Capital and risks: inspecting internal models

Banks are required to hold capital against risks. To calculate these own funds requirements, banks may use internal models for some eligible risks. ECB Banking Supervision is required to authorise these models and does so by conducting internal model investigations or IMIs, as they are known in supervisory jargon.

The importance of internal models for the euro area banking system becomes immediately apparent if we consider that more than half of the own funds requirements of the roughly 120 significant institutions directly supervised by the ECB result from using such models. The best-known and most widespread type of internal model is the internal ratings-based approach for credit risk, but internal models can also be used for market risk, operational risk and counterparty credit risk.

To see how the ECB authorises new internal models, or how it deals with material model changes, reversions or partial use, let’s assume a bank has developed a new model for the purpose of calculating its own funds requirements. After the bank announces its intention to seek approval for the new model, the ECB starts coordinating with the on-site investigation unit of the bank’s national supervisor, the national competent authority (NCA). Depending on the bank’s geographical spread several national supervisors may be involved. This initial coordination is carried out to prepare the on-site assessment and to guarantee a smooth authorisation process. The planning is challenging because of the sheer number of on-site activities and the high number of stakeholders involved. The ECB launched almost 300 on-site inspections and IMIs in 2017.

In many cases there will be a preliminary review of the model to identify potential road blocks early on. If this first quick check has a positive outcome, the ECB notifies the bank of the upcoming inspection at the bank’s premises.

Once the assessment team has met the bank’s representatives for a kick-off meeting, members of the IMI team interview the bankers involved, e.g. risk managers or the designers of the model, and study the relevant documents and examine the bank’s risk management systems. Given the ECB’s holistic view on internal models, the assessment covers both the algorithm assigning risk measures to exposures and the overall framework in which this algorithm is embedded, ranging from data quality to governance. Assessment teams therefore include not only quantitative analysts (or “quants”), as is often assumed, but also experts from different backgrounds. They investigate whether the legal requirements for granting approval are met (or continue to be met) and where the bank stands in relation to observed best practices.

The investigation usually takes between 7 and 15 weeks, depending on its scope, and involves up to 10 inspectors. When it is completed the team, guided by the head of mission, prepares a model assessment report which is reconciled with the views of the relevant horizontal supervisory units at the NCA(s) and at the ECB, and subsequently with those of the bank.

Based on this report, a dedicated horizontal unit at the ECB writes a draft decision to (conditionally) approve the bank’s request to use a specific internal model. The fact that the draft decision is prepared by a dedicated horizontal unit – and not the assessment team itself or the Joint Supervisory Team for the bank – is to ensure consistency across all ECB-supervised banks.

Draft decisions usually also include a list of remedial actions for the bank. If severe shortcomings are detected, the ECB may ask for additional measures, for instance capital add-ons to cover risks that are not appropriately addressed by the model. The regulation gives the bank the right to be heard on the draft decision before it is adopted by the ECB and the final decision is sent to the bank.

As well as IMIs that are initiated by banks’ requests for approval, an increasing number of IMIs are triggered by the ECB. This is a result of the targeted review of internal models (TRIM), a multi-year project to review many existing internal models for credit, market and counterparty credit risk. Most of these models had already been approved by national competent authorities before the Single Supervisory Mechanism was established, following different administrative practices that led to different outcomes. In a way TRIM is thus the ECB’s response to concerns about internal models that arose in the aftermath of the financial crisis. As part of TRIM, the ECB will conduct more than 150 IMIs, or TRIMIs as they are called in the TRIM context, over two years, using standardised and consistent inspection techniques and assessment criteria. By so doing, the ECB is fulfilling its mandate to create a level playing field for euro area banks also in the domain of internal modelling, thereby contributing to the resilience of these banks.