On the horizon: 2025 update of the ECB guide to internal models

14 August 2024

Banks are allowed to use internal models to compute their own funds requirements – i.e. the minimum amount of capital they must maintain by law – provided they have prior authorisation from the competent authority. It is therefore essential to apply high supervisory standards to internal models and to make sure that related rules are understood and applied consistently. To this end, the first edition of the “ECB guide to internal models” (the Guide) was published in October 2019. It has been a useful tool for banks and supervisors alike ever since. The Guide has helped achieve several key results for the supervision of internal models. Specifically, it helps by:

• transparently detailing the ECB’s understanding of regulatory requirements, and providing the supervisory perspective to complement regulatory initiatives;
• ensuring consistency in the implementation of regulatory requirements;
• supporting a harmonised supervisory assessment of internal models.

As a result, internal models are now better aligned with regulatory requirements, while internal model frameworks and assessments within European banking supervision are sounder.

The Guide is a living document. It is therefore regularly updated to incorporate new regulatory developments, state-of-the-art supervisory expectations and refinements based on experience with its application. A revised version was already published on 19 February 2024. That version clarified how banks should include material climate-related risks in their models. It also provided detailed requirements for common definitions of default, counterparty credit risk and default risk in the trading book, as well as information on how banks can return to the standardised approach. Another update of the Guide is now planned for 2025, covering the revision of the Capital Requirements Regulation (CRR3), which will enter into force on 1 January 2025. CRR3 will implement the Basel III reform in the EU prudential framework. For internal models that determine own funds requirements, CRR3 introduces several amendments spanning all risk types. The current Guide therefore needs revising in order to stay fully up-to-date.

The next update of the Guide will primarily cover the following items:

• credit risk:
  • amendments/additions related to the application of the CRR3 (e.g. new levels of internal ratings-based approval at exposure class level, new requirements for estimating risk parameters);
  • refinements to topics already included and/or additional clarifications, where needed;
• market risk: supervisory expectations related to the Fundamental Review of the Trading Book;
• all risk types (even though this issue currently mainly concerns credit risk): supervisory expectations on the use of machine learning techniques in internal models.

In the frequently asked questions published on 19 February 2024, the ECB stated that future updates to the Guide might be released without prior public consultation. To enable timely publication of the Guide once CRR3 enters into force, the ECB will not conduct a public consultation. Instead, it will host virtual round tables on selected topics during the fourth quarter of 2024. These meetings will inform banks of the main elements of the next revision and enable them to provide feedback for the ECB’s consideration before the revised Guide is published. Further details on these round tables will be provided to the industry in due course.

ECB Banking Supervision is confident that the next revision will help make the Guide an even more effective tool for implementing and supervising internal models, fostering a more consistent implementation of models across banks and greater alignment with the newest regulatory requirements.