New PRIIPs Regulation leaves optimistic Credit Risk Measure unchanged

On January 1^st 2023 a series of amendments [1] to the current regulation [2] governing the risk and return calculations in the Key Information Document (KID) for Packaged Retail Insurance or Investment based Products (PRIIPs) will be in effect. This will be relevant to asset managers qualifying as UCITS [3] or AIF [4] offering retail investment products. The Summary Risk Indicator (SRI) ranging from 1 to 7 is probably the most iconic component of the Key Information Document. Although the rigorous calculations required for the Market Risk Measure (MRM) has been the focus of attention for most investment funds offering PRIIPs, the rules regarding the assessment of the evenly important Credit Risk Measure (CRM) are less well known. Since RiskQuest has ample experience in the development and validation of Advanced Internal Ratings Based (AIRB) credit risk models for the calculation of capital requirements for banks, we anticipated improvements in the too optimistic credit risk assessment for the PRIIPs KID. Unfortunately, neither the amendments to PRIIPs Regulation to be implemented in January 2023 nor the advisory report [5] by the European Supervisory Authorities (ESAs) regarding further future amendments, entail any changes regarding the assessment of the CRM. By means of this blog, RiskQuest proposes two changes to the credit risk assessment in the PRIIPs Key Information Document (KID):

• More conservative approach to diversification benefits;

• Apply seniority adjustments also to the PRIIPs underlying investments.

Diversification benefits

An old trading wisdom teaches us never to put all our eggs in one basket. The regulator has taken this wisdom rather seriously for what concerns credit risk assessment for the PRIIPs KID. That is, Annex II Part 2 Article 35 of the PRIIPs Regulation [6] requires a credit risk assessment only for instruments for which more than 10% of the PRIIP’s total assets are exposed to one obligor. Moreover, page 21 paragraph 2 of the PRIIPs Q&A [7] of December 17^th 2021 clarifies that all other credit risk bearing instruments that do not meet the 10% threshold, are assumed to bear no credit risk at all and hence a CRM of 0 should be assigned to such exposures. The result of the 10% diversification threshold is that a hypothetical investment fund [8] owning 5 unsecured bonds with S&P BB credit rating [9] having 4 years [10] to maturity all with different obligors, such that each bond position is 20% of the fund’s total assets receives a CRM of 4. If instead the same fund would own 20 of such bonds with 5% exposure each, the PRIIPs regulation would consider the fund to bear no credit risk at all! According to RiskQuest, such crude diversification benefits are in stark contrast to other European regulation governing credit risk quantification where no such benefits exist, such as the capital requirements regulation [11] (CRR). RiskQuest considers the current diversification benefits too optimistic and hence proposes the following more conservative approach:

• Removal of the 10% exposure threshold for credit risk assessment;
• Introduction of a PRIIP level CRM reduction, depending on the fund’s Herfindahl-Hirschmann concentration index (HHI). RiskQuest proposes to tie the CRM reduction to the HHI thresholds for bond holdings suggested by the Dutch Central Bank [12]:
  • HHI > 0.50: Very high concentration à No reduction
  • 0.25 < HHI < 0.50: High concentration à No reduction
  • 0.10 < HHI < 0.25: Moderate concentration à 1 notch reduction
  • 0.00 < HHI < 0.10: Low concentration à 2 notches reduction

Seniority adjustments at the level of underlying investments

To arrive at the final CRM, one should first determine for which assets a credit risk assessment is required and subsequently a credit quality step (CQS) is assigned based on the credit rating [13] of every credit risk bearing position. Subsequently, the CQS is adjusted based on the maturity of the instrument or the recommended holding period of the PRIIP [14]. The final value of the CRM also depends on so called credit risk mitigation and credit risk escalation factors, related to:

• Collateral: The CRM can be reduced [15] to 1 or 2 depending on the collateral covering the obligation, if available.
• Seniority: The CRM should be increased [16] by 2 if the retail investor is subordinated to other creditors of the PRIIP, increased by 3 if the retail investor holds an equity stake in the PRIIP and the CRM can be reduced [17] by 1 if the retail investor has a priority claim over other creditors.

