Revised ECB Guide to internal models

May 2024

On 19 February 2024, the European Central Bank (ECB) released its final revised guide to internal models, together with related feedback statement. The final guide applies immediately and, notwithstanding industry feedback collected during consultation, is a barely altered version of the draft published during the summer of 2023. Our previous article summarises the new guide’s key revisions across its four chapters: general topics, credit risk, market risk and counterparty credit risk. Banks should now move quickly to address implications for their systems and procedures. The following are three areas that we expect banks to find particularly challenging.

1. Integrating material C&E drivers into market and credit risk models

The new guide requires banks to treat material climate-related and environmental (C&E) risk drivers in the same way as any other relevant and material risk driver, incorporating them into internal models for credit and market risks approved for calculating own funds requirements (OFRs). This poses several challenges:

• Determining the relevance and materiality of C&E risks under an appropriate time horizon and scenario, which depends on factors such as improved data collection, enhanced data management processes and revised risk assessment methodologies. In such exercise, banks should also take into account the principles included in the ECB guide on C&E risks  and the EBA Guidelines on the management of ESG risks currently in draft form.
• Where C&E risks are relevant and material, banks face a further challenge to integrate them into credit and market risk management frameworks and quantify them – something that’s likely to require changes to internal model policies and procedures.
• Banks with limited historical experience of quantifying material C&E risks or restrictions on the availability of sufficiently granular relevant data (with sufficient historical depth and representativeness) should consider reviewing override and Margins of Conservatism (MoC) frameworks to tackle uncertainties, hence adopting a more conservative approach.

Supervisory expectations on material C&E risk drivers are part of the revised ECB guide, however banks should also be mindful that such expectations reflect a broader on-going evolution of the regulatory landscape about the management of climate related risks as part of risk management frameworks, policies and procedures.

2. Proofing IT implementation readiness and ensuring timely implementation

IT implementation of a new model or a material model change is expected to be ready when applying for approval.  Following supervisory approval, the ECB states that implementation should happen within a “reasonable time frame”, which they generally expect to be no longer than three months from the date of notification. That is a challenging expectation given the need for a robust implementation process to ensure and verify system readiness.

With this in mind, application packages submitted to the ECB should include evidence that systems are ready for new or altered models to produce risk parameters, complete UATs¹, calculate OFRs under the internal ratings-based (IRB) approach, produce COREP reporting and integrate with risk management and reporting frameworks. Banks should also set out clear implementation roadmaps. Any potential impediments to the three-month timeline (e.g. in case of IT technical constrains or implementation across different jurisdictions) are allowed only in exceptional cases and must be reported to the ECB as soon as possible, but not later than when submitting comments within the model decision process.

To ensure they can comply with these requirements, banks should consider:

• Defining a sound IT implementation plan and setting up a robust IT environment for parallel model operation (allowing to execute implementation tasks in parallel with development), including the systems, databases and power needed for implementation, data storage and processing.
• Allocating staff with expertise in risk modelling, data analysis and regulatory compliance to work on the different elements of the application process for new models or material model changes and the design and development of suitable IT environments.
• Collecting compelling evidence of robust implementation and effective operational processes for inclusion in the application package.
• Streamlining internal processes (such as timely involvement of internal control functions) in order to meet the three-month implementation deadline.

3. Reverting to less sophisticated approaches for credit risk

As stated in the revised guide, and in accordance with Article 149 of the Capital Requirements Regulation (CRR), banks wishing to revert from the IRB approach to the standardized approach (SA) or the foundation-IRB (F-IRB) approach are expected to:

• Document the factors – which must have arisen after the original IRB authorization was granted – leading them to reconsider using an advanced approach.
• Assess the affected exposures, defining objective, consistent and intuitive criteria (e.g. materiality, data availability and representativeness, availability of another IRB approach, impact on OFRs) for deciding which approach is best suited to which exposures.
• Provide convincing evidence that risk-weighted asset (RWA) reduction is not the goal of reversion, particularly where reverting to a SA or F-IRB approach would lead to a non-negligible reduction of OFRs.

Fulfilling these expectations will require banks to:

• Reassess their internal model strategy – which could include updating internal model approaches and policies.
• Perform a thorough impact assessment covering both the quantitative (e.g. RWA impact) and qualitative (e.g. changes to processes, frameworks, reporting) implications of reversion.
• Collect and formalise compelling evidences underlying the reversion to prove its meaningfulness.
• Ensure that applications to revert are accompanied by establishing the internal mechanisms that will enable compliance with the three-month implementation timeline.

In supervisory terms, banks are already experiencing rigorous investigations from the ECB, with the potential for supervisors to issue severe findings and even delay or withdraw bank applications for new models or material model changes.  The publication of the revised guide simply reiterates supervisory expectations, some of which banks have already encountered in previous investigations.

In purely practical terms, ECB expectations pose a wide range of challenges in terms of data gathering, technology implementation, resources and costs allocation, internal process and framework adaptation.
It is important to note the supervisory expectation regarding IT implementation readiness, which may pose a challenge and significant additional costs for some banks. This could result in delays in finalising application packages and subsequent approval processes, ultimately impeding the timely integration of revised models of components into risk management frameworks.

At present, banks should continue with their initiatives to remediate findings and restore compliance with supervisory expectations on internal models. Additionally, banks should carefully assess potential second-round effects stemming from remediations to on-site inspection (OSI) findings in credit risk-related areas (e.g., IFRS 9 and commercial real estate), which may impact the scope of internal models. This could further increase complexity within ongoing internal model-related initiatives.

Institutions should also be mindful of implications resulting from upcoming Basel IV/CRR III, which – amongst others – is expected to impose further model restrictions and limitations, with associated additional strain on bank internal resources and capabilities. In this regard, the ECB might also revise its expectations once the new regulation will enter into force – generating further guidance that banks are currently looking for.

Against this background, banks should consider rationalising their model landscape by assessing and identifying which asset classes should be managed under A-IRB, F-IRB or SA approaches. Key drivers to consider for decision include data availability, data quality levels and operational complexity to manage regulatory internal models. From a business and profitability strategy standpoint, the availability of cost allocation strategies to bear the costs of a less sophisticated approach for determining regulatory capital requirements would also be pivotal.

Within reviews of internal model landscape, banks should stand ready to justify and evidence rationales and criteria underneath their selection; availability of clearly defined thresholds and indicators to consider for triggering reversion initiatives play a key role. Additionally, the ability to exploit and maximise synergies (e.g. data, risk drivers, IT procedures, processes) across internal model frameworks constitute a strategic factor to shape its internal model strategy and define prioritisation initiatives.

Decisions about internal model strategies are not merely technical – they will have direct impact on Board-level matters such as lending strategies, balance sheet management, profitability strategies and optimisation of procedures and costs.