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  • SUPERVISION NEWSLETTER

Taming internal models – TRIM and beyond

19 May 2021

With adequate capital levels, banks can navigate a regular economic cycle and even withstand possible extraordinary financial shocks. But what is adequate? Banks have two ways of calculating their capital needs: by applying standardised calculation techniques with parameters set by regulation, or by estimating risk parameters themselves with internal models that require supervisory approval. More than 60 significant banks under European banking supervision currently use one or more internal models for different risk types, and each of these models is unique. Many models were developed and approved before the start of European banking supervision in November 2014. Diverging national supervisory practices and different ways of understanding and implementing the European regulatory requirements led to similar cases being handled differently across countries, meaning there was no European level playing field at that time.

The better a bank’s internal model is, the more appropriately it reflects the underlying risks and, in turn, the more accurate the bank’s calculation of its capital needs will be. Where used, sound internal models form the basis for effective internal risk management. This is why reviewing and harmonising internal models was high on European banking supervision’s agenda and why it launched its targeted review of internal models (TRIM) back in 2016. Five years later, in April 2021, supervisors successfully completed the project.

Under TRIM, supervisors carried out 200 on-site model investigations in 65 significant banks between 2017 and 2019, covering internal models for credit risk, market risk and counterparty credit risk. Overall, TRIM confirmed that banks can continue to use their internal models to calculate own funds requirements, in some cases subject to supervisory measures. However, ECB Banking Supervision identified various cases of non-compliance with regulatory requirements, resulting in more than 5,000 findings across all risk types. Around one-third of these findings were estimated to have a material impact on banks’ own funds requirements, internal governance, risk control or management. Not only does this reflect the depth and level of detail of the TRIM assessments, but it also confirms that, as suspected, requirements had been understood differently at the national level before the harmonisation triggered by TRIM. In addition, before TRIM and the regulatory review of the internal ratings-based (IRB) approach conducted by the European Banking Authority (EBA), banks lacked the clarification and guidance they needed in order to implement certain requirements properly. The TRIM project report provides detailed information about the findings and horizontal analyses by risk type.

TRIM has triggered intense supervisory follow-up: banks within the scope of the project received more than 250 supervisory decisions in total requesting them to address the identified shortcomings. Here, the ECB used the different measures in its supervisory toolbox. For cases where regulatory requirements were infringed, banks received legally binding obligations. Those banks are required to ensure full compliance with regulatory requirements, for the most part within 12 to 18 months of the supervisory decision being issued. The ECB also noted cases where capital requirements were, owing to the observed shortcomings, potentially too low or the appropriate level was highly uncertain. Here, it limited how those banks could use internal models to calculate certain risk parameters. In most cases, supervisors required banks to increase the parameter values by a multiplier set by the ECB or to apply backstops, or “floors”, to make sure that a value cannot fall below a given threshold. These limitations were imposed for the period banks were remediating their shortcomings, with a view to ensuring an adequate level of own funds to cover the underlying risk.

The ECB estimates that the supervisory follow-up on TRIM led to an overall increase of about €275 billion in risk-weighted assets (RWAs) from 2018 to 2021, which equates to an average impact of around 70 basis points on the Common Equity Tier 1 ratios of banks subject to TRIM. This means that, all else being equal, banks need to set aside more capital to cover the true risks of their portfolios. Banks that had already prepared for TRIM, for example by proactively improving their internal models, were better placed, as they faced only moderate impacts on their capital. By contrast, large capital impacts were seen in banks using internal models that were severely non-compliant with regulatory requirements for their material portfolios.

TRIM marks a key milestone in the supervision of internal models. In addition to assessing the soundness of the various models, it improved the reliability and cross-bank comparability of internal model outcomes and contributed to reducing non-risk-based variability of RWAs. TRIM also ensured that regulation on internal models is applied consistently by banks and supervisors alike. In particular, the dedicated Guide to internal models, a first version of which was shared with the banks at the beginning of the project, provides full transparency about the ECB’s understanding of the applicable regulations. The project has also shown the benefits of European collaboration. More than five years of intense work proved that it is indeed possible to foster a level playing field in an area as large as that covered by European banking supervision. It has also shown that internal models can be implemented consistently.

But the road does not end there – banks will need to continue working on their internal models to maintain the high quality achieved through TRIM. Banks should take into account the insights gained from TRIM, including those on the efforts and investments needed, in their internal model strategies, for example when deciding whether to develop new models or maintain the current ones, and when considering how their available resources can be best used. Banks are also expected to improve less material or less critical models that have not been reviewed under TRIM if these models suffer from any of the issues detected during the project. Alternatively, banks may also consider simplifying and streamlining their current model landscapes by focusing on their most material and important models in line with the corresponding regulatory requirements. This should be assessed taking into account new regulatory developments, such as those stemming from the EBA’s regulatory review of the IRB approach.

For the ECB, TRIM allowed supervisors to gain an even greater understanding of existing modelling practices and identify typical flaws in the use of internal models across countries. This increased knowledge will be a powerful asset when deciding on future supervisory strategies and priorities. The ECB will continue its intrusive, risk-based supervision of internal models. New model requests will be assessed on or off-site, depending on the materiality and scope of the model, applying insights from the ongoing monitoring of already approved models. Future model investigations in areas covered by TRIM will apply the harmonised assessment methodology that was developed for TRIM. In doing so, ECB Banking Supervision will ensure consistent assessments – a prerequisite for consistent supervisory decisions.

TRIM is ECB Banking Supervision’s largest project to date. It has raised the bar for banks that use internal models and paved the way for better models in the future. TRIM may also indirectly trigger simpler internal model landscapes within banks subject to European banking supervision. TRIM led to a wealth of results and its benefits will continue beyond 2021, especially given the synergies between this project and ongoing regulatory initiatives. The regulatory review of the IRB approach led by the EBA, the remediation of TRIM findings and the implementation of Basel III standards in European law will complement each other and make Europe’s internal models more reliable and comparable.

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Europejski Bank Centralny

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