What is the targeted review of internal models?

15 February 2017

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 they are reliable and comparable. Banks sometimes 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 (RWAs). This may occur because the current regulatory framework gives banks a certain freedom when modelling their risks.

TRIM also seeks to harmonise practices in relation to specific topics. As a result, the review should help to ensure that internal models are being used appropriately.

Thus, the objectives for TRIM coincide with two major goals of ECB Banking Supervision: to foster a sound and resilient banking system through proactive and tough supervision and to create a level playing field by harmonising supervisory practices across the euro area.

TRIM was launched in late 2015 and is expected to be finalised in 2019.

Why is the ECB doing this now?

In recent years the use of internal models to determine regulatory capital requirements has become more and more controversial. There are two main reasons for this:

  • Internal models have become increasingly complex since they were initially introduced under Basel II. This has made it more and more difficult for banks and supervisors to understand them and to assess whether risks are being mapped correctly and consistently.
  • A number of benchmarking studies have highlighted inconsistencies as well as high variability in the capital requirements calculated by different banks’ internal models.

What is the timeline and overall cost? How many people will be involved? To what extent will staff from the national authorities, external auditors and/or consultants participate?

ECB Banking Supervision is making a large investment in TRIM in terms of its own staff as well as the cost of external resources. With regards to staff, close to 100 ECB and national supervisors will be involved.

The on-site missions will take place in 2017 and 2018 (with a possible extension into 2019). Each on-site mission requires at least six people to work over a period of at least ten weeks. More than 100 missions will take place in 2017. For each on-site mission, up to half of the workforce will be made up of external consultants. This allows the ECB to maintain its other ongoing supervisory activities.

Is there a connection between (the finalisation of) Basel III and TRIM?

The Basel III discussions on whether internal models are used appropriately and in the spirit of their creators make the ECB’s project to review internal models most timely.

TRIM addresses exactly what opponents of internal models tend to criticise: by checking whether banks correctly apply their Pillar 1 internal models when calculating own funds’ requirements, the ECB aims to contribute to ensuring that models are indeed being used appropriately.

Are you even sure that internal models will continue to exist after Basel III has been finalised?

Despite some question marks, the ECB believes that internal models can play a useful role in determining regulatory capital according to the institution’s risk exposure, provided that certain conditions are met: risks must be modelled adequately and models must give consistent results.

Will this affect all banks directly supervised by the ECB?

As part of the project, the ECB will check all banks that it directly supervises and that have approved Pillar 1 internal models (three banks are exempt for various reasons, such as being in the process of a merger). This leaves 68 banks within the scope of the project.

The project covers credit, market and counterparty credit risk. For these risk types, the project also aims to account for potential changes in regulatory requirements on internal models that are expected to be introduced during the course of the project.

What does the ECB do with its findings? Will they feed into the Supervisory Review and Evaluation Process (SREP)?

In line with standard procedure, ECB Banking Supervision will ask banks to address any gaps in their compliance with regulatory requirements directly after completing the on-site mission.

Where banks fall short in regard to the ECB’s guide on TRIM, the ECB will issue an operational act pointing out deficiencies once the peer reviews are stable enough to ensure a level playing field.

Finally, decisions asking banks to take remediating action will be sent to the institutions to address any remaining shortcomings based on the final version of the guide after public consultation. The banks will be given sufficient time to adjust, especially if expectations differ from national standards used by supervisors in the past.

Will the exercise result in higher capital requirements overall?

It is important to note that while the project aims to reduce unwarranted variability in RWAs across banks, a general increase in RWAs is not the intention. Nevertheless, TRIM could result in increases or decreases in capital needs for individual banks.