From 1st January 2021 the new guidelines on the application of the definition of default (EBA/GL/2016/07) are in effect in all EU countries. The purpose of the guidelines is to ensure a common and consistent definition of default across institutions not only under the same local supervisor but also across EU countries. One key component of interest is the introduction of a new standard on the materiality rule for the past due criterion in counting of days past due and the identification of default.
Our experience from credit portfolios in many countries also confirms that there is a diversity of implemented versions of the past due criteria making EBA’s view to establish a common ground reasonable. However, the requirements bring new dynamics and additional challenges for the financial institutions. In this article, we are discussing about the patterns introduced under the new definition, the potential impact on the Bank’s portfolios and models, while we also look at the applicability of the definition in making business decisions.
The New Standard on Counting Delinquency
Among other changes, under the new definition, the counting of days past due begins from the moment when the sum of the past due amounts breaches the relative and absolute thresholds. This approach of counting days past due shows the following main characteristics:
- There is a delay in the identification of delinquencies and defaults as the counter begins when the total past due amount becomes material.
- The counter continues to increase even in the case of some repayments of past due amounts as long as both thresholds being breached.
The following table presents an example of a retail non-forborne mortgage loan.
The table provides a comparison between the past due criterion under the new definition and the past due counter before the new changes. We will use this as an example to highlight the ‘path to default’ in both definitions. In the example, both materiality thresholds under the new definition are breached on 07/2021 and the material past due counter begins counting while it needs additional time to trigger the default event. Despite the regular payments of past due amounts, the exposure continues to be delinquent as the remaining past amounts still breach the materiality thresholds. After full repayment of the overdue amount is made, it takes additional 3 months to exit NPE status due to the probation period introduced with the new default exit criteria.
On the contrary, the existing past due counter shows delinquent behavior from the first unpaid amount while never reaches non-performing status (90+ DPD), irrespective of materiality threshold used in default definition, due to the regular repayments of past due amounts.
Portfolio Impact
The introduction of the new definition of default in retail portfolios may impact to a varying degree all aspects of credit risk modelling and reporting. The effect in terms of non-technical defaults can be complicated and depends on the definition that each institution had already in use before complying with the new standard.
Distribution Impact
Figure 1 presents the distribution of exposures at each DPD group (bucket) for a retail mortgage portfolio comparing the new DPD against the existing DPD calculation.
Figure 2 provides the compound flow rate to bucket 4 from a given current delinquent state.
Figure 3 presents the flow rate to subsequent buckets.
The main points to consider are:
- The materiality thresholds in days past due counting create a higher concentration of exposures in the 0 DPD group (“Bucket 0”) relative to the existing DPD counting, when delinquent amounts fail to exceed both thresholds.
- For the new material DPD, when the past due amount remains above the thresholds, delinquency buckets 1-3 are only transitory stages in which an exposure either continues to higher delinquency buckets reaching eventually non-performing status or transits to current status if adequate repayments are made. The transitory behavior of the new material DPD is evident in graphs 2 & 3 where on average there is higher flow rate to subsequent buckets and ultimately to bucket 4 state under the new DPD counting compared to the existing one.
- The lower proportion of bucket 0 population and their higher flow to bucket 1 depict the early warning nature of the existing DPD counting as it can identify payment difficulties even before they become material.
Impact on Risk Profile
The following table shows the default rates based on the new DoD for the ‘Bucket 0’ population under the new DPD counting by segments of the existing DPD counting (existing delinquency buckets) for a retail mortgage portfolio.
The table shows a contamination effect especially under the new definition. The higher concentration of exposures in the bucket 0 conceals segments of the portfolio with riskier profile. The existing past due counter is able to identify riskier segments mainly because can indicate exposures with missed payments before the total past due amount becomes material under the new definition. Using a combination of the new materiality DPD counter with a more traditional DPD counter could potentially identify portfolio segments with different risk profiles creating more robust rating systems.
Business Impact
By design, the new definition of default reflects on supervisors’ objectives and point of view, leaning towards to a more conservative approach of classification of NPE exposures. This may not be optimal to be used for business decisions where close monitoring of exposures’ performance is required for prudent risk management. Potential hurdles by using the new DoD in managing the portfolios may be:
- As discussed above, customers that make regular payments but not repaying their total past due amount (effectively being above the materiality thresholds) will eventually be characterized NPE under the new definition. This could happen in deviation of their contractual terms, resulting in implications in bank-customer relationship, especially if the information reported to credit bureaus result in sudden worsening of their credit rating. Business wise, such profiles are profitable for the banks providing additional interest earnings, while having a moderate risk profile.
- The new definition lags in identifying delinquent exposures until they become materially past due. Thus, it is less applicable for collection purposes, where early delinquency tracking and management is important for prudent collection strategies.
- Exposures in probation, even if classified as non-performing until the completion of the probation under the New DoD, exhibit actual repayment behaviour and should be monitored closely or even managed as performing. The prolonged characterization as NPE puts them in the middle between management by collections (for which they are probably not applicable if they follow payment schedule) and performing exposures (from which they are excluded from most models).
Conclusion
The new definition of default is a regulatory oriented definition which introduces new dynamics in the loans portfolios. Financial institutions should consider additional information and not solely rely on the new definition of default when they assess their business policies and set their strategies.
Thus, the challenge for financial institutions is to decode the new portfolio dynamics and their impact, model their behavior and assess whether the new definition of default is aligned to their business practices. All these changes need to be assessed during a period of high uncertainty introduced by the ongoing COVID-19 pandemic which could potentially limit the ability of financial institutions to run the assessment on representative sample periods.