Application of Article 199(6)(d) for low default portfolios

In cases where institutions do not have a sufficient internal track record of default and liquidation events due to the low-default nature of certain portfolios, is there an alternative approach, such as the use of relevant external data, market evidence, or a combination of internal and external information, that could be considered acceptable to demonstrate compliance with Article 199(6)(d) for eligible physical collateral?

Article 199(6) was introduced to recognize the risk-mitigating effect of eligible physical collateral beyond traditional financial assets. The provision allows institutions to apply reduced Loss Given Default (LGD) rates to exposures secured by such collateral, reflecting the fact that physical assets can provide effective credit protection when their recoverability is sufficiently evidenced. In particular, subparagraph (d) requires institutions to demonstrate that, for at least 90% of liquidation cases for a given type of collateral, realized proceeds are not lower than 70% of the collateral value. This requirement could implicitly assume the availability of a sufficiently large number of historical default and liquidation events to support such an assessment. However, certain physical collateral is characterized for being accepted only in relation to high credit quality counterparties and conservative risk acceptance criteria, accordingly, default events are infrequent. As a result, internal historical data may not be representative or statistically meaningful for the purpose of assessing collateral recoveries, despite the underlying physical collateral being of high quality and demonstrably liquid in the market. In these circumstances, reliance exclusively on internal default data may limit the practical applicability of Article 199(6)(d) for physical collateral associated with low-default portfolios (in relation to which the institution has no related defaults recorded). This may prevent the recognition of eligible physical collateral in cases where its risk-mitigating effect could otherwise be substantiated through alternative, objective evidence. The intent of Article 199(6) is to enhance risk sensitivity, capital efficiency, and prudential soundness through the appropriate recognition of collateral. For these objectives to be effectively achieved, the framework should be also operationally applicable in relation to physical collateral associated to portfolios with limited internal default experience, without undermining prudential standards.