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Western EuropeApril 26 2017

ECB pushes case for internal models

The European Central Bank is undertaking a major project to ensure the internal models used by eurozone banks work properly. A useful spin-off could be to tackle the Basel Committee on Banking Supervision’s scepticism over their use, as Justin Pugsley reports.
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What is happening?

Internal models used by banks to calculate risk-weighted assets is a controversial topic, as some partly blame them for the financial crisis. Just to ensure they are working properly, the European Central Bank (ECB) is undertaking a huge project to evaluate them. 

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The use of internal models is controversial. Some commentators – and even regulators – blame their use for allowing banks to take on too much risk and to not set aside sufficient capital.

One of the differences between Basel II and Basel III is that the Basel Committee on Banking Supervision (BCBS) is attempting to confine their use mainly to areas where there are vast amounts of data, such as credit card loans. Calculating risk-weighted assets for exposures in other areas, such as lending to financial institutions and very large corporates, will be done according to the standardised approach, giving banks less wiggle room over capital allocations.    

However, for the Europeans, internal models remain a key part of the banking landscape. This prompted the ECB to launch its Targeted Review of Internal Models (TRIM) project back in 2015 and it will likely run into 2019. It will involve reviewing thousands of models and cover some 68 eurozone banks and is tackling credit, market and counterparty credit risk.

Why is it happening?

Europeans are very wedded to using internal models. Banks have argued that severely restricting their use would sledgehammer their already low profitability, and could even render some banks unviable.  

Politicians and regulators that are desperate to return the eurozone to a sustainable growth path supported by banks, rather than constant pump-priming by the ECB, have received that message loud and clear. However, some European regulators have long held suspicions that these models might still harbour unacceptable levels of risk.

Hence the ECB exercise. And visits to banks have resulted in some having to raise their capital levels, which from the ECB’s viewpoint shows that TRIM is an exercise that is worth the effort.  

Apart from making Europe’s banks more resilient, the ECB also wants to build market confidence in internal models by reducing excessive variability. A useful spin-off from this project is that it might help the Europeans convince the BCBS not to be so restrictive in the use of internal models. And the best way to win that argument is to demonstrate that these models can indeed be robust while also being risk sensitive.

What do the bankers say?

For the banks, it is yet another intrusive and deeply time-consuming exercise, which comes on top of an already very heavy compliance work load. And it has a potentially unpleasant sting in the tail for them – having to set aside even more capital against exposures if the ECB finds fault with their model formulas.

In effect, the ECB’s exercise is likely to drive a greater standardisation across internal models, thereby reducing output variation, particularly at the margins. Also, some models are likely to be killed off permanently.  

The move has caused dark mutterings among some bankers with talk of reducing risk sensitivity and variety in approaches to calculating risk. For example, Deutsche Pfandbriefbank CEO Andreas Arndt said the German real estate lender would have to revisit its capital approach if the ECB’s more ‘standardised’ approach forces it to raise its risk weightings.

But amid all the hassle and inconvenience, there is some good news. The fact that the ECB is going to all this trouble shows it is fully committed to retaining internal models, possibly to the point of defying the BCBS if an acceptable compromise cannot be reached over their use.

Will it provide the incentives? 

If the ECB does its evaluations properly, then yes it should. Reducing excessive variability is also what the Basel Committee is trying to do – though in a more drastic fashion by imposing its standardised approach for certain exposures and output floors for some internal models where it will allow their use.

Though it is causing short-term pain, the long-term gain is that banks will assess risk more robustly, making them more resilient to shocks; and if the outcome of TRIM wins investor confidence then it should help reduce funding costs. The rating agencies, for example, view TRIM as a credit positive.

A real bonus for the Europeans would be to get the BCBS onside and the BCBS for its part should note that the fact this project is being done at all shows that the Europeans fully intend to use internal models far into the future.

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