to which that tranche is exposed. The more junior the tranche, the greater the spread would be expected to be in order to reflect the higher exposure to risk.

2.15

Likewise the PRA would expect to see evidence that the securitisation structure provides loss absorbency to protect the senior note payments, eg a proportion of the cash flows accruing to the junior note in the early years of the transaction being kept in reserve in case of subsequent losses that reach the senior notes.

2.16

Reliance on any credit-enhancing or liquidity-enhancing features should be carefully justified, taking into account the availability of these facilities over the expected lifetime of the SPV, including under stressed scenarios such as those referred to in paragraph 2.12 above.

2.17

Qualitative factors that a firm may need to reflect in the internal credit assessment could include:

• uncertainty over the quantitative risk factors above resulting from a lack of data;
• the terms and conditions of the legal agreement(s) between the insurer and the SPV (eg cross-default provisions, covenants);
• uncertainty about the recoverability of the receivables when they become due (eg due to legal rights or practical considerations); and
• quality of loan servicing (eg ability to monitor properties and maintain knowledge of exposure and risk).