For EU banks, there can be no ‘back to normal’

The ECB’s recent review of risk models shows lenders got it all wrong pre-pandemic

After 14 months of Covid-19 restrictions, “let’s get back to normal” has become a popular refrain among politicians and pundits alike. But when it comes to European banks, recent findings suggest that the pre-pandemic ‘normal’ was not good enough. In fact, the ‘normal’ risk profile of many banks was distorted, obscured, or underestimated to a concerning degree.

That’s according to the European Central Bank’s final report on the Targeted Review of Internal Models (Trim). The exercise, launched in 2016 and completed in April, set out to ensure banks’ internal risk models meet regulatory requirements and to root out unwarranted variability in risk-weighted asset (RWA) calculations across institutions. In total, 65 top lenders were investigated by the ECB.

The results overwhelmingly show that banks’ risk modelling practices were not up to scratch and, as a result, that their capitalisation of market, credit and counterparty exposures fell short of what the risks justified. In total, the ECB found over 5,800 weaknesses in participants’ models and issued 253 sanctions, known as ‘supervisory decisions’. These decisions led to a whopping €275 billion ($330 billion) (12%) increase in aggregate RWAs. With minimum Pillar 1 capital requirements set at 8% of RWAs, the effect of the Trim was to boost charges for participants by €22 billion.

Will banks have learnt enough from Trim to ensure they don’t underestimate their risks in the ‘new normal’ to come?

Put simply, banks lowballed their capital requirements ahead of the pandemic. This could have spelled disaster for some when the market crisis hit, as their buffers may have proved insufficient to absorb the losses inflicted over the first months of the coronavirus crisis. This outcome was averted thanks largely to a blitz of regulatory changes by European authorities and the quick action of governments to guarantee loans and approve payment moratoria. ECB analysis shows the median Common Equity Tier 1 capital ratio actually increased 30 basis points following the implementation of these and other measures.

But capital requirements, and asset risk-weighting, will become more stringent again over time as the pandemic recedes. Will banks have learnt enough from Trim to ensure they don’t underestimate their risks in the ‘new normal’ to come? As the ECB’s final report implies, much depends on whether and how they improve their data management capabilities. Shortcomings around internal ratings-based model data were found in almost all on-site investigations, with many failings linked to problematic control frameworks and “weaknesses in the allocation of roles and responsibilities” in data management.

Model deficiencies could also be reduced if banks strengthened their independent internal validation functions. The ECB wrote these are important “to ensure an ongoing internal challenge” and prevent “gaming” of capital requirements by model users.

Both of these remedies require manpower and investment. But with EU bank profitability in the doldrums, executives may be reluctant to spend on initiatives that don’t translate into higher earnings. Of course, in the long term, failure to upgrade internal model practices could saddle banks with huge costs in the form of higher RWAs or greater-than-expected losses if and when a major counterparty defaults. For their own sake, then, executives should reject going ‘back to normal’ and embrace a fundamentally different approach to handling their internal models going forward.