ECB guide to internal models

Frequently asked questions

Frankfurt am Main, 19 February 2024

What is the purpose of the ECB guide to internal models?

The ECB guide to internal models helps to achieve a major objective of ECB Banking Supervision: ensuring that high supervisory standards are applied consistently for directly supervised institutions and that the rules regarding the use of internal models are understood and applied in a consistent manner. These rules are laid down in the Regulation (EU) No 575/2013^[1], however this ECB guide does not address the rules relate to the alternative internal models approach (Chapter 1b of Part 3, Title IV of the CRR). The guide provides transparency on how the ECB understands these rules governing the internal models used by the institutions it directly supervises to compute own funds requirements for credit, market and counterparty credit risk.

What is the purpose of the different chapters of the ECB guide to internal models?

The general topics chapter of the ECB guide to internal models describes, in a clear and transparent manner, how the ECB aims to ensure a uniform understanding of the general (i.e. non-model-specific) topics relating to internal models (e.g. internal model governance, internal validation, internal audit). This chapter explains the overarching principles applicable to all risk types and also elaborates on the qualitative features of the internal ratings-based approach.

The three risk-type-specific chapters of the ECB guide to internal models (i.e. the chapters on credit risk, market risk and counterparty credit risk) explain, in a clear and transparent manner, how the ECB understands various aspects of the applicable regulations for each specific risk type.

The content of each chapter of the ECB guide is based on the requirements of the Regulation (EU) No 575/2013. Each chapter expresses how the regulatory provisions of relevance to the topic in question are understood by the ECB when it reviews the internal models used by institutions. In each review, the ECB will take the specificities of each bank into consideration when applying the relevant framework.

The ECB guide to internal models does not aim to cover exhaustively all the topics related to the Regulation (EU) No 575/2013 requirements on the use of internal models for regulatory purposes.

What was the main reason for revising the ECB guide to internal models?

Since its publication in October 2019, the ECB guide to internal models has proven to be a very useful and welcomed tool for institutions and supervisors alike, as it provides transparency on the ECB’s expectations regarding the implementation of regulatory requirements for internal models. After more than three years of having used this guide effectively and constructively, the ECB nonetheless considered a review to be necessary to:

• properly reflect ongoing developments in regulatory requirements;
• include some refinements on topics already included in the previous version of the guide based on past experience;
• include additional topics for which further clarification of the existing regulatory requirements appears to be necessary based on past experience.

The ECB is confident that this review will help to make the guide an even more useful tool for implementing and supervising internal models, contributing to a more consistent implementation of models across institutions and further enhancing their alignment with the regulatory requirements.

What are the main differences compared with the previous version of the ECB guide published in October 2019?

The updated ECB guide to internal models that was published on 19 February 2024 has retained the same structure as the version published in October 2019, with a general topics chapter followed by three risk-type-specific chapters.

However, the main changes to the actual content of each chapter of the guide are summarised below.

General topics chapter

Section 1 of this chapter, which describes the internal models used for the calculation of own funds requirements for credit, market and counterparty credit risk, now comprises the ECB’s understanding of how climate-related and environmental risks should be included in these internal models, where these risks are deemed by institutions as both relevant and material. These principles take into account the expectations relating to risk management, as laid down in the ECB Guide on climate-related and environmental risks. Section 1 also has a new subsection on the expectations concerning the date of implementation of any changed or extended model.

A new subsection was also introduced for Section 2, as the ECB considered that institutions would benefit from additional guidance if they were to opt to simplify their internal model landscapes. Reverting to less sophisticated approaches (i.e., the standardised approach or the foundation internal ratings-based approach) could indeed be one way for institutions to focus on their most material and critical models. This new subsection is meant to ensure that any such requests for reversion to simpler approaches meet all supervisory expectations based on the applicable regulatory requirements. This new subsection contains the relevant supervisory expectations concerning the reversion to the use of less sophisticated approaches in accordance with Article 149 of Regulation (EU) No 575/2013. This is meant to ensure that there is a common and consistent approach across all institutions that choose to submit these requests.

There is also a new subsection on the use of internal models in the context of consolidation, which provides additional information on the implementation of the relevant supervisory approach outlined in the ECB Guide on the supervisory approach to consolidation in the banking sector. In particular, this new subsection clarifies the concept of the “return to compliance” plan, which institutions need to provide to clarify how they intend to address specific internal model issues arising after consolidation, for example after one bank acquires another bank.

