Overrides for climate risks
-
Hi RiskBowl,
Where banks choose to incorporate climate and ESG risks via overrides, do they
generally do this before or after “calibration”?-
Before calibration means that when you say customer X is riskier, then the average PD for everyone else goes down (in order to ensure you hit the target portfolio PD) – conceptually this is fine for me provided that the target portfolio PD has been adjusted to reflect future (heightened?) risks from climate/ESG. My concern is that if the target just reflects historical default rates, as these will not have been impacted by climate / ESG risks to the extent we might expect in the future, you wind up mis-estimating the risk
-
After calibration means that whilst target might be e.g. 1.2%, after the application of climate / ESG overrides (assuming they tend to be adjustments that increase the risk), the average predicted PD might be e.g. 1.3%
-
I realise that EBA / ECB has specific views re: whether overrides should, in general, be reflected pre- or post-calibration (favouring pre-calibration), but I’d worry that, unless you adjust your target portfolio PD, doing this before calibration would just “reallocate” historical default patterns and not reflect heightened risk.
Challenges or experience on what you have seen banks do welcome
-
-
@OP
In my experience, it typically depends on the bank's approach to the override:
-
Pre-calibration would typically be included if they are trying to include is as an statistical predictor of risk: i.e. you have some historical information that help you calibrate the specific weight and you only include the override if it increases the predictive ability of the model
-
Post-calibration if they want it to be a “penalization” mechanism for management (however this will not be fully compliant with EBA calibration guidelines for the use of overrides in IRB models)
-