Fit for TRIM?
Most of the larger European banks have already implemented their internal risk models quite a while ago. At the time, these models were validated and approved by the National Competent Authorities (NCAs) as the foundation for creating the required capital calculations (based on risk-weighted assets). Supervision of the 128 systemic European banks transferred from the NCAs to the European Central Bank (ECB) in 2014. The ECB will soon take a critical look at all the risk models from these systemic banks. The objective of the Targeted Review of Internal Models (TRIM) is to assess if the internal models of banks meet all the requirements, and if they are comparable to each other. The ECB is working to have TRIM finalized in 2019. Consequently, on-site investigations will take place at the systemic banks in 2017 and 2018.
The ultimate goal of the ECB is to create a more harmonized, level playing field across the euro area, which was also the reason for the introduction of Basel I in 1988. The freedoms received by banks under Basel II (including the introduction of internal credit risk models) and yet-to-be-completed Basel III (including additional balance sheet requirements) have unintentional effects. As a result, the ‘risk numbers’ from individual banks are increasingly more difficult to compare.
An example: each bank uses different credit risk models that generate credit ratings for their customers. These models perform differently, as evidenced by annual back testing. The ratings are then linked to probabilities of default (PD). Each bank adheres to its own PD scale. This constitutes important input for the risk-weighted assets, whether or not it meets the capital requirement. Incompatibility is the logical consequence. With the introduction of Basel II, even knowing what we knew back then, these unintentional effects were long in sight.
With TRIM, the ECB aims to reduce this unwanted variability in risk-weighted assets. First and foremost, a fresh, critical look at the already implemented internal models is welcome. An independent, central review will only benefit the quality and reliability of these models. Implemented models that do not comply with the regulations will be modified and replaced with new models. By using better comparable models, the ‘risk numbers’ become more comparable as well. However, there is also a serious danger in this increasing uniformity. The systemic risk in the banking sector will increase as a whole. Economic theory teaches us that diversification reduces risk; the opposite, unintentional effect of this initiative is apparent.
With the first Asset Quality Review (AQR), in 2014, the ECB broadened its focus with micro-prudential supervision. Nonetheless, there is a good chance that TRIM will reveal a flaw in the ECB supervision. This flaw arises when macro-prudential goals (focused on the soundness of the financial system as a whole) are counteracted by micro-prudential measures such as TRIM.
Despite everything, it is ultimately clear that the systemic banks must be fit for TRIM on a short-term basis. However, we hope that the new supervisory framework will stay fit for the long haul!
For more information about TRIM, please contact Evert de Vries or Henno van der Roest.