Internal model investigations

Internal model investigations (IMIs) assess whether the internal models used by banks to calculate capital requirements are compliant with legal requirements. They can be triggered at the request of a bank (initial approval, material changes, extensions, roll-out, permanent partial use or reversion to less sophisticated approaches) or they can be initiated by the ECB.

Supervisors draft decisions relating to the use of internal models once an investigation has been completed. Before they can become final, decisions must be endorsed by the Supervisory Board and adopted by the ECB’s Governing Council under the non-objection procedure.

Framework for internal model investigations

The ECB’s guide to on-site inspections and internal model investigations clarifies the general framework and process applicable to IMIs.

Guide to on-site inspections and internal model investigations

It is complemented by the ECB’s guide to internal models, which focuses on the content of the internal model investigations.

Criteria

IMIs assess whether a bank meets the requirements for using internal models. In particular, IMIs:

• examine the portfolio to which the internal model has been applied, especially in terms of relevant risk drivers, 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 and capital calculation
• assess the performance of the model, its capacity to predict risk (including, but not limited to, back-testing exercises and testing the model in various hypothetical and historical market conditions)
• assess the IT infrastructure, the input data and the data used to set up the internal model
• challenge model outcomes where feasible

Process

At the start of the preparatory phase of an IMI, the availability and readiness of all parties involved must be confirmed (see also the section on submitting requests related to internal models).

The process for the investigation itself is depicted in the graphic below (for a detailed description of the process, see the guide to on-site inspections and internal model investigations).

Guide to on-site inspections and internal model investigations

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Who does what?

• Head of Mission (HoM): the HoM is appointed by the ECB from among ECB or national competent authority (NCA) staff to lead the inspection. The HoM is the main contact person for the inspected bank on the topics reviewed during the inspection. The HoM manages the inspection team, organises the various steps of the inspection and is the only member of the inspection team to sign the inspection report.
• Inspection team: the inspection team conducts all necessary inspections on the premises of the inspected bank under the responsibility of the HoM. The team can be composed of ECB inspectors, supervisors employed by NCAs, Joint Supervisory Team members or other persons authorised by the ECB. Members of the inspection team are appointed by the ECB.
• Joint Supervisory Team (JST): The JST’s main contributions to on-site activities include
  1. preparing the supervisory examination programme
  2. communicating with the inspection team during the inspection (or sometimes participating as a member of the inspection team)
  3. preparing the draft decisions resulting from the IMI, and
  4. subsequently following up on any remedial actions or supervisory measures.
• Internal model investigations division (IMI division): the IMI division, within the Directorate General On-site Inspections and Internal Model Investigations, is responsible for the ECB guide to internal models, the methodology for internal model investigations and the consistency check of model assessment reports. Members of the IMI division lead, and participate in, internal model investigations.

Submitting requests related to internal models

To facilitate a consistent approach for requests related to internal models across the European banking supervision, also referred to as the Single Supervisory Mechanism (SSM), ECB Banking Supervision has published a set of documents and processes that significant institutions are invited to use when sending applications to the ECB that relate to internal models.

Overview of the application process

Forms and guidelines relating to the (pre-)application process are provided below, together with links to the set of documents that should be used to inform the ECB of any non-material model changes or extensions, whether these are being planned or have already been implemented.

Banks seeking initial model approval, or a material model change or extension which is not due to the fulfilment of a previous obligation, are requested to:

• confirm the intended application date by email to the JST at least four months in advance
• submit a pre-application package (see links below) at least two months prior to the confirmed application date

ECB Guide on materiality assessment for IMM and A-CVA model extensions and changes

The Capital Requirements Regulation stipulates that the competent authority must approve material model extensions and changes to credit, operational and market risk internal models. Regulatory technical standards (RTS) have been adopted by the European Commission for the materiality assessment of model extensions and changes to the internal ratings-based approach for credit risk, the advanced measurement approach (AMA) for operational risk and the internal models approach for market risk. Based on these RTS, model extensions and changes to internal models are categorised either as material extensions and changes that require prior approval from the competent authority or as extensions and changes that are not material and require either ex ante or ex post notification.

For counterparty credit risk for both the internal model method (IMM) and the advanced method for credit valuation adjustment risk (A-CVA), the adoption of similar RTS is not mandated by the current text of the Capital Requirements Regulation. The ECB therefore published a Guide on materiality assessment (EGMA) which provides assistance to significant institutions in their self-assessment of the materiality of changes and extensions to IMM and A-CVA models under the applicable legal framework. The EGMA is not intended to replace, overrule or affect in any other way applicable EU and national law. Moreover, it should be borne in mind that the EBA may regulate this field by adopting guidelines on the basis of Article 16 of the EBA Regulation, or by adopting RTS based on future EU legislation.

ECB Guide on materiality assessment (EGMA)