Andreas Dombret of Bundesbank on Internal Models in Banking Regulation

Mr. Dombret discussed the benefits of internal models and their state before and after the financial crisis. He further noted that models can never get a calculation fully right. Limiting mis-measurement requires dealing with risk and uncertainty. He noted that internal models played an important role in the Basel III finalization package, even though they have rightfully lost their sacrosanct status, as they revealed big weaknesses during the last financial crisis. Models will never be perfect and there must be awareness about the underlying assumptions and their shortcomings. After regulatory reform, internal models rightly continue to play a big role, but now a complementary one. Limits have been set. However, we shouldn't overreact. It is also important to maintain incentives for banks with regard to a risk-sensitive framework. This is why, on the Basel Committee, German authorities have resolutely argued in favor of sufficient incentives for internal models. On the basis of the limits set by the Basel III reforms, we must to look forward now, said Mr. Dombret. National competent authorities, EBA, and Single Supervisory Mechanism (SSM) must work on improving internal models further so that they can contribute to efficient and stable financial markets.

He highlighted the need to support the benefits of internal models. He emphasized that banks have to build better models, models that not only focus on the efficient use of capital but also ensure that a bank can weather future storms. With regard to credit risk and the boundaries for the internal ratings-based (IRB) approaches, it is important to implement the Basel III compromise in a rigorous way. He mentioned, "Another important point concerns credit risks, but also other risk type models. The targeted review of internal models, the TRIM project, by the SSM should be conducted in a responsible and considered manner...." This means the biotope of risk modeling approaches must be kept diverse. A right understanding of harmonization means not only treating equal things equally, but also treating unequal things unequally. TRIM must ensure, that the playing field for banks is leveled, but not create a monoculture of models driven by supervisory rules. The changes that will be introduced through the TRIM project must be implemented reasonably. Banks need a transitional period to adopt the new standards. In the end, he reiterated, "You have a full agenda of challenges in risk modeling ahead of you. Moreover, during the coming years, you, hopefully, will help to make financial risk models better."

Related Link: Speech

Keywords: International, Banking, Internal Models, IRB Approach, Banking Regulation, TRIM, Bundesbank, BIS