Getting risk models runway ready

Successful financial risk models share few traits with fashion models, but both have to be up-to-the-minute and flawless in their execution – whether it be calculating default probabilities in Monaco or showcasing the latest season’s attire in Milan. Without these, neither type of model can be truly ‘runway ready’. Awkwardly for eurozone lenders, the latest round of model health checks conducted by the European Central Bank found such qualities wanting. 

The targeted review of internal models (Trim) was launched in 2016 to assess whether the models used to sum statutory capital requirements are fit for purpose and conform to regulations. In a recent update, the watchdog laid out issues with banks’ market risk modelling practices. Those branded the most severe concerned value-at-risk calculations, the essential building blocks of market risk capital charges. 

Shortcomings have also been found with credit risk models. Last year, the ECB disclosed that a third of eurozone banks were non-compliant with internal ratings-based credit modelling standards. Separately, the European Banking Authority found 39% of firms’ IRB models lowballed capital charges versus the regulator’s own benchmarks.

Faulty models worry watchdogs because they could produce regulatory capital requirements that underestimate the risks banks are running. This could leave them short of the resources needed to cover losses under stress. 

However, through Trim the ECB has a stick with which to beat recalcitrant models into line. The central bank’s investigators can order changes to bring deficient models up to scratch. These generally result in the models producing higher capital requirements.  

A handful of banks have already disclosed, or anticipate disclosing, such uplifts. For example, Dutch lender ABN Amro’s credit risk-weighted assets have swelled by more than €6 billion since Q3 2018 because of Trim.

Yet risk models undergo style changes just the same as fashion models. Even as banks grapple with today’s requirements, the Fundamental Review of the Trading Book is ushering in a new generation of modelling practices that will push them to the limit. Revisions to the IRB framework are also to be implemented under Basel III reforms from 2022.

It’s taking years for eurozone banks to conform with current model standards. Quite how they will cope with the souped-up requirements remains to be seen. Those firms struggling the most today may end up dispensing with internal models for some risks entirely in favour of regulator-set standardised approaches – the equivalent of choosing a wardrobe off-the-rack versus bespoke. No self-respecting fashion model would make that choice. But banks have a duty to hold capital in line with regulations. If this cannot be achieved using a tailored approach, then ready-made is their only option.