Major upcoming changes to banks’ credit risk modelling

The regulatory and supervisory frameworks for banks’ internal rating based (IRB) approaches will be significantly adjusted over the coming years. The overall objective is to increase the robustness of capital requirements and ensure consistency across banks. Well-functioning IRB models are key to the capital assessment of the larger Swedish banks and hence a supervisory priority for FI.

Several current initiatives will in combination have a significant impact on the future role of IRB modelling. A key factor is the EBA's development and adoption of several new Guidelines (GL) and Regulatory Technical Standards (RTS) to ensure consistency in models' outputs and the comparability of risk-weighted exposures. Banks using IRB models ("IRB-banks") in the EU will have to comply with the new rules by the end of 2020.

The EBA package

EBA has scheduled the regulatory developments in four phases:

  1. IRB assessment methodology for competent authorities. EBA/RTS/2016/03  were published 2016/07/21, but have not yet been adopted by the EU Commission.
  2. Harmonizing definition of default. Consists of EBA/RTS/2016/06 adopted by the Commission and published in the Official Journal and EBA/GL/2016/07 published 2016/09/28
  3. Risk parameter estimation and treatment of defaulted assets (EBA/GL/2017/16 published 2017/11/17) and downturn LGD estimation which is under development.
  4. Credit risk mitigation: Under development with the aim to develop RTS for recognition of conditional guarantees, liquid assets and master netting agreements.

Revisions to the IRB modelling framework will also come from the Basel 3 reform package announced in December 2017, once these changes have been implemented into EU legislation. The Basel revisions to IRB will limit the overall scope of modelling, and are to be applied from 2022.

In Sweden, IRB-banks account for more than 90% of banking sector assets. FI has actively participated in the work of both the Basel Committee and the EBA to further develop the IRB framework and welcomes the new EBA rules, which will support FI's supervisory priority to increase the robustness and consistency of the Swedish banks' IRB approaches.

Stricter criteria for IRB models

The EBA package of GL and RTS targets the main identified sources of possible inconsistencies between banks' IRB models and its implementation will require substantial work from both institutions and competent authorities.

A key feature of the new rules is the harmonization of definitions and practices in the estimation of risk parameters in order to reduce the unwarranted variability of banks' risk weighted exposures when using IRB models. For FI the new rules will be an effective tool for strengthening the supervisory framework in order to improve the robustness and consistency of Swedish banks' IRB models. FI expects that this will likely require material changes to most IRB models currently in use by Swedish banks. Hence, these changes will also require applications for approval by FI. In assessing these model changes FI will – reflecting the new EU rules – apply stricter criteria in specific areas including: reducing pro-cyclicality in the models; using sufficiently prudent downturn-/cycle-adjustment; and using an adequate margin of conservatism when addressing different sources of uncertainty. These model changes are in general expected to increase Swedish IRB institutions' risk weights.

In order to support an efficient and transparent process of implementing the new adjustments to the IRB framework, FI will regularly communicate clarifications of GL/RTS and the supervisory expectations which banks must meet.

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