What is the targeted review of internal models?
15 February 2017 (updated 16 April 2018)
What is the targeted review of internal models? What is its main goal?
The targeted review of internal models, or TRIM, is a project to assess whether the internal models currently used by banks comply with regulatory requirements, and whether their results are reliable and comparable. Banks can use internal models to determine their Pillar 1 own funds requirements, i.e. the minimum amount of capital they must hold by law.
One major objective of TRIM is to reduce inconsistencies and unwarranted variability when banks use internal models to calculate their risk-weighted assets (a commonly used regulatory metric that “weighs” a bank’s assets based on their riskiness and constitutes a key factor in determining the bank’s own funds requirements).
TRIM also seeks to ensure consistent supervisory practices. As a result, the review should help to make sure that internal models are being used appropriately and consistently. The objectives of TRIM are therefore in line with two major goals of ECB Banking Supervision: to foster a sound and resilient banking system through proactive supervision and the use of best practices and to ensure that supervisory practices are applied consistently across the euro area.
Does TRIM affect all banks directly supervised by the ECB?
Under the project, the ECB will check Pillar 1 approved models at all directly supervised banks that use them. However, not all approved models at all banks will be checked and there are a few other exceptions, e.g. banks undergoing a merger or those which may no longer be subject to direct supervision. This means that about 65 banks fall within the scope of TRIM.
The project covers credit, market and counterparty credit risk (operational risk has been excluded given the Basel Committee on Banking Supervision’s stance against using internal models for such risk).
What is the timeline of the project? How many on-site investigations will be conducted?
In December 2015 the ECB decided that it would carry out a targeted review of internal models. TRIM on-site investigations started in 2017, following initial preparatory work in 2016 to identify the underlying methodology and tools and the models to be reviewed. Further on-site investigations will take place in 2018 and 2019. It is expected that around 200 such investigations will be completed during the whole project.
The project has two key phases:
- Phase one – involves a review of the models used to assess the credit risk for retail and small and medium-sized enterprise portfolios, as well as market risk and counterparty credit risk; on-site investigations were conducted in 2017 and are continuing during the first half of 2018.
- Phase two – mainly focuses on the models used to assess the credit risk for so-called low-default portfolios (these cover exposures to medium-sized/large corporates and institutions, as well as specialised lending); it will start in the second half of 2018 and continue throughout 2019.
Why did the ECB launch TRIM?
In the aftermath of the financial crisis, there has been much debate about the use of internal models to determine regulatory capital requirements. There are two main reasons for this:
- Internal models have become more complex since they were first introduced under Basel II. This has made it increasingly difficult for banks and supervisors to assess whether risks are being mapped correctly and consistently.
- A number of benchmarking studies have highlighted potential inconsistencies as well as high variability in the capital requirements that different banks with similar portfolios have calculated using internal models.
TRIM therefore seeks to reduce unwarranted variability in the calculation of risk-weighted assets and to confirm the adequacy and appropriateness of internal models, thereby also enhancing the credibility of the internal models being used by banks subject to European banking supervision.
Will the exercise result in higher capital requirements overall?
The project aims to reduce unwarranted variability in risk-weighted assets across banks, not to increase risk-weighted assets in general. Nevertheless, TRIM could lead to increases or decreases in the capital needs of individual banks.
How does the ECB communicate with participating banks?
The ECB maintains an ongoing dialogue with participating banks. It provides them with regular updates on the overall status of the project, informs them of upcoming milestones, etc. This is done through dedicated conferences and workshops, regular project information letters, bilateral exchanges, and ECB staff participation in industry events.