What risks do the financial institutions take? How much capital do they need? These questions are key elements of risk management for the banking sector moving in a constantly changing world. On the authority of the ECB, the banks may use internal models to estimate their minimum capital requirements. These internal models are currently challenged by the supervisor of the Euro zone.

Following the financial crisis of 2007-2009, the internal models used by banks to calculate regulatory capital requirements were heavily criticised, in particular regarding the complexity of these models and the unwarranted (i.e. non-risk based) variability in their results.

“The aggregated impact of TRIM limitations and model changes […] will lead to a 12% increase in the aggregated RWA.”

In this context and in collaboration with national competent authorities, the European Central Bank (ECB) launched in 2016 its vastest project so far: the Targeted Review of Internal Models (TRIM). Covering internal models for credit, market and counterparty credit risk, this project aims to increase the transparency and ensure consistent practices through the different institutions.

In total, around 200 investigations were performed on-site in 65 institutions across 15 countries in Euro zone. Note that, a horizontal analysis was carried out to identify the most common or critical shortcomings of internal models among all institutions.

Finalized in April 2021, the outcomes of the investigations have been compiled and published in the Project report. Overall, this report highlights that the institutions can continue to use their internal models. However, a large number of limitations has been expressed and distributed with different levels of severity, to ensure that the level of own fund is appropriate and sufficient to cover the risks.

What is the impact/outcome of TRIM?

Firstly, one of the conclusions of this exercise was that the ECB guidance has been wrongly interpreted on how the models should be used to generate consistent and comparable risk measures.

The ECB identified a variety of areas in which their requirements were not well specified or where national authorities had pursued inconsistent interpretations of the ECB requirements. So, one of the key outcomes of the TRIM is enhanced guidance from the ECB. This will reduce the instances of variation in RWA due to differences in interpretation of what is required.

Secondly, due to some lack of data, the ECB identified models, which were likely to be unreliable. This was an issue for Low Default Portfolios in general and Loss Given Default models in particular. As a result, the ECB is applying “limitations” on some models to ensure that the outputs are sufficient to cover the risk of the relevant portfolios.

Thirdly, the ECB’s report disclosed that the TRIM has resulted in 253 supervisory decisions that are expected to result in a 12% increase in the aggregate RWAs of the models covered by the review. In other words, it is estimated that all the limitations and model changes approved would lead to an overall absolute increase in RWAs of about 275 billion euros over 2021-2022. Yet in practice, it will depend on how each financial institution will address its obligations.

Conclusion of TRIM report

The goal of TRIM is not to allow the use of internal models but rather to assess how adequate the models in use are.

In the future, banks will need to continue to invest in high-quality models. For that purpose, it is particularly important that banks further strengthen their internal validation function. For its part, the ECB will continue its demanding risk-based supervision of internal models to ensure that banks continuously meet the requirements for the use of such models.

Good internal models are a basis for sound risk management. Bringing models in line with regulation better helps banks to manage risks under regular or stressed economic and market conditions.

Reference: European Central Bank, 2021, Targeted Review of Internal Models, Project report