Targeted review of internal models

Targeted review of internal models

In recent years, banks’ internal models have been subjected to an increasing amount of public scrutiny. Several benchmark studies have exposed high variability in regulatory capital calculations that cannot be explained solely by differences in risk appetite or business models(1). This variability is driven by inappropriate modeling, which takes advantage of the freedom granted by the current regulations(2). Due to this unwarranted variability in risk weighted assets (RWA), financial markets and supervisors find it difficult to compare banks to each other, resulting in a loss of confidence in regulatory capital ratios.

In response to these developments, the European Central Bank (ECB) has launched the Targeted Review of Internal Models (TRIM). This review was launched in 2015 and is expected to be finalized in 2019. TRIM aims to enhance the credibility and confirm the adequacy and appropriateness of approved Pillar 1 internal models by reducing inconsistencies between banks’ internal models.

In 2016, the ECB published a working paper on model- based capital regulation(3). The results highlight that there is a trade-off between the effectiveness of financial and complex regulation. If challenges that result from complex regulations are too high, then simpler rules may increase the effectiveness of financial regulation.

Following the results of the abovementioned working paper, in conjunction with other macro-prudential and micro-prudential analysis, the ECB has identified sources of banking sector risk.As a consequence, the ECB has set TRIM as one of its top supervisory priorities for 2017.(4)

In February 2017, the ECB shared a guide to TRIM with institutions that are in scope of the review. The main objective of this guide is to ensure a harmonized interpretation and application of the existing legal framework.

Another objective is to ensure close alignment with upcoming changes in the regulation of internal models.

Guide to TRIM

The guide to TRIM sets out the ECB’s view on appropriate supervisory practices. It provides an exhaustive list of all relevant EU requirements (e.g. Capital Requirements Regulation (CRR) and EBA guidelines) pertaining to specific topics within the Internal Ratings-Based (IRB) and Internal Model Approaches (IMA).

Furthermore, it describes the ECB’s interpretation of the relevant EU laws on internal models for credit, market, and counterparty credit risk and on general model governance topics.

Lastly, the guide has been developed to define best practices with regards to the specified topics.

The guide will be refined during the coming months based on the feedback received by the institutions through this process. Furthermore, the ECB will also take into account the outcomes of the on-site assessments performed during the TRIM investigation, results of the horizontal analyses on peer groups and the latest regulatory developments. Before finalizing the guide, a formal public consultation will be launched for each risk type.

As previously stated, the main objective of TRIM is to reduce unwarranted variability in RWAs. In order to reach this objective, the TRIM exercise consists of two approaches:

  1. Ensuring compliance with all regulatory requirements related to the internal models. This is done through, amongst others, the on-site missions to institutions that are currently taking place. The ECB will request institutions to address any gaps in their compliance with regulatory requirements directly after completing the on-site mission. By adhering to the ECB TRIM guide compliance with regulatory requirements is ensured. Institutions will be requested to take remediating actions to address any remaining shortcomings to the guide, once the guide is final.
  2. The reduction of unwarranted variability in RWA as it relates to internal model outcomes. The ECB takes into account the results of benchmarking, interpretations of the CRR and addresses current gaps in interpretation of regulation relating to internal models. The interpretations of regulations are incorporated in the TRIM guide. Where institutions fall short with regards to the TRIM guide, the ECB will issue an operational act pointing out deficiencies once the peer reviews are sufficiently stable to ensure a level playing field. Institutions will be given appropriate time to adjust, especially if expectations differ from national standards used by supervisors in the past.

The following sub-sections will provide the most relevant points of attention addressed in the ECB TRIM guide. The sub-sections detail each of the topics specified by the ECB. These topics are general model governance, credit risk, market risk and counterparty credit risk. Furthermore, this article concludes with future developments of TRIM and how the market perceives the impact of TRIM.

General model governance

The TRIM guide informs institutions on the ECB’s interpretation of the principles regarding compliance with the IRB framework. It takes into account requirements set out in the CRR and the regulatory technical standards prepared by the EBA.

In order to have a complete understanding of risks and risk measurement, institutions are expected to either develop group-wide principles and guidelines relating to the development and maintenance of internal models, or ensure that each relevant entity has an appropriate, independently audited framework in place.

Furthermore, a model risk management framework should be in place. This enables institutions to identify, understand and manage its model risk on entity level and monitor how these models relate to the group internal model guidelines.

With regards to IRB, an institution should apply the approach by asset class. For example, once approval to use internal models has been granted to a bank, it is expected that the IRB approach is applied across all material exposures within the asset class. The minimum coverage per asset class is 50% of the exposures at initial application of the IRB approach, with a target ratio of 80% by the end of the implementation period.

Credit risk

The TRIM guide informs institutions on the ECB’s interpretation of the principles regarding the IRB approach requirements for credit risk. The guide incorporates the requirements set out in the CRR and technical standards prepared by the EBA. By doing so, it also provides specifications on how competent authorities should assess compliance with the IRB framework.

