As we are in the third quarter of 2017, various investment management firms we speak with continue to research and plan their technology implementation for PRIIPs regardless of the regulatory uncertainty. As part of this theme we wanted to take some time to write an article on one of the important aspects of KIDs for PRIIPS, the CRM Assessment. As a precursor, in defining the Summary Risk Indicator (SRI) for PRIIP KIDs, there are two primary components that investment management firms need to focus on; the Market Risk Measure (MRM) and the Credit Risk Measure (CRM).
In this post we wanted to take a more detailed look at the CRM assessment process. Within the Regulatory Technical Standards (RTS) there are specific requirements for the assessment of a CRM where three different processes can be utilized under the regulatory proposal. We will come to these three different processes, but we wanted to start off by looking at the distinction where the CRM metric is either deemed necessary or unnecessary, said differently where no CRM is assigned to a PRIIP.
In general, the credit risk, when deemed relevant, aims to reflect the probability of defaults related to relevant payments to investors. If available, the credit risk is based on ratings. Otherwise default credit assessments are taken into account. The ratings and assessments show Credit Quality Steps (CQS) that need to be adjusted according to the maturity or recommended holding period of the PRIIP or its underlyings before the CRM can be assigned.
The first such case is when the market risk class of the PRIIP is 7. The next scenario is when the value of the PRIIP does not depend on the creditworthiness of the obligor, underlying investments or exposures. Aside from these two specific exceptions on the PRIIP level, there are also cases that do not require the credit risk assessment on the level of the underlyings, we will come to these as well.
As part of the Regulatory Technical Standards (RTS) there are three different processes that firms can use for the assessment of a CRM, depending on the requirements, these include a direct, cascade or look-through assessment.
Here the direct assessment of the credit risk is done, if there is an entity that directly engages to pay the return to the retail investor and if the exposure is not fully and appropriately collateralized. In those cases the CRM must be determined on the level of the PRIIP or obligor of the PRIIP. One or more ratings are provided by External Credit Assessment Institutions (ECAI). If there are multiple assessments available, the median shall be used. The (median) rating is set to the corresponding Credit Quality Step (CQS), which needs to be adjusted according to the maturity or Recommended Holding Period (RHP) of the PRIIP, in case the PRIIP does not have a maturity. The detailed adjustments can be found in the table below:
|Credit Quality Step (CQS)||Adjusted CQS, when maturity of PRIIP or its RHP is up to one year||Adjusted CQS, when maturity of PRIIP or its RHP is 1 - 12 years||Adjusted CQS, when maturity of PRIIP or its RHP exceeds 12 years|
In the next and last step, the adjusted credit quality step is converted into a credit risk measure according to the table below:
|Adjusted Credit Quality Step (CQS)||Credit Risk Measure (CRM)|
In cases where there is a guarantor for all payment obligations, the credit risk of the entity can be taken for the CRM assessment, if it is more favourable. If there is no rating available for both the PRIIP and obligor of the PRIIP, the so called default credit quality steps are assigned:
- A CQS of 3 is used for PRIIPs whose obligor is regulated as a credit institution or insurance firm under EU regulation with the member state being allocation on CQ3 or lower.
- A CQS of 5 is used for PRIIPS whose obligors do not fulfill the requirements above.
The default credit quality step is adjusted according to the maturity or recommended holding period following the rules described above. The same holds for the mapping of the adjusted credit quality step into a CRM.
All steps explained for the direct assessment are not necessary, with two general exceptions being where a CRM of 1 or 2 can be assigned depending on the quality of the risk coverage:
- A CRM of 1 is used for PRIIPs showing a credit risk that is backed by assets in segregated accounts which are not available to other creditors.
- A CRM of 2 is used for PRIIPs showing a credit risk that is backed by assets in registered accounts on which the claims of retail investors to the respective PRIIP have priority over other creditors.
Look through assessment:
The look through assessment of the credit risk is done, in cases where the PRIIP invests in or is exposed to underlyings that show a credit risk and whose exposure is relevant. The relevance is not given, if:
- The underlying represents an exposure of less than 10% of the total value of the PRIIP.
- The underlying is a derivative which is listed or subject to central clearing.
In cases where the relevant credit risk is appropriately collateralized or backed by assets, a CRM of 1 (segregated accounts) or 2 (registered accounts with prioritization) can be assigned to the respective underlying. Other than that the ratings of the underlyings or obligor of the underlyings are taken from External Credit Assessment Institutions and adjusted according to the explanations for the direct assessment (please find tables above). In case there is no rating available for both the underlying and obligor of the underlying, the default credit quality step of 3 (obligor is regulated, member state is CQS 3 or lower) or 5 (requirements for CQS 3 are not fulfilled) is assigned, adjusted and converted into a CRM.
The cascade assessment is chosen if the requirements for both, the direct and the look through assessment, are fulfilled. On the one hand there is an entity that pays the return to the investor and the exposure is not fully and appropriately collateralized. On the other hand there are underlyings or techniques with a relevant exposure connected to the respective PRIIP that entail credit risk. In such cases the direct assessment and the look through assessment must be done separately. With having the results, the highest CRM of PRIIP, obligor and underlyings is determined.
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