Revised ECB Guide to internal models

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:

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.