· The ongoing review of the continuing appropriateness of the models in use shall be conducted within the Pillar 2 framework The framework for supervisory cooperation should follow the steps outlined above.
3. Supervisor’s assessment of the application concerning the minimum requirements of the CRD – Credit Risk
3.1. Permanent Partial use and rollout
3.3.1. Assignment to exposure classes
3.3.1.2. Corporate Exposure class
3.3.1.2.1. SMEs in the corporate exposure class
173. In Annex VII, Part 1, Paragraph 4 of the CRD, which requires institutions to substitute total assets for total sales in the modified correlation formula for SME exposures when total assets is a more meaningful indicator of firm size, the term ‘sales’ can be defined as total gross revenue received by a firm from selling goods and services in the normal course of business. For some industries, ‘sales’ needs to be defined more exactly. For example, insurance companies’ sales should be defined as gross premium income. It is not necessary to come up with uniform definitions, as country specificities may be important.
174. The CRD requires substituting assets for sales when this is a more meaningful indicator. Substitution on a voluntary basis may be possible when the institution can present evidence that this is at least an equivalently conservative approach and is applied consistently over time and laid down in its internal rules.
3.3.1.2.2. Specialised Lending
175. Specialised Lending (SL) exposures form a subclass of the corporate exposure class. These exposures are characterised by a strong linkage between pledged assets and the payments that service the loan.
176. Specialised Lending exposures within the corporate exposure class possess the following characteristics, according to Article 86(6) of the CRD:
(a) The exposure is to an entity which was created specifically to finance and/or operate physical assets.
(b) The contractual arrangements give the lender a substantial degree of control over the assets and the income that they generate.
(c) The primary source of repayment of the obligation is the income generated by the assets being financed, rather than the independent capacity of a broader commercial enterprise.
177. Not all of these requirements necessarily have to be met to the same full extent. Individual elements of the definition could be somewhat relaxed in order to capture different kinds of exposures. However, all three elements of the Specialised Lending definition should be fulfilled in one way or another, at least in substance. The most critical criterion for SL classification is the criterion that the primary source of repayment is the income generated by the assets.
178. The institution should pay special attention to the definition of Specialised Lending in borderline cases between Specialised Lending and the securitisation framework. Certain items might be classified both as Specialised Lending and as a securitised position. The institution should classify such positions consistently over time.
179. The typical counterparty in a Specialised Lending arrangement is a special purpose entity which takes its own legal form and whose payments are segregated from other entities or from the group. There should be a legal contract between the entity and the assets as regards the income that is generated.
180. The number of assets involved in an arrangement is not important in defining Specialised Lending. What is important is whether or not the pledged assets are the source of repayment of the loan. Similarly, it should not be considered important for the definition whether or not the entity has entered into some kind of longterm lease that contractually cannot be terminated. Although such arrangements represent a transfer of risk, this does not alter the fact that payments are originating from the same object that is being financed and serves as security.
Demonstration of fulfilment of requirements
181. According to Annex VII, Part 1, Paragraph 5 of the CRD, institutions can use PD estimates for their Specialised Lending exposures only if they meet the minimum requirements for the IRB approach. In order to reduce opportunities for regulatory arbitrage, it was considered necessary to
apply these minimum requirements at the level of certain defined sub classes of Specialised Lending, rather than at the level of individual exposures.
One possible solution is to use the subclasses of Specialised Lending defined in the Basel II framework. The Basel Committee specified five subclasses. 12 It is suggested that Specialised Lending be divided into the four main Basel II subclasses. The introduction of the fifth subclass, HighVolatility Commercial Real Estate (HVCRE), shall remain a national option for supervisors. Exceptions from the Basel II subclasses can be allowed and will be handled flexibly. Application of SL risk weights 182. Article 87(5) of the CRD requires that the risk weighted exposure amount is calculated in either of two different ways.
183. “Notwithstanding Paragraph 3 [referring to the calculation of risk weights for ordinary corporate exposures], the calculation of risk weighted exposure amounts for credit risk for Specialised Lending exposures may be calculated in accordance with Annex VII, Part 1, Paragraph 5 [referring to the alternative method for Specialised Lending exposures]. Competent authorities shall publish guidance on how credit institutions should assign risk weights to Specialised Lending exposures under Annex VII, Part 1, Paragraph 5 and shall approve institutions assignment methodologies”.
184. The best way of providing such guidance would be to apply the approach of the Basel II framework. The Basel Committee has already developed ‘Supervisory Slotting Criteria’ for riskweighting Specialised Lending exposures. 13 These criteria should be used as the primary guidance for European institutions.
185. Risk weights for Specialised Lending exposures are available only to IRB institutions. Institutions that use the Standardised Approach for credit risk are not allowed to use the SL risk weights. Furthermore, the use of the Basel II Supervisory Slotting Criteria requires that the institution has also applied the Basel Framework SL subclasses, as mentioned above.
186. An institution specialising in certain areas could well wish to refine elements of the provided guidance. This should be allowed as long as the refinements introduce additional elements, but do not replace the elements of the guidance.
Application of preferential risk weights
187. The CRD states that competent authorities may authorise a institution to assign preferential risk weights to highlyrated (categories 1 and 2) SL exposures with remaining maturities of less than 2.5 years, provided the institution’s underwriting characteristics and other risk characteristics are
12 The five Basel II subclasses are Project Finance, Object Finance, Commodities Finance, and Income Producing Real Estate (these are the main subclasses), and HighVolatility Commercial Real Estate. 13 Supervisory Slotting Criteria for Specialised Lending, International Convergence of Capital Measurement
substantially strong for the relevant category. In exercising this discretion, supervisors should rely on institutions to demonstrate that the specified requirements are fulfilled and that their rating systems are stricter than the standards.
188. Especially when faced with scarcity of data for the estimation of key risk factors, institutions could be encouraged to apply additional techniques such as various kinds of simulation. However, the institution should collect its own default and loss data, as well as external data when they are representative.
189. The different aspects of Specialised Lending should be reviewed at least annually. This includes the ratings, but also the categorisation of exposures as Specialised Lending and the demonstration that exposures can or cannot be treated within the general IRB framework.