ECB’s models review heaped €275bn of extra RWAs on banks

The European Central Bank’s sweeping audit of in-house risk modelling has saddled eurozone lenders with €275 billion ($331 billion) of extra risk-weighted assets (RWAs), eroding their aggregate Common Equity Tier 1 (CET1) capital ratio by an average of 71 basis points.

The Targeted Review of Internal Models (Trim), which kicked off in 2016 and ended last year, sought to address RWA output variations across firms where these were not warranted by actual differences in underlying credit and market risks.

The adjustments imposed across the 65 lenders scrutinised by the ECB have added 12% to their RWAs in aggregate since 2018, to €2.52 trillion total, a new report shows. This in turn caused their aggregate CET1 capital ratio to fall 60bp over the same period.

 

Credit RWAs for low-default portfolios (LDPs) – covering corporates, institutions and specialised lending – inflated most following the review percentage-wise, by 16% to €1.33 trillion. Their increase accounted for 39bp of the collective CET1 ratio drop. The ECB said it had to apply model backstops to banks’ own loss-given default (LGD) and credit conversion factor calculations in these portfolios most frequently.

Credit RWAs for small and medium-sized enterprises (SMEs) and retail lending ratcheted up 8% through the Trim, to €844 billion. The ECB found lenders had the capabilities to build “generally adequate” internal models for these exposures, but added that lenders needed better data to differentiate risk levels between borrowers.

Market RWAs required the least adjustment. Post-Trim, these increased 5% to €230 billion at the in-scope banks. “High-severity” deficiencies were identified in 60% of investigations of value-at-risk and stressed VAR models, and in 80% of cases concerning lenders’ incremental risk charge models.

Counterparty credit RWAs increased by 10% to €117 billion, and were responsible for a 2bp drop in the aggregate CET1 ratio. Most of the ECB’s concerns in this area related to validation processes, such as back-testing and governance.

What is it?

The Trim was conducted by the ECB between 2016 and 2020 to assess whether the models used by banks to calculate their statutory capital requirements were fit for purpose and aligned with all applicable regulations.   

The first stage focused on credit risk models for SMEs and retail portfolios, counterparty credit risk and market risk models. The second stage concerned models for so-called low-default portfolios. 

By the end of the review, ECB supervisors had completed around 200 on-site investigations at 65 banks.

The Trim project will formally close in Q2 of this year.

Why it matters

Trim added to the pressures faced by certain lenders last year. However, the ECB said the review was not intended to discourage the use of internal models, but rather to bring them in line with regulations and prevent banks from ‘gaming’ their capital requirements. 

Still, greater standardisation of internal models in the wake of Trim seems inevitable. So does a shift of portfolios out of the modelled approach and into the regulator-set standardised approach. The likes of ING have already undergone such a transition.

On the other hand, more comparable models may help European regulators understand the true distribution of risks across the banking system. Recently, the European Banking Authority said its annual model benchmarking exercise had been hindered by a lack of data standardisation. That may be less of a problem if bank models were constructed on a more similar basis.

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