RiskQuest would expect that not only the mitigation factors related to collateral, but also the escalation factors related to seniority mentioned above, apply at the level of underlying investments in case no credit risk is present at the level of the PRIIP [18]. However, Annex II Part 2 Article 48 suggests that only mitigation factors related to collateral apply to underlying investments and the ones related to seniority do not apply. The latter article is contradicted by page 21 paragraph 2 of the PRIIPs Q&A, because the example provided by this paragraph aggregates the CRM at the level of the underlying investments based on exposure, to arrive at a final CRM at the level of the PRIIP. This order of calculations suggests that the credit risk mitigation and escalation factors are applied at the level of the underlying investments before exposure based aggregation to arrive at the PRIIP level CRM. RiskQuest opines that the regulator’s intention has been not only to apply a better CRM in case of appropriate collateral, but also to apply a worse CRM in case of unfavorable seniority (like subordination) in case there is only credit risk at the level of the underlying investments.

Conclusion

RiskQuest opines that the credit risk measure (CRM) prescribed by the current PRIIPs regulation is too optimistic. The reason for this is twofold. First, the 10% exposure thresholds for diversification benefits leads to a too optimistic credit risk measure for diversified funds. Therefore, RiskQuest proposes to remove this 10% diversification threshold and instead allow for CRM reduction based on a quantitative measure of diversification, i.e. the Herfindahl-Hirschmann index. Second, confusion exists as to the application of punitive CRM notches for subordinated exposures in case credit risk exists only at the level of underlying investments. RiskQuest understands that it would not be prudent if the CRM can be improved due to the existence of collateral, but at the same time no worse CRM can be assigned for subordinated instruments in case credit risk exists only at the level of the underlying investments.

[1] COMMISSION DELEGATED REGULATION (EU) 2021/2268 of 6 September 2021.

[2] COMMISSION DELEGATED REGULATION (EU) 2017/653 of 8 March 2017.

[3] Undertaking for Collective Investments in Transferable Securities.

[4] Alternative Investment Funds.

[5] “Call for advice on PRIIPs: ESA advice on the review of the PRIIPs Regulation” JC 2022 20 of 29 April 2022.

[6] COMMISSION DELEGATED REGULATION (EU) 2017/653 of 8 March 2017.

[7] https://www.eba.europa.eu/sites/default/documents/files/document_library/About%20Us/Governance%20structure/JC/Q%26As/1025523/JC%202017%2049%20(JC_PRIIPs_QA_update_Dec_2021).pdf

[8] Suppose an Alternative Investment Fund (AIF) for the sake of the example, for which credit risk is considered to be present only at the level of the underlying investments according to Annex II Part 1 Article 34.

[9] According to page 7 sixth column of the “Long-Term issuer credit ratings scale” row under the Standard & Poor’s heading in the credit quality step mapping table of COMMISSION IMPLEMENTING REGULATION (EU) 2016/1800 of 11 October 2016, the S&P BB-rating maps to a credit quality step of 4.

[10] According to Annex II Part 2 Article 42 and 45 a credit quality step of 4 leads to a credit risk measure of 4 in case there are more than 1 year and less than 12 years until maturity.

[11] REGULATION (EU) No 575/2013 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 26 June 2013.

[12] Page 5 of “Market concentration in the euro area bond markets - an application with granular sectoral securities holdings statistics” by Boermans (2015) of the De Nederlandsche Bank: https://www.dnb.nl/media/0bahio41/market_concentration_in_the_euro_area_bond_markets.pdf

[13] If such a rating is not available, Annex II Part 2 Article 43 prescribes that the CQS is 3 in case the obligor is a regulated credit institution and 5 otherwise.

[14] The position is punished for a maturity longer than 12 years.

[15] Annex II Part 3 Article 46 and 47.

[16] Annex II Part 3 Article 50 and 51.

[17] Annex II Part 3 Article 49.

[18] That is, in case there is only credit risk at the level of the PRIIP’s underlying investments.