Credit risk chapter

Under Section 2 of this chapter, there are new supervisory expectations regarding the implementation of a new or changed internal model in the institutions’ IT systems, these complement the current supervisory expectations regarding IT infrastructure and implementation testing.

A new Section 4 on the definition of default has been introduced, including the ECB’s understanding of the relevant provisions to ensure a common and consistent approach to the application of the definition of default in accordance with Article 178 of Regulation (EU) No 575/2013, Regulation (EU) 2018/1845 of the European Central Bank of 21 November 2018^[2] and its Corrigendum^[3], as well as the EBA Guidelines on the application of the definition of default under Article 178 of Regulation (EU) No 575/2013 (EBA/GL/2016/07). In particular, this section explains the ECB’s understanding of selected topics related to the following areas: i) consistency in application across the institution, the parent undertaking or any of its subsidiaries; ii) days past due criterion; iii) unlikeliness to pay criterion; iv) return to non-defaulted status; v) consistency of external data; and vi) adjustments to risk estimates in the event of changes to the definition of default. The ECB had already communicated several of its supervisory expectations to institutions as part of its assessment of institutions’ implementation of the new definition of default.

The subsection on calibration to the long-run average default rate under Section 5 has been further amended to clarify the ECB’s views regarding the calibration process and the additional calibration tests required. In particular, the new supervisory expectations explain that the aim of the calibration is to obtain probability of default estimates which reflect the long-run average default rate at grade or pool level, and at calibration segment level; to raise awareness of potential issues arising from the data used to perform the calibration; as well as to further elaborate on the ECB’s supervisory expectations regarding the additional calibration tests.

The ECB’s understanding of the provisions on massive disposals under Article 500 of Regulation (EU) No 575/2013 is further specified in the subsection on realised loss given default. Further guidance relating to the implementation of Article 500 has been provided, for example, on the use of the incomplete workout treatment for the purpose of calculating adjustments.

Finally, the credit risk chapter includes further clarifications regarding the management and quantification of climate-related and environmental risks in the context of internal ratings-based models, with further details on the generic expectations included in the chapter on general topics.

Market risk chapter

The update of this chapter clarifies how to treat instruments lent out or repoed out under the internal model approach for the calculation of own funds requirements for market risk.^[4] It explains the ECB’s understanding that counterparty credit spread risk may not be included within the scope of the internal model approach, as it falls neither under the definition of general nor specific risk. Furthermore, this chapter now clarifies that, in the ECB’s view, funding risk embedded in own liabilities held in the trading book should be modelled under the internal model approach, as this approach is meant to capture all material price risks. Moreover, the update of the ECB guide details the ECB’s expectations regarding the use of probabilities of default in the incremental default and migration risk charge model. These models measure, for all trading book positions subject to an own funds requirement for specific interest rate risk, the default and migration risk which is not yet covered in the regulatory value-at-risk measure.

Counterparty credit risk chapter

The update of this chapter includes clarifications of the ECB’s understanding (i) of the term “most recent exchange of collateral” in the definition of the margin period of risk, which describes the period starting with the last collateral exchange and ending with closeout under Article 272(9) of Regulation (EU) No 575/2013; (ii) of early termination clauses in the context of Article 162 of the same regulation; and (iii) of market value corrections in relation to back-testing. With regard to non-easy replacements and concentration of trades or collateral in margined netting sets that may lead to an increase in the margin period of risk under Article 285(3) of Regulation (EU) No 575/2013, the ECB’s understanding has been included in the margin period of risk section.

A new subsection has been introduced on the potential upfront implementation by institutions of material model extensions and changes for the purposes of internal risk management as part of the use test before receiving the ECB’s permission. Another new subsection has been introduced explaining how, in the ECB’s view, institutions should treat “risks not in effective expected positive exposure” so as to cover immaterial risks outside of the effective expected exposure. This is similar to the framework on “risks-not-in-the-model engines”, which is covered in the market risk chapter of this guide.

What is the next step after this consultation on the ECB guide to internal models?

The ECB guide to internal models will be updated once industry feedback has been considered.

Once the guide is published, will the guide be further updated in the future?

Yes. Some parts of the guide may require revision or expansion, for example if the supervisory criteria or the regulatory requirements change. In particular, the ECB will once again assess the need to revise the guide once the new amending Regulation (EU) No 575/2013 on the requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor is finalised and comes into force. Furthermore, future updates of the ECB guide to internal models may be released without a prior public consultation.