The ECB publishes its revised guide to internal models

Publication
10 minute read
18 Apr 2024

Introduction

On 19 February 2024, the European Central Bank (ECB) published its revised guide to internal models (the Revised Guide). This blogpost sets out the background of the changes, the key changes and their potential impact on institutions and concludes with a brief analysis.

Background

The Capital Requirements Regulation (CRR) mandates the ECB to authorise the use of internal models for credit risk, counterparty credit risk, and market risk by institutions, provided that a set of requirements outlined in the CRR are fulfilled.

The ECB’s guide to internal models was published in October 2019 (the Original Guide) with the main objective to ensure consistent application of high supervisory standards across directly supervised institutions, fostering uniform understanding and adherence to regulations governing internal models.

The Original Guide's chapters align with the CRR requirements and provide a clarification of the ECB’S interpretation of these requirements and publications of the European Banking Authority (EBA) relevant to the internal ratings-based (IRB) approach (e.g., EBA guidelines (GL) on probability of default (PD) and loss given default (LGD) estimation, and EBA GL on definition of default, EBA regulatory technical standards on assessment methodology, etc.).

The Original Guide has served as a valuable resource for both institutions and supervisors, offering transparency on the ECB’s expectations for implementing regulatory requirements related to internal models. Nevertheless, the ECB deemed a revision necessary due to the following reasons:

To accurately incorporate evolving developments in regulatory requirements.
To introduce refinements to topics covered in the previous version, informed by past experiences.
To address additional topics requiring further clarification of existing regulatory requirements, as identified through past experiences.

On 22 June 2023, the ECB launched a consultation on its proposed revisions to the Original Guide (the Consultation Version) which ended on 15 September, 2023.

During this period, a total of 20 respondents submitted 625 comments to the Consultation Version. The ECB has reviewed these comments and, together with the Revised Guide, issued a feedback statement, offering a comprehensive summary of the comments and the ECB's evaluations thereof.

The major revisions to the Original Guide were implemented in the Consultation Version, with the Revised Guide primarily incorporating clarifications arising from the consultation feedback.

The Revised Guide has retained the same structure as the Original Guide, with a general topics chapter followed by three risk-type-specific chapters.

In the table below we have included a description of the key changes to the Original Guide, their impact, and the required actions for institutions because of these changes.

Key change topic	Description of change	Impact	Required actions
Overarching principles for internal validation	Fulfilling the additional requirements specified for Internal Validation function becomes a requisite rather than suggested as being the best practice. Requirements are specified in Articles 10(3) or 10(4) of Commission Delegated Regulation (EU) No 2022/439 for the institutions, based on whether they have separate validation function or not.	Medium high	Institutions should fulfill the additional requirements for internal validation functions in case they have not been implemented yet.
Roll-out and permanent partial use	Where a new type of exposure is created the institution should verify which scope it falls under or requires to notify the competent authority. Where a new business unit is created (e.g., consolidation of a new legal entity), institutions should verify the suitability for permanent partial use (PPU) according to the criteria established in their relevant internal policy and act accordingly.	Medium	The institution should verify if the new type of exposure: Falls under the scope of an approved rating system, falls under the scope of an approved permanent partial use of SA, and Requires any notification or request to the competent authority.
Reverse the use of less sophisticated approaches	Where there is a request to reverse the use of less sophisticated approaches, ECB expects that institutions will be capable of implementing the approach requested no longer than three months from the date of the notification, unless an exception is requested under specific circumstances.	Medium high	Exceptions to three-month expectation should be requested as early as possible in case of: Staggered Approach Joint Implementation
Definition of default	90 days past due may be treated as technical default, when a dispute or moratoria were initiated before the default classification under specific circumstances. Whenever a new default trigger becomes applicable while the probation period is running, then the probation period is reset to zero and immediately starts again. With respect to the new definition of default, institutions should redevelop their models to the extent needed instead of performing full redevelopment of their models.	Medium high	Some banks may need to rethink their DoD application: ensure that their methodology fully aligns with the Guide. In case of requirement of change, banks should redevelop their models to the extent needed
Probability of default	Overlapping one-year time windows should preferably be used when the observed average default rate using overlapping one-year time windows is significantly different from the observed average default rate and either; distribution of default rates is not stable over time or significant variation between the observed average default rates.	Medium low	Institutions should check whether they should choose overlapping one-year time windows considering the change of hierarchy of the circumstances stated by ECB.
Loss given default	While calculating “the average estimated LGDs for comparable exposures in default that have not been finally liquidated”, instead of making a proposal as to what constitutes a sufficiently long time, institutions should monitor whether most cases that were incomplete as of the date of the massive disposal, have been closed.	Medium	Institutions should track the closure of cases that were incomplete at the time of disposal. If most of these cases have been closed, it can be concluded that enough time has passed and make a final assessment of whether the adjustment needs to be updated

Highlighted: Climate-related and environmental risk

The Revised Guide specifies that banks should include material climate-related and environmental (C&E) risks in their models. The graphic below sets out the components of the PD/LGD models where C&E data can be considered and what banks should do to be able to meet this criterion.

On the back of this, banks should take the following action:

1) Banks should start collection of Climate & Environmental data

The next generation of models should consider C&E factors across the entire modelling process
In order to fulfill this requirement, the collection and analysis of relevant C&E factors needs to start now
This will pose a significant challenge to each insititution in the identification and sourcing of data that satisfy regulatory requirements on data quality

2) Banks should refine override frameworks to include C&E risk

This should be done now — since including drivers in models directly is not feasible for most banks yet
Clear guidance is needed for credit officers who are responsible for rating assignment and loan approval

Conclusion

Clearly for several banks, the Revised Guideline introduces challenges that might require substantial investment and resource allocation.

The key challenges are related to the new path laid out to revert to the less sophisticated methods and the adjustments to the existing roll out plans in the pillar 1 modelling space. All related challenges with this reversion to the less sophisticated methods, starting with the new segmentation, the calibration, and the default trigger identification several technical methodological issues, should be addressed . To be able to address some of these challenges, the relevant IT infrastructure should be improved or upgraded.

The additional clarifications provided regarding the introduction of climate-related and environmental risks in the IRB space are clearly welcome, but still have room for progress in near future.

Contact us

Luís Filipe Barbosa

Credit Risk Modelling Workstream Lead, Partner, PwC Portugal

Tel: +351 914 201 014

Kaan Aksel

Credit Risk Modelling Workstream Lead, Partner, PwC Germany

Tel: +49 160 95648160

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