ECB Supervision zooms in on internal models

Banks’ internal models, long the realm of maths wizards, are suddenly on everyone’s minds in the context of the finalisation of the Basel III reforms. As a result, the discussion of whether internal models are used appropriately and in the spirit of their creators has made the ECB’s project to review internal models most timely.

The truth is that the ECB’s targeted review of internal models (TRIM), in the making since late 2015, is already entering its second phase with a view to being finalised in 2019. TRIM addresses exactly what opponents of internal models tend to criticise: by checking whether banks under its direct supervision correctly apply their Pillar 1 internal models when calculating own funds requirements, the ECB’s Banking Supervision aims to contribute to a responsible use of these models.

As one major objective, TRIM seeks to reduce unwarranted variability of risk weighted assets (RWAs) that is driven by the modelling freedom granted by the current regulatory framework. The project will assess whether the internal models comply with regulatory requirements, and are reliable and comparable. It also seeks to harmonise practices on specific topics. Thus, the objectives for TRIM coincide with two overriding goals of the ECB’s 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.

As part of the project, the ECB will check all banks under its supervision with approved Pillar I internal models. As three banks are exempted due to ongoing mergers, 68 banks are in the scope of the project. The project covers credit, market and counterparty credit risk.

TRIM is the latest in a series of large-scale projects such as the comprehensive assessment in 2014 and the defining of a common methodology for the annual Supervisory Review and Examination Process (SREP). These projects have enabled ECB Banking Supervision over the last two years to significantly improve the correlation between banks’ risks and corresponding capital requirements.

With a multi-year horizon, the project is jointly performed under the direction of the ECB and the national supervisors, with support from consultants. Close to 90 people are now involved in the project at the ECB and the national competent authorities. In 2017 more than 100 on-site missions will be performed for 68 banks in 15 countries, involving about 800 people including national supervisors and externals.

At present, the ECB is starting to request data pertaining to the models selected for review in 2017. Before each on-site mission, the ECB will request specific information so that the on-site teams have all the necessary data before they start. Banks have already been informed about the upcoming on-site investigations. The ECB will provide additional information at a banking conference on 28 February. The on-site missions will begin in April 2017 and will last an average of about 11 weeks.

The TRIM project requires banks to cooperate, which is in their own interest in order to benefit from a better level playing field. In 2016 banks were already asked to contribute to four information requests, dedicated to credit, market, and counterparty risk as well as to general topics in the context of model risk management. This collaboration has resulted in the definition of a supervisory Guide for TRIM and the selection of models for review in 2017. The upcoming on-site missions will require frequent and timely data exchanges as well as meetings between banks and ECB on-site teams. The more resources the banks allocate, the smoother the process will be.

In line with standard procedure, the ECB’s Banking Supervision will ask banks to address potential compliance gaps regarding regulatory requirements directly after completing their on-site mission. Where banks fall short in regard to the ECB’s supervisory Guide, the ECB will send a follow-up letter once the peer reviews are stable enough to ensure a level playing field. As a conclusion, based on the final version of the Guide after consultation, decisions will be sent to the institutions to address the remaining shortcomings. The banks will have sufficient time to adjust, especially if expectations differ from national standards used by supervisors in the past

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

In future, the TRIM process will also account for potential changes in internal model requirements that are expected to be introduced during the project’s lifetime. In this vein, and following the recent discussions at the Basel Committee on Banking Supervision, operational risk will be excluded for now and so-called low-default portfolios will only be tackled later. Therefore, in 2017 on-site missions for credit risk will focus on retail and corporate SME portfolios for which a large amount of data is typically available. Low-default portfolios will be in the focus at a later stage of the project.

The same is true for the ongoing Fundamental Review of the Trading Book: To exclude the impact of any changes arising from that, TRIM will focus on areas that will persist even after expected changes, for example incremental risk capital models.