Banks may use internal models to estimate their own funds requirements – i.e. the minimum amount of capital they must hold by law – provided they have prior authorisation from the competent authority. The ECB is the competent authority for all significant banks, while less significant banks are directly supervised by the national competent authorities.
Decisions relating to the use of internal models by significant banks – for example, the granting of approval for their use or the approval for a material change in methodology – are adopted by the ECB’s Governing Council, based on draft supervisory decisions endorsed by the Supervisory Board. These draft decisions are generally the result of internal model investigations.
Internal model investigations are in-depth assessments of banks’ internal models, which look in particular at methodology, economic appropriateness, risk, risk controls and governance. They are carried out by the ECB in collaboration with the national competent authorities.
Internal model investigations assess whether a bank meets the requirements for using internal models.
More specifically, internal model investigations:
In preparation for an internal model investigation, the readiness of all involved parties needs to be confirmed. This may involve initial meetings at the bank’s premises at an early stage. In such cases the bank receives feedback from the ECB on whether or not it is ready to submit an official application for approval of internal-model-related activities.
The process for the investigation itself is depicted in the graphic below:
The timeframe for approval depends on the complexity of the investigation, which depends on the type of application (e.g. initial model approval, material model change etc.), type of model, scope of model, and other model characteristics.
For a typical internal model investigation, the duration from kick-off meeting to final decision is generally around 10-12 months.
In order to facilitate a consistent approach for requests related to internal models across the Single Supervisory Mechanism, ECB Banking Supervision has published a set of documents and processes that significant banks are invited to use when sending applications to the ECB for:
All related forms and guidelines are provided below, together with links to the set of documents to be used when informing the ECB of any non-material model changes or extensions that have either already been implemented or are planned.
The objective of ongoing model monitoring is to verify a bank’s ongoing compliance with the regulatory requirements for internal models used for the calculation of the bank’s minimum capital requirements.
The competent authority – either the national supervisor or the ECB – assesses on an ongoing basis whether the bank uses well developed and up-to-date internal model techniques. The information gained from ongoing model monitoring is incorporated into the ongoing assessment of the bank and is a key element in the SREP decision.
Typical ongoing model monitoring activities include:
Internal validation plays a key role in the assessment of the reliability and accuracy of the internal models of significant institutions. At the same time, it serves as an important input for the ECB’s assessment of the regulatory compliance of internal models.
To ensure a level playing field, in 2018/2019 the ECB began requiring significant institutions to report specific data on the validation of internal models used for calculating own funds requirements for credit risk and operational risk. This data collection does not replace institutions’ own internal validation processes, but establishes a common minimum set of metrics to be reported to the ECB on an annual basis together with institutions’ internal validation reports.
Significant institutions that have permission to use the internal ratings-based approach to calculate their own funds requirements for credit risk are required by the ECB to provide information on their probability of default (PD), loss given default (LGD) and credit conversion factor (CCF) models, and the slotting approach they apply to specialised lending exposures. This reporting involves statistical measures and tests similar to those typically used by such institutions, and which are to be conducted on a standardised set of validation samples.
Significant institutions that have permission to use the advanced measurement approach (AMA) to calculate their own funds requirements for operational risk are required by the ECB to provide information on the design and performance of their AMA model. The reporting includes capital figures and results of statistical tests on inputs and outputs of the AMA model and on the modelling assumptions. Furthermore, loss data and the input data needed for the calculation of the future standardised approach proposed by the Basel Committee on Banking Supervision are also to be reported.
All related documents are provided below, together with the respective templates to be filled in and submitted to the ECB by significant institutions.
The targeted review of internal models (TRIM) aims to reduce inconsistencies and unwarranted variability when banks use internal models to calculate their risk-weighted assets (RWAs). These may occur because the current regulatory framework gives banks a certain freedom when modelling their risks.