On Tuesday, the European Central Bank released documents and presentations giving more details about its “Targeted Review of Internal Models” (TRIM), the latest acronym to give European bank management teams a headache. Alongside its press release will be a 150 page guide outlining the central bank’s expectations for banks which use internal models, to be pored over in more detail than GlobalCapital can stomach by bank capital management teams.
TRIM is an exercise launched last year which sets out to bring consistency to banks which use internal models to calculate risk weights.
European and international supervisors have been sensitive to criticisms that some banks use the “Internal Rating Based Approach” — that is, their own models — to lower capital requirements, perhaps by plugging in excessively optimistic assumptions about the probability of default and loss-given-default for certain assets.
They argue that the lack of consistency between banks, which shows up when supervisors give banks “model portfolios” and ask for hypothetical capital requirements, is bad for transparency, and means that investors cannot compare the riskiness of different institutions.
That’s the thinking behind the controversial “capital floor” proposals that will be part of the Basel IV capital rules package. This proposes to limit how much capital banks can save by switching from the “standardised” approach to IRB – but has recently hit a brick wall of political controversy.
Late last year, Andreas Dombret of the Bundesbank threatened to veto any Basel IV deal that didn’t work for Germany, while the incoming Trump administration in the United States has argued for deregulation in the financial sector and a brake on US involvement in the work of international financial regulatory bodies such as Basel.
The Basel Committee was supposed to reveal where it might set the “capital floor” in January — figures between 60% and 90% of the standard risk weighting had been mentioned — but the meeting was postponed, and market participants now expect the big reveal in June, if it comes at all.
TRIM suggests it might not.
The ECB will send its supervisors, along with a small army of consultants (the exercise will take up 15% of the supervision budget for 2017) to do on-site visits, and detailed model reviews across credit risk, market risk, and counterparty risk (operational risk models, likely to be scrapped by the Basel Committee, will not be examined).
Banks whose models don’t measure up will have to smarten up their operations, with a sliding scale of remedies. Few banks have disclosed how serious the TRIM operation will be, but Bank of Ireland released a capital update just before Christmas saying that its mortgage risk weights would rise from 26% to 34% — a huge move, if replicated across all of Europe’s mortgage lenders.
TRIM affects the models themselves, rather than their outputs, as Basel IV will. But if the ECB has comprehensively reviewed the way the firms it supervises calculate risk-weights, and is happy that they are acceptably consistent, it will have little reason to support a further intrusive measure designed to achieve the same objective.
Europe’s bankers, of course, will not be off the hook. Their capital requirements will take another leg up either way But TRIM could be just what’s needed to make sure Basel IV won’t happen.