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How will Banks respond to ECB Validation Reporting and Model Risk Management requirements?

Prometeia Survey


Significant institutions’ internal validation plays a key role in the European Central Bank’s assessment of the reliability and accuracy of their internal models. At the same time, it serves as an important input to the ECB’s assessment of the quality and regulatory compliance of internal models.

As part of its ongoing review of the regulatory compliance of the internal ratings based (IRB) approach, the ECB requires significant institutions that have permission to use the IRB approach to calculate their own funds requirements for credit risk to provide information on their PD, LGD, CCF models and the slotting approach

The ECB requires this information in order to be able to assess:

  • whether models under the IRB approach effectively capture the credit risks to which institutions are exposed so they can adequately calculate their own funds requirements for credit risk;
  • whether institutions have robust systems in place to validate the accuracy and consistency of rating systems, processes and the estimation of all relevant risk parameters.

The information from the validation reporting on internal models for credit risk will be crucial in the ECB’s future supervision of institutions’ internal models, enabling the ECB to:

  • enhance the prioritisation of on-site and off-site model reviews
  • monitor the completeness of validation reports prepared according to the annual validation cycle; 
  • monitor and challenge the results of the internal validation reports over time using transparent statistical measures and tests.

The European Central Bank now requires IRB Banks to activate a process of annual reporting of their IRB credit risk models’ validation results. Starting from October 1st 2019, institutions are obliged to deliver to the ECB, on an annual basis (for each internal IRB approved model, following the finalization of the yearly validation process), a pre-defined set of templates which aims at evaluating, in a harmonized way, the quality of the banks’ IRB models.

This will require banks to standardize and automate the reporting of quantitative results of internal models, as current validation units will need to face an additional burden to meet ECB requirements, while the number as well as the complexity of models in place will make even more difficult for validators to carry out all the required activities.

On the other hand, the ECB is requiring banks to comply with the Model Risk Management framework, by setting up sound framework and processes in order to properly manage Model Risk, given that the proliferation of internal models (IRB, IFRS9, managerial) represents a significant source of risk for all institutions.

Following this regulatory wave, Prometeia's industry survey intends to involve Validation Units and CRO areas to understand whether and how banks are approaching ECB recent requirements and to identify best practices in preparation for compliance. Results of the survey can be valuable for institutions willing to address this challenge.

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