The European Central Bank (ECB), acting in its role as the head of the Banking Union’s Single Supervisory Mechanism (SSM) published on April 3, its interim update on the Targeted Review of Internal Models (TRIM) (the April 2019 Note).1 The document is called a “note” rather than a “letter” in comparison with the June 11, 2018 Status update on TRIM (the June 2018 update).2 Both are published as part of the ECB’s “Letters to banks” which are namely communications to the banking industry and Banking Union Supervised Institutions (BUSIs) to clarify processes and practices related to its supervisory tasks.
However, as discussed in this Client Alert, the letter is the first of its kind and given the fact that the ECB does not have absolute power to make use of publication findings in such a manner, the April 2019 Note could thus be seen as trying to establish precedent. Could this publication be compared to the FCA’s Dear CEO letters? There are grounds to suggest so, as these types of communications usually highlight the supervisor’s concern about particular issues in an industry area. What is the ECB aiming to achieve with it? That remains to be seen but several potential answers emerge as the ECB-SSM sets a starker supervisory tone but on the one hand consults on amendments to how it levies fees3. TRIM has been and remains a multi-annual supervisory priority even if, now in 20194, it is starting to come to an end. The April 2019 Note also states that: “Going forward, the note may be updated and expanded as necessary to reflect additional analyses conducted in the meantime.” This, like the ECB’s Guide on internal models points to the April 2019 Note being viewed by the ECB as a “living document” that forms the basis of on-going supervisory dialogue between SSM and BUSIs.
The April 2019 Note’s letter-like introduction reports on the updated outcomes of TRIM and aims to facilitate involvement of the different institutions in the supervisory process and foster a better understanding of the context of the procedure. This is similar to the concluding statements of the June 2018 Update which also stated that involvement of institutions’ top management in TRIM is essential to the success of the project and the role played by internal models. The April 2019 Note explicitly states that individual institutions will then be informed about possible updates of the document to reflect the additional analyses conducted in the meantime. This begs the question why the interim findings then need to be publicly distributed? One answer could be that the April 2019 Note should be seen as somewhat of a spring “report card” aimed at indicating how well or badly institutions are doing when it comes to the supervisory objectives the ECB-SSM set in TRIM.
In terms of content, the April 2019 Note is structured in three parts with: a high-level summary of the TRIM objectives and main achievements; a detailed overview on the main insights that have emerged from the horizontal analyses; a summary of the next steps. Additionally, it also aims to provide an overview of the main findings related to data quality review; to report the most common or critical shortcomings identified during TRIM investigations on internal models for market risk and to complement the analysis on credit risk internal models which also featured in the 2018 June Update.
The TRIM project’s main aims included goals to reduce unwarranted variability when institutions use internal models to calculate their risk-weighted assets (RWA) and to ensure a consistent use of high supervisory standards in the Banking Union. It covered internal models for credit, market and counterparty credit risk and since its inception in 2015 and start of the execution phase in 2017, TRIM has involved about 200 on-site investigations on internal models at 65 significant credit institutions across the SSM. During the execution phase a review of the internal credit risk models for retail and small and medium-sized enterprise portfolios and market risk and counterparty credit risk models was conducted. A review of the models used to assess the credit risk for low-default portfolios is still ongoing. It is also feeding into ECB-SSM supervisory reforms that are part of the 2019 supervisory priorities that in turn are also impacting reforms on ICAAP and ILAAP – as discussed in standalone Client Alerts.
The April 2019 Note sees TRIM as contributing to success in four key areas:
The remainder of the April 2019 Note considers the TRIM horizontal analyses and provides an overview of the features of internal models as the most important part of TRIM’s tasks.
The April 2019 Note’s section on investigations and horizontal review follows almost word for word the 2018 June Update. It states that cases of outright non-compliance with the applicable regulation were addressed through supervisory decisions imposing obligations on the affected institutions to remediate the issues. Further, additional potential misalignments with further aspects of the regulatory framework were communicated to the institutions via follow-up letters requiring action on their behalf.
As a whole the numbers are the same as in the 2018 findings with 29% of the 21 institutions that received a dedicated supervisory decision on general topics being found to have shortcomings in the absence of a model change policy or absence of notification of material model changes to the competent authority. This is followed by 24% of the institutions lacking evidence of annual back-testing for some rating systems. 19% of the institutions use the standardized approach without formal authorization of a permanent partial use and the same number also have no strict segregation of staff performing validation activities and staff involved in tasks of the credit risk control function. Finally, 14% were allocated as having a deficiency in terms of their “current resources allocated to the internal validation function thereby preventing a robust validation process”. All of this is not very encouraging both for TRIM relevant firms but equally not for the ECB-SSM.
