Institutions should define and document two definitions of default, employed in two different contexts: (i) for the purpose of rating model development and (ii) for the purpose of estimating and calibrating probabilities of defaults. These two definitions of default can be identical or different, if necessary. The scope of these definitions should cover all credit facilities and all business segments of the institution. In this process, institutions should apply the following principles.
2.5.2
For rating models: The definition of default in the context of a rating model is a choice made to achieve a meaningful discrimination between performing and non-performing obligors (or facilities). The terminology ‘good’ and ‘bad’ obligors is sometimes employed by practitioners in the context of this discrimination. Institutions should define explicitly the definition of default used as the dependent variable when building their rating models.
(i)
This choice should be guided by modelling considerations, not by accounting considerations. The level of conservatism embedded in the definition of default used to develop rating models has no direct impact on the institution’s P&L. It simply supports a better identification of customers unlikely to perform.
(ii)
Consequently, institutions can choose amongst several criteria to identify default events in order to maximise the discriminatory power of their rating models. This choice should be made within boundaries. At a minimum, they should rely on the concept of days-past-due (“DPD”). An obligor should be considered in default if its DPD since the last payment due is greater or equal to 90 or if it is identified as defaulted by the risk management function of the institution.
(iii)
If deemed necessary, institutions can use more conservative DPD thresholds in order to increase the predictive power of rating models. For low default portfolios, institutions are encouraged to use lower thresholds, such as 60 days in order to capture more default events. In certain circumstances, restructuring events can also be included to test the power of the model to identify early credit events.
2.5.3
For PD estimation: The definition of default in the context of PD estimation has direct financial implications through provisions, capital assessment and pricing.
(i)
This choice should be guided by accounting and regulatory principles. The objective is to define this event in such a way that it reflects the cost borne by institutions upon the default of an obligor.
(ii)
For that purpose, institutions should employ the definition of default articulated in the CBUAE credit risk regulation, separately from the MMS and MMG. As the regulation evolves, institutions should update the definition employed for modelling and recalibrate their models.