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October 09, 2019

Next steps on the IRB models journey

Implications of the European Banking Authority’s progress report on the IRB roadmap

Overview

 

On July 9, 2019, the European Banking Authority (EBA) published its progress report1 on the internal rating-based (IRB) model roadmap – as set out in February 2016 – to repair models used by banks to calculate own funds required for meeting credit risk.

 

The roadmap seeks to address concerns about undue variability in the own funds requirement, and improve trust in the models by ensuring comparability of risk parameter estimates, while retaining their risk sensitivity.

 

The progress report marks the finalisation of the IRB regulatory review, which includes all the EBA-related guidelines and Regulatory Technical Standards (RTS). It clarifies the next steps, which provide European banks the opportunity to rethink their approaches towards internal models for different asset classes.

 

Why the roadmap was needed

 

In 2006, the Basel Committee on Banking Supervision (BCBS) published revised standards on capital adequacy (commonly known as the Basel II framework). Thereafter, the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR) were issued by the European Parliament in 2006 and 2013, respectively, to ensure implementation by the European banking system.

 

Back in December 2013, the EBA published its report on comparability and pro-cyclicality of own funds requirement under the IRB approach, showing substantial divergences in the approaches taken by institutions and subsequently approved by the supervisors. This also produced significant variability in the own funds requirement, which could not be explained only by differences in the underlying risk profiles.

 

As a follow-up, the EBA set out a roadmap in 2016 to:

 

  • Review the regulatory setting of the IRB approach
  • Ensure supervisory consistency
  • Increase transparency

Most of the EBA’s work emphasises the regulatory review, based on the belief that the IRB framework would result in improved credit risk management practices and, consequently, advantages for the IRB institutions. The latest progress report on the EBA’s IRB roadmap finalises the regulatory review of the framework, which we examine in detail in the next section.