Identification of Defaults

FINANSTILSYNET
Postboks 1187 Sentrum
0107 Oslo
Circular
Identification of Defaults
CIRCULAR:
4/2020
DATE:
08.12.2020
THE CIRCULAR APPLIES TO:
Banks
Holding companies
Financing companies
Credit companies

Identification of Defaults
2 | Finanstilsynet
1 Introduction
The capital adequacy regulations provide criteria for identifying defaulted exposures. This circular clarifies the understanding of certain criteria, specifically when it should be considered unlikely that a counterparty can fulfill its obligations, and when a default on one exposure should spread to other exposures with the same counterparty. 2 Regulatory Framework According to Article 178 of the Capital Requirements Regulation1, an exposure shall be considered defaulted if a payment is more than 90 days past due and the amount is not insignificant, or if it is unlikely that the counterparty will be able to fulfill its obligations. The Regulation is made applicable in Norway through Section 2 of the Regulation on Capital Requirements and National Adaptation of CRR/CRD IV (CRR/CRD IV Regulation). The European Banking Authority (EBA) has published guidelines (GL-2016-07)2 on how banks should record defaults, which Norwegian banks and credit companies are expected to comply with.
2.1 Criteria for Identifying Defaults
Companies must, according to Chapter 10 of the EBA guidelines, have internal guidelines that define default and specify in which cases it is unlikely that the counterparty will be able to fulfill its obligations. The Capital Requirements Regulation provides a number of examples of events that must be considered as defaults: realization of collateral, write-downs due to weakened creditworthiness, changes in payment terms that reduce the value of the cash flow, debt forgiveness, and sale of the receivable at a discount. In cases of changes to payment terms that do not reduce the value of the cash flow, it must be assessed whether the exposure should be considered defaulted if the new payment plan has a large payment at the end of the period, low payments at the start, a grace period, or if repeated changes have been made to the payment plan, cf. the discussion in Chapter 5 of the EBA guidelines. Finanstilsynet clarifies that in the assessment of whether a default exists, urging the customer to sell the collateral asset is to be equated with realization. Furthermore, the value of collateral cannot be included in the assessment of whether an exposure is defaulted. Materiality thresholds for defaulted amounts must be stated as part of the total exposure and a nominal amount, both of which must be exceeded for the amount to be considered material. Companies may have different amount thresholds for mass-market exposures, i.e., loans to private individuals and small companies that are part of a well-diversified portfolio of many exposures with similar characteristics such that the risk is reduced, cf. Article 123 (standard approach) and 147(5) (IRB approach) of the Capital Requirements Regulation, and other exposures. According to Section 7 of the CRR/CRD IV Regulation, the nominal amount threshold is 1,000 NOK for mass-market exposures and 2,000 NOK for other exposures, while the relative threshold is 1 percent for all types of exposures. Relative materiality thresholds can become very high for housing loans and other loans with long maturities, which may lead to delayed identification of defaults. Companies should therefore consider lower relative thresholds for such exposures when setting internal guidelines. Regardless of the amount thresholds, companies should assess whether non-payment of installments indicates that it is unlikely that the counterparty will be able to meet its obligations.
Chapter 4 of the EBA guidelines clarifies how companies should count days after payment due dates and under what circumstances a payment default can be considered a technical default that should not be marked as defaulted, as well as for special conditions regarding exposures to central and local authorities, factoring exposures, and purchased receivables. The counting of days after due date starts when the customer has a due amount that exceeds the amount threshold, and continues until the customer no longer has a due amount that exceeds the amount threshold.
2.2 Cases Where Multiple Exposures with the Same Counterparty Are Considered Defaulted
The main rule is that if one of the customer's loans is considered defaulted, the entire exposure to the customer must be considered defaulted (default contagion). This can also apply to exposures to affiliated counterparties. Chapter 8 of the EBA guidelines describes how the default definition should be applied consistently across exposures. For mass-market exposures, default can be assessed per loan. This is discussed in Chapter 9 of the EBA guidelines, which among other things states that the company must assess whether the default of one loan affects whether the customer is considered likely to fulfill their other obligations. This implies, in Finanstilsynet's assessment, that default should spread between exposures in the same category; if a customer defaults on an unsecured loan, all of the customer's unsecured loans must be considered defaulted. Furthermore, the entire exposure must be considered defaulted if loans that constitute a significant part of the total exposure are defaulted.
2.3 Curing of Defaulted Exposures
Chapter 7 of the EBA guidelines describes the criteria for when an exposure is no longer to be considered defaulted. If the payment default has been settled, and it is likely that the counterparty will fulfill its obligations, the exposure can be considered cured after a quarantine period of 90 days. In cases of partial debt forgiveness or changed terms, the quarantine period is at least one year.
3 Housing loans can also be included in the mass-market portfolio according to Articles 124 and 125 of the Capital Requirements Regulation. Criteria for categorizing small companies as mass market are given in Circular 11/2015 from Finanstilsynet.

Identification of Defaults
Finanstilsynet | 3

Identification of Defaults
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2.4 Estimation of Risk Parameters and Expected Credit Loss
The default definition can be used by companies in their estimation and calibration of expected credit loss and risk parameters such as probability of default (PD), loss given default (LGD), and exposure at default (EAD). If historical data are based on a different default definition than the current one, companies must assess whether historical data should be adjusted to ensure consistency. Chapter 6 of the EBA guidelines describes how this consideration should be taken into account in cases where IRB banks use external data. For banks using the IRB approach, changes in the default definition require approval from Finanstilsynet, cf. CRR/CRD IV Regulation Section 2, which implements Commission Regulation 529/2014.

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