EBA Report Examines the Consistency of Internal Model Outcomes

By Regulatory News

January 10, 2019

EBA published two reports on the consistency of risk-weighted assets (RWAs) across all EU institutions authorized to use internal approaches for the calculation of capital requirements. The reports cover credit risk for high- and low-default portfolios (LDPs and HDPs) as well as market risk. The results confirm previous findings, with the majority of risk-weight variability explained by fundamentals.

Credit Risk Exercise. The credit risk report examines the drivers leading to the observed dispersion across banks' models. Results are broadly in line with previous exercises, with 50% of the difference in variability explained by the proportion of defaulted exposures in the portfolio and the portfolio mix. The remaining could be attributed to differences in collateralization and other institution-specific factors, such as risk strategy and management practices, idiosyncratic portfolio features, modeling assumptions, client structure, and supervisory practices. This confirms previous findings that RWA variability can be explained, to a large extent, by looking at some measurable features of exposures of institutions. The competent authorities performed an assessment of the internal models, which have been identified as outliers in this benchmarking exercise. Their monitoring activities are increasingly noticing issues identified by the EBA benchmarking exercise. The same conclusion holds for institutions' internal validations. This is reassuring and indicates that the increased regulatory and supervisory attention paid to internal models is contributing to the consistency of the RWA of internal models.

Market Risk Exercise. Compared to the previous exercise, the 2018 analysis shows a reduction in the dispersion in the initial market valuation (IMV) and risk measures. The persisting variability in the results mainly stems from different interpretations and heterogeneous market practices adopted by firms. Some of these issues have been addressed and the quality of the data has improved. From a risk-factor perspective, interest rate portfolios exhibit a lower level of dispersion than the other asset classes, which is most likely due to the use of more consistent practices and assumptions that are more homogeneous across the banks when modeling interest rate risk. This finding confirms the conclusions drawn in last year's analysis. In line with the previous exercises, a significant dispersion for all the risk measures is observed. More complex measures such as incremental risk charge (IRC) and all price risk (APR) show a higher level of dispersion. This report has provided input for competent authorities on areas that may require their further investigation, such as IMV variability for some credit spread products. Supervisors should pay attention to the materiality of risk factors not in VaR and, in particular, not encompassed in the IRC models.

EBA conducts the the benchmarking exercises annually. The exercises constitute a fundamental supervisory and convergence tool to address unwarranted inconsistencies and restoe trust in internal models. For credit risk internal models, EBA has followed its roadmap for the implementation of the regulatory review of internal models. The regulatory technical standards (RTS) on the assessment methodology for internal ratings-based approach are a key component of the EBA work to ensure consistency in models outputs and comparability of risk-weighted exposures. EBA guidelines on the definition of default and the estimation of Probability of Default (PD), Loss Given Default (LGD), and the treatment of defaulted assets are other components of this review. The exercises provide a regular supervisory tool based on benchmarks to support competent authorities' assessments of internal models and produce comparisons with EU peers.

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Keywords: Europe, EU, Banking, Internal Models, 2018 Benchmarking Exercise, Benchmarking, Market Risk, Credit Risk, EBA

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