ECB consults on revised Guide to internal models

The ECB has initiated a public consultation on its revised Guide to internal models. This revision incorporates changes in the legal framework and draws upon the ECB’s extensive experience in overseeing internal models. The approval process for a bank’s use of internal models involves initial approval by ECB Banking Supervision, followed by internal model investigations and ongoing model monitoring. These steps are taken to ensure that banks continue to meet the requirements for employing internal models.
By the end of 2022, approximately 60% of risk-weighted exposure amounts for credit risk in banks directly supervised by the ECB (significant banks) were calculated using internal models, while about 40% utilized standardized formulas. Credit risk constituted approximately 85% of the total risk-weighted exposure amounts for significant banks, which amounted to €8.6 trillion.
The Guide to internal models was originally developed by the ECB as part of the TRIM. TRIM aimed to address inconsistencies arising from the use of complex internal models and reduce non-risk-based variability of outputs.
The Guide explains the ECB’s interpretation of the rules applicable to banks when using internal models to calculate their required capital. Banks are permitted, with the ECB’s approval, to employ their own internal models to determine their risk-weighted assets, which serve as a measure of the risks held by the bank and form the basis for calculating the necessary capital. Supervisors ensure that banks adhere to the relevant EU banking rules governing the use of internal models.
In the revised version of the Guide, which is currently under consultation, banks are provided with guidance on including material climate-related and environmental risks in their models. It also offers clarification for banks considering a return to the standardized approach for calculating risk-weighted assets. Specific to credit risk, the guide aids all banks in achieving a common definition of default and a consistent treatment of massive disposals. Additionally, the updated market risk chapter outlines methods for measuring default risk in trading book positions. The Guide also offers clarifications regarding counterparty credit risk, which pertains to the risk of default by the counterparty in a transaction.
The consultation on the updated Guide to internal models will conclude on 15 September 2023. The ECB will release the received comments along with a feedback statement and the revised Guide.
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The ECB also published FAQs in the context of the consultation on the revised ECB Guide to internal models, whose questions we would like to present here in full, along with a short summary of the corresponding response:
What is the purpose of the ECB guide to internal models?
The guide provides transparency on how the ECB understands the rules governing the internal models used by institutions it directly supervises to compute own funds requirements for credit, market, and counterparty credit risk.
What is the purpose of the different chapters of the ECB guide to internal models?
The general topics chapter explains the overarching principles applicable to all risk types, while the three risk-type-specific chapters explain how the ECB understands various aspects of the applicable regulations for each specific risk type.
What was the main reason for revising the ECB guide to internal models in 2023?
The review was necessary to properly reflect ongoing developments in regulatory requirements, include refinements on topics based on past experience, and include additional topics for which further clarification of existing regulatory requirements appears to be necessary based on past experience.
What are the main differences compared with the previous version of the ECB guide published in November 2019?
The updated ECB guide to internal models has retained the same structure as the previous version but includes new sections on climate-related and environmental risks, reversion to less sophisticated approaches, and internal models in the context of consolidation.
What is the next step after this consultation on the ECB guide to internal models?
The ECB guide to internal models will be updated once industry feedback has been considered.
Once the public consultation process is finalised, will the guide be further updated in the future?
Yes, the guide may require revision or expansion in the future if supervisory criteria or regulatory requirements change.