Furthermore, the guide focuses primarily on portfolios characterized by a large number of defaults, i.e. retail and corporate SME portfolios. In particular for probability of default (PD) and lossgiven default (LGD), institutions are expected to demonstrate that their models perform adequately.

This should be expressed in terms of discriminatory power and predictive power on economically significant and operationally consistent buckets of the rating systems. These buckets are identified by creating a segmentation of all obligors, on the basis of potential drivers for risk differentiation.

Regarding the estimation of the LGD for an economic downturn (DT LGD), institutions are expected to characterize an economic downturn in terms of economic and credit indicators over an historical period.

A minimum set of indicators has been specified in the guide (e.g. GDP growth, inflation rates and unemployment rates). Furthermore, the length of the historical dataset of economic indicators should be at least the past 20 years.

The specified downturn period should be at least one year. In accordance with the regulatory requirements, institutions are expected to compare the DT LGD with a referenced value.

First, the referenced value is determined by identifying the two individual years, from the most recent 20 years, with the highest observed losses considering the defaults observed in those years.

Second, the reference values should be calculated as the average realized LGD from those two individual years, for each facility grade or pool that institutions use.

Market risk

For market risk, in particular for the IMA, the TRIM guide informs institutions on current requirements of the CRR as well as expected revision of the market risk framework within the CRR, arising from recent developments in the Basel market risk framework (i.e. Fundamental Review Trading Book, FRTB).

Institutions are expected to have policies in place describing which instruments are part of either the trading or banking book. In addition, it is expected that policies also encompass rules for moving instruments between the trading book and the banking book.

The guide further describes the treatment of specific positions. For example, institutions that have approval to use internal models for interest-rate risk are expected to include their own creditworthiness as an individual risk factor in the specific risk component of the VaR, stressed VaR and in the incremental risk charge (IRC). Furthermore, treatment of defaulted debt and collective investment undertakings are elaborated upon further in the guide.

Counterparty credit risk

The TRIM guide informs institutions on principles defined for the Internal Model Method (IMM), with regards to counterparty credit risk. However, it does not provide an exhaustive list of principles regardingcompliance with the IMM requirements. The outcome and subsequent analysis of the TRIM-related on-site investigations could also identify additional areas for harmonization.

In order to ensure compliance with the IMM, the guide provides information regarding subjects that are (currently) identified as areas for harmonization by the ECB. In particular, for trade coverage, the guide describes the different types of treatment that have been observed during the on-site missions.

Based on the observed treatments, the guide points out the items that supervisors should assess with regards to trade coverage. In particular, the pricing functions used to calculate the effective positive exposure (EPE) should be internally validated by the institution and account for all trade-related cash flows.

Another item is that institutions should prove that the use of pricing approximations and fall-back solutions for the estimation of the exposure profiles are adequate and that they do not lead to a systematic underestimation of the exposure.

Lastly, institutions need to compare the values of pricing functions used for revaluation in the IMM with values from the front office or accounting systems on a regular basis.

Consequently, the guide provides the interpretation of the ECB, which describes the best practice approach that institutions should apply in order to be compliant with IMM. The guide follows the same structure for other specified items, including (but not limited to) collateral modeling, modeling of initial margin and alpha parameters.

Future developments

Potential changes in the internal model requirements that are expected, due to upcoming regulations, will be taken into account throughout the lifetime of the TRIM process. In this regard, and following the recent discussions in the Basel Committee on Banking Supervision (BCBS), operational risk will be excluded from the TRIM exercise for the meantime. In addition, the low default portfolios will be tackled at a later stage of this exercise.

With regards to upcoming regulations, in order to exclude the impact of any changes arising from the Fundamental Review of the Trading Book (FRTB), TRIM exercise will focus on areas that will persist even after expected changes, e.g. incremental risk capital models.

 

Conclusion

Due to the TRIM exercise, internal models are effectively becoming more streamlined, which in turn results in the RWAs becoming more standardized. Although the ECB has reiterated that a general increase of RWA is not a goal, the impact of TRIM on financial institutions remains unclear. However, the market sentiment is that it seems likely that remedial actions required by the ECB, due to TRIM, will ultimately lead to higher RWA levels on particular exposure classes subject to internal models.

This is illustrated by actions already taken by the Bank of Ireland. They performed a revision on their mortgage loan portfolio, in anticipation of TRIM. The bank revised its calculation of capital requirement under the IRB approach on its Republic of Ireland mortgage non-defaulted loan portfolio. This revision led to an increase of the (average) credit risk weighting from 26% to 34% for mortgages. The impact on the fully loaded CET1 ratio was approximately 60 basis points(5).

(1) Source: bis.org/bcbs/implementation.htm
(2) The Basel II regulatory framework introduced the Internal Ratings-Based (IRB) and Internal Model Approaches (IMA), allowing banks to use internal models for the determination of their Pillar I own funds requirement. IRB and IMA eligibility is dependent on the banks’ ability to prove to supervisors that they adhere to the minimum standards that are set under the Basel Accords.
(3) Source: ecb.europa.eu
(4) Source: bankingsupervision.europa.eu
(5) Source: bankofireland.com