Supervision of internal models evolves with regulatory developments

13 August 2025

The supervision of internal models is evolving following new developments in regulation. The ECB recently published an update to its guide to internal models, incorporating changes introduced by Regulation (EU) 2024/1623 (CRR3)^[1]. The update also supports efforts to continue streamlining the internal ratings-based landscape. Alongside these developments, the ECB will gradually increase the number of proactive internal model investigations that cover areas warranting higher levels of supervisory attention. Reactive investigations, triggered by banks requesting to change their own models, remain in place and continue to be vital for the quality of the European model landscape. Against this backdrop, applications that are accurate and of high-quality remain an essential requirement for swift, transparent and simple supervisory assessments.

An update to the ECB’s guide to internal models

The guide to internal models, updated in July 2025, clarifies the ECB’s expectations in relation to EU legal requirements for banks using internal models to determine their own funds requirements, and it also describes the ECB’s approach to assessing these models. The guide fosters a common understanding and consistent application of the requirements, without altering or exceeding them, while also reflecting developments in the regulatory framework.

The 2025 update addresses changes in regulatory requirements, in particular changes introduced by the CRR3. It further clarifies and refines previous versions of the guide based on industry feedback and practical experience, and it also improves the structure. A more detailed explanation of the update and its rationale is available in the related press release and FAQ document.

The update introduces new supervisory expectations in several key areas, including:

• supervisory expectations concerning data governance practices and the use of machine learning techniques in internal models;
• supervisory expectations for banks’ applications relating to internal models on credit risk, internal validation and internal audit processes, definition of default, probability of default quantification, downturn loss given default estimation and loss given default models based on multiple components;
• supervisory expectations for the use of market risk models in the context of the fundamental review of the trading book under CRR3;
• supervisory expectations for modelling exposure changes during the margin period of risk for margined trading, in the context of counterparty credit risk.

By providing more clarity on requirements for internal models, the updated guide aims at supporting banks to better select portfolios that are suitable for internal model application. This in turn would help them streamline their model landscapes.

As announced in August 2024, the ECB listened to industry feedback when drafting this update. At two virtual round tables, around 90 banks raised a total of 200 comments on key specificities in the guide. This made it easier to fine-tune supervisory expectations effectively – for example, on the adoption of the internal ratings-based approach, probability of default quantification, downturn loss given default estimation and modelling of counterparty credit risk exposure spikes.

Some banks have already significantly simplified their internal model landscape

Regulators recognise the limitations of internal ratings-based modelling techniques inherent in the Basel 2 framework that have been applied across all exposure classes. In recent years, the ECB has encouraged banks to evaluate and simplify their internal ratings-based model landscapes.

Consequently, the number of rating systems decreased by 18% from the end of 2022 to the end of 2024. This was mainly driven by banks using simpler approaches for smaller portfolios: here, the number of rating systems dropped significantly by about 30%. In the same period, the volume (represented as the share of modelled exposures) decreased by 3.3%. Furthermore, banks revised their roll-out plans and reduced the intended share of exposures subject to sequential internal ratings-based implementation by about 25%.

This confirms that banks increasingly focus their models on key strategic portfolios, while adopting less sophisticated approaches for smaller portfolios. Banks with fewer modelled exposures can better comply with regulatory requirements for their strategic portfolios. Joint supervisory teams and banks already discuss additional model simplifications as part of the supervisory dialogue and further simplification is expected in the near future.

CRR3 provides an opportunity for further simplification

While previous amendments to the Capital Requirements Regulation (CRR)^[2] promoted higher shares of modelled exposures, CRR3 introduces a selective approach to internal ratings-based modelling. With the transitional arrangement under Article 494d, which is valid until 10 July 2027^[3], it gives banks an opportunity to reconsider their strategy for internal ratings-based models.

Banks applying for the transitional arrangements under Article 494d are invited to submit (preferably) a single application to the ECB covering all exposure classes to be reverted.^[4] This should be done only once the model strategy and the target model landscape have been discussed with the relevant joint supervisory team, in line with the approach outlined by the European Banking Authority. The ECB will then assess these requests and check whether the applications are consistent with the model strategies and whether they align with the banks’ business models.

At least 15% of the banks using an internal ratings-based approach have already requested to apply Article 494d and an additional 25% are discussing its application with their joint supervisory teams. This indicates that banks are using this opportunity, not only to revert less strategic exposure classes to the standardised approach, but also to revert non-retail exposures to the foundation approach, where they only model the probability of default estimate.

Internal model investigations going forward

Following the Targeted Review of Internal Models and the internal ratings-based repair initiative from the European Banking Authority, banks had to fix weaknesses and ensure regulatory compliance through model changes. This required the ECB to conduct a large number of investigations requested by banks. While these reactive investigations form a large share of the overall number of missions, the ECB also conducts some proactive investigations. Going forward, these proactive investigations will become more frequent as they are an important aspect of effective internal model supervision that aims to address areas of concern or follow up on outliers. However, a revamp of extensive review projects like the Targeted Review of Internal Models is not deemed necessary for the time being.

When evaluating the readiness of a bank’s application for an investigation, the ECB will scrutinise more strictly whether the bank has already implemented and tested the model in a non-production environment to ascertain that it is ready to go live once approved. This will help prevent premature model investigations and will further optimise the use of supervisory resources.

It is equally important that a bank’s management enables and empowers its internal control functions in order to assess model applications thoroughly and independently. This is why the ECB will further focus on adequate evaluation and follow-up with regard to the deficiencies identified by the internal validation functions, and it will seek to ensure that application packages do not include models with material deficiencies.

The ECB is convinced that it is important to reduce the number of model changes to the same rating system in a short time period, as frequent changes without comprehensively addressing deficiencies and shortcomings can create inefficiencies for banks and supervisors alike. Banks are therefore encouraged to ensure thorough and independent assessments by their control functions and to anchor model change requests to a longer-term strategic view of the evolution of their model landscape.

Banks are also encouraged to submit high-quality and accurate applications up front. Better submissions make the assessment process more efficient. They also ensure timelines are more predictable and they enable swifter decision-making. All this is ultimately to the benefit of both the ECB and the banks themselves.

If inefficiencies are averted, banks will eventually benefit from faster implementation of material model changes. The tone from the top is crucial for achieving these objectives, and the ECB will continue to assess whether banks’ management teams are committed to the quality of their applications. If there are poor quality applications and/or persistent deficiencies, the ECB may look more closely at the institution’s underlying governance arrangements.