ECB Identifies Internal Model Deficiencies at Big Banks

The changes to correct the deficiencies will result in an overall absolute increase in risk-weighted assets of about EUR 275 billion. 

The ECB (European Central Bank) has issued 253 supervisory decisions to significant institutions requiring them to make changes to their internal models following the completion of a review which began in 2016.

Typically banks considered significant institutions may use internal models to estimate their minimum capital requirements if they have prior authorisation from the ECB.

The ECB has just completed its five-year targeted review of internal models (TRIM) involving 200 on-site investigations at 65 institutions to assess internal models for credit risk, market risk and counterparty credit risk. It found 5800 deficiencies with the internal models across risk types, 30 percent of which were labelled as “high severity”.

Among the deficiencies, credit risk models for retail and SME portfolios were found to have low risk differentiation. Improvements in the calibration approaches are required, particularly to incorporate adequate data to ensure that PD estimates reflect long-run average default rates and are sufficiently conservative. For LGD models, the calculation of realised LGD was a frequent cause of compliance issues.

For LDPs (low default portfolios), deficiencies were found in relation to the rating assignment process and risk quantification, mainly concerning the calibration methodology and the calculation of long-run average default rates.

In the credit risk on-site investigations, the ECB highlighted areas that need to be amended or adapted to ensure compliance with requirements on data quality and management. These areas include data quality monitoring and internal control, and the allocation of roles and responsibilities relating to data management.

In regard to market risk models, the greatest number of findings related to the VaR (value-at-risk) and sVaR (stressed value-at-risk) methodology, regulatory back-testing and the scope of the IMA (internal models approach). About 60 percent of the TRIM investigations on market risk resulted in at least one high-severity finding on the VaR and sVaR methodology.

In regard to counterparty credit risk models, all of the investigations featured at least one deficiency found related to validation and governance. In 60 percent of these cases the findings were deemed ‘high severity’. There were also deficiencies on specific modelling topics such as trade coverage, the margin period of risk, collateral, initial margin, and risk factors and calibration.

The ECB has issued feedback letters to the institutions found to have deficiencies with recommendations on the parts of their practices were not in line with applicable regulatory requirements.

A subset of institutions have received a supervisory decision containing obligations to address deviations. About two-thirds of the institutions have 12 or 18 months for implementation. For the remaining obligations, the time frame is greater than 18 months.

“The TRIM project has led to detailed supervisory follow-up with the involved institutions,” the ECB says. “Institutions are expected to work intensely to address the findings raised and to ensure that these remedial actions also take appropriate account of the new requirements stemming from the EBA’s regulatory review of the IRB approach.”

The ECB estimates that the total 253 supervisory decisions issued (or in process) will result in a 12 percent increase in the aggregated RWA covered by the internal models, which corresponds to an overall absolute increase in RWA of about EUR 275 billion (USD 332.7 billion).

The main results and conclusions from the TRIM exercise are summarised in the TRIM project report, available here.

An FAQ on the TRIM is available here.

The ECB has also developed a guide to internal models, which aims to provide transparency on how it applies applicable EU and national law when assessing whether banks meet legal requirements.

The guide is available here.

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