The April 2019 Note also includes a non-exhaustive list of examples of issues communicated in the follow-up letters and the number of institutions, 55 of them, in terms of what they received. These are as follows and will also likely be relevant for other Banking Union Supervised Institutions that have not (yet) received TRIM follow-up letters:
1. Implementation of a model risk management framework
• Despite some measurement of model risk and partial controls in place, practices not formalized/documented
• Absence of model risk management (steering and mitigation)
• Model risk not identified as a material risk by the institution (lack of awareness)
2. Application of the IRB approach and monitoring of permanent partial use (PPU) provisions
• Absence of monitoring of the PPU conditions
• Absence of clear criteria for the decision on the application of the IRB approach (selection done on a case-by-case basis)
3. Decision-making responsibilities and internal reporting
• Level of detail in the reporting is not appropriate
• Management body (or a designated committee thereof) does not approve all risk management policies
4. Organization of the internal validation function
• Deficiencies in the validation policy and procedures
5. Scope and frequency of the audit review of the rating systems
• Lack of resources to allow a relevant assessment of the IRB requirements
• Some of the rating systems not reviewed by internal audit
• Certain aspects of the rating systems not reviewed regularly
6. Non-rated exposures and outdated ratings
• Non-rated exposures or exposures with outdated ratings not monitored by the institution
• No specific prudential treatment for non-rated exposures, or exposures with outdated ratings, or such exposures treated under the standardized approach
7. Change policy and re-rating process
• Process for the re-rating and implementation of the new model not formalized
• Model change policy missing key elements such as responsibilities, impact assessment procedures or process for the classification of the changes
The rest of the section follows closely the 2018 June Update. TRIM investigations in 2018 focused on credit risk models related to exposure classes Retail and Corporate SME and their compliance with the CRR. In the event of non-compliance supervisory decision were issued with institutions being asked to address the findings. The findings focused on the probability of default (PD), loss given default (LGD) and credit conversion factor (CCF). The findings with regards to the PD and LGD parameters are taken directly from the 2018 letter and state that the shortcomings in the PD area are related to a lack of consideration of relevant risk drivers or lack of an appropriate definition of the grades, while those in relation to the LGD parameter involve the use of an inappropriate discount rate and the treatment of multiple defaults; and specific aspects of the calculation (such as lack of an appropriate treatment of restructuring case or insufficient consideration of indirect costs) identified during the on-site investigations.
The new analysis included in this part focuses on the review of data management practices applied by the institutions to the specific credit risk models under review, as well as the review and assessment of the quality of PD and LGD historical data used. The analysis concluded that data quality-related findings are present in all institutions be it in relation to data management or data quality processes such as: the data quality framework’s governing principles and scope of application; the policies on data quality management and processes; the allocation of roles and responsibilities in relation to the management of data quality; the current metric approach for monitoring data quality; the processes for data quality incident remediation. Data management and data quality processes were the areas where the findings with higher severity were found. IT infrastructure was also found lacking with a lack of documentation on the infrastructure and processes as well as issues related to the technical implementation of the Definition of Default and technical tests on the data maintenance.
In terms of the market risk investigation which was completed in June 2018, the majority of the findings concern the value-at-risk (VaR) and stressed VaR (sVaR) methodology regulatory back-testing, the scope of the internal model approach (IMA) and the incremental risk charge (IRC) methodology. The shortcoming in relation to VaR and sVaR are the most severe and relate to the general model issues and documentation weaknesses; data quality issues; inadequate or not fully validated coverage of risk factors in the Var or sVaR models and issues regarding the pricing methods in the model. The ECB guide is seen here as providing guidance and a clear definition of proxies in a way ensuring common understanding and alignment of practices.
The TRIM review also showed that the elements recognized for actual (losses predicted by the VaR model with those actually realized) and hypothetical (hypothetical losses predicted by assuming that positions remain unchanged) P&Ls were not always in line with regulatory requirements, not aligned across institutions. These relate to regulatory back-testing which is a key element to monitor the quality of VaR models. On-site investigations also reveled that well-justified PD values in IRC models are not used by all institutions and that PDs assigned to the same or similar issuers can vary materially across institutions. The ECB guide thus recommends that PDS used in IRC models should be risk-sensitive and strictly greater than zero for all obligors.
The TRIM project is due to end in early 2020 upon finalization of the analyses and the relevant project documentation. A consolidated version of the ECB Guide on internal models is expected to be published shortly, while the on-site investigations will continue throughout the year with the investigations on models for low-default portfolios. That activity is expected to factor back into the ECB’s Guide on internal models which is expected to evolve as a “live document”. Delivery of TRIM also coincides with the SSM taking stock of 5 years6 of how it has implemented its model of supervision and the road ahead under new leadership.
What is telling is that the April 2019 Note finishes by saying that “intense follow-up work by the institutions is expected in the short term to remediate the shortcomings identified in the relevant decisions.” As such BUSIs are encouraged to proactively plan and engage with the ECB-SSM’s Joint Supervisory Teams given what the ECB-SSM phrases as an “intense period ahead for internal model resources.”