Internal models

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

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.

The ECB is currently conducting a public consultation on a Guide to on-site inspections and internal model investigations – see the FAQ.

Criteria

Internal model investigations assess whether a bank meets the requirements for using internal models.

More specifically, internal model investigations:

  • assess compliance of a model with regulatory requirements
  • examine the portfolio to which the internal model is applied, especially in terms of the inherent risks, and assess the adequacy of the model’s reach
  • examine the adequacy and adaptability of business processes related to the model, such as pricing, decision-making, risk management, validation, capital calculation
  • assess the model’s economic appropriateness
  • assess the performance of the model, i.e. the capacity of the model to predict risk (including, but not limited to, back-testing exercises and testing of the model in various hypothetical and historical market conditions)
  • assess the IT infrastructure as well as the input data and the data used to set up the internal model
  • compare model outcomes where feasible, e.g. with available information from ECB Banking Supervision exercises or other benchmarking exercises
Process

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:

Timeframe

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.

Who does what?
  • Head of mission and inspection team: the Head of mission is appointed by the ECB from among ECB or national competent authority staff to lead the inspection/investigation (“inspection”). The Head of mission is the main contact person for the banks on the topics reviewed during the inspection, manages the inspection team, signs the inspection report, and keeps relevant ECB divisions and managers informed of the mission’s progress. The inspection team can be composed of ECB inspectors, supervisors employed by the national competent authority of the inspected bank’s Member State, and supervisors from other national competent authorities, as well as Joint Supervisory Team members or other persons authorised by the ECB. The inspection team conducts all necessary inspections on the premises of the inspected bank under the responsibility of the Head of mission.
  • Joint Supervisory Teams (JSTs): A Joint Supervisory Team is assigned to the ongoing supervision of each significant bank. It is composed of supervisors from the ECB and national competent authorities and headed by a coordinator, who is an employee of the Directorate General in charge of the microprudential supervision of the significant bank. The JST is responsible, among other things, for preparing the supervisory examination programme, which includes internal model investigations. The JST communicates with the inspection team during the inspections, and reviews draft decisions commonly prepared by the ECB’s Internal Models Division.
  • The ECB’s Internal Models Division (INM): INM is part of the Directorate General Microprudential Supervision IV. INM carries out quality and consistency reviews of assessment reports and writes the majority of the draft decisions.
  • Once a draft decision proposal has been prepared it is submitted to the Supervisory Board.

Ongoing model monitoring

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:

  • an assessment of the bank’s compliance with the supervisory requirements, conditions, limitations and obligations (e.g. remedial actions) imposed in ECB decisions, as well as the bank’s compliance with implementation plans and any other supervisory measures pertaining to the model which have been imposed on the bank
  • the analysis of back-testing results and a time series analysis
  • the analysis of banks’ model validations
  • an assessment of the outcomes of the annual European Banking Authority benchmarking process
  • an assessment of non-material model changes and extensions

The targeted review of internal models

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.

Supervision. Explained. What is the targeted review of internal models?