#EBA releases its annual assessment of the consistency of internal model outcomes

| February 1, 2020

The European Banking Authority (EBA) has published two Reports on the consistency of risk weighted assets (RWAs) across all EU institutions authorised to use internal approaches for the calculation of capital requirements. The reports cover credit risk for high and low default portfolios (LDPs and HDPs), as well as market risk. The results confirm that the majority of risk-weights (RWs) variability can be explained by fundamentals. These benchmarking exercises are a fundamental supervisory and convergence tool to address unwarranted inconsistencies and restoring trust in internal models.

Credit Risk exercise

The credit risk Report examines the different drivers leading to the observed dispersion across banks’ models. The results are broadly in line with previous exercises, with 50% of the difference in variability explained with simple risk drivers (“top down analysis”), a RW deviation on LDPs below 10 percentage points (“common counterparty analysis”) and estimates for HDPs generally on the conservative side when compared with empirical observed metrics (“backtesting analysis”).

Furthermore, this year, for the first time, on HDPs, the EBA performed a comparison with the standardised approach (SA) risk weights. The overall observed variability under the SA is at a similar level than the one observed on IRB. In this regard, within a single exposure class, the variability under the IRB approach follows, in a conservative manner, the empirical variability of risk (observed via default rates). On the other side, it is worth noting that the variability of RWAs in the SA is less linked to the empirical risk variability.

As in previous years, the quantitative analysis is complemented with a qualitative one in order to better understand the quantitative metric of the exercise. In addition to a questionnaire filled in by supervisors and interviews conducted with seven institutions, a survey was carried out among institutions to better assess the variability of practices in terms of rating scales. This survey highlights the variability of practices on the type of calibration of the probability of default (PDs).

Market Risk exercise

The Report presents the results of the 2019 supervisory benchmarking and summarises the conclusions drawn from a hypothetical portfolio exercise (HPE) that was conducted by the EBA during 2018/19.

The 2019 exercise is the first exercise with the new set of hypothetical instruments and portfolios. The new set of instruments mainly consists of vanilla instruments and is more extensive in terms of the number of instruments to model with respect to the three previous benchmarking exercises. Compared to the previous exercises, the 2019 analysis shows a substantial reduction in terms of dispersion in the initial market valuation and some reduction in risk measures, especially for the aggregated portfolios. This improvement was expected and is likely due to the simplification in the market risk benchmarking instruments. The remaining dispersion is probably the result of new benchmarking instruments being used by banks for the first time

As for the dispersion, the bulk of it has been examined and justified by the banks and the competent authorities. A minor part of the outlier observations remain unexplained and are expected to be part of the on-going supervisory activities.

The quantitative analysis, which has been extended in terms of scope with respect to the previous exercises, was also complemented by a questionnaire to competent authorities. Although the majority of the causes were identified, and actions put in place to reduce the unwanted variability of the hypothetical RWAs, the effectiveness of these actions can be evaluated only with on-going analysis.

 

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