Can you explain why banks use IRB models?

With IRB framework license in place, financial institutions can assess risks and allocate capital buffer to cover those potential risks, based on internal data, and estimates of risk components. It also allows banks to model risk and specify risk appetite in a more precise manner, which will consequently lead to a more precise calculation of capital requirements.

Permission to use IRB models on considerably big and at the same time high credit quality low-risk profile portfolios, could have a significant impact on lowering capital requirements. This could result in a noticeable financial benefit for the shareholders. At the same time banks could benefit from the investments in IRB models by leveraging from the increased advance in IT and data infrastructure, knowledge pool in predictive analytics area, better understanding of their client data and potential behaviour. Being more advanced in credit risk management practices, evolves into a better risk understanding and gives a possibility to build more accurate, risk-related pricing systems and models, more effective and automated credit decision engines and processes, better overview and oversight of the quality of already existing banks’ asset basis.

Introduction of IRB models increases transparency and integrity towards the regulatory environment too. It requires the exceptionally open dialogue towards all drawbacks in existing model space, data, and development processes with the regulators; which guarantees higher trust among customer basis and financial society in general.

How can a bank use IRB models as a method of reducing its capital requirements?

IRB roll-out could potentially decrease capital requirement. However, internal risk estimates have to be robust enough, incorporating sufficient amount of high quality historical data, well-accepted technical standards and assumptions, adequate amount of default events, having the right level of conservatism and high standard IRB development practices.

In my opinion, the reduction of the capital requirement should not be the only and the main incentive of becoming IRB advanced bank. The introduction of the competent, collaborative with regulators and transparent risk management and modelling function, should also be one of the main aspects in the process of adopting IRB framework. 

What do you think is the future of IRB models and the standardised approach?

In my opinion, the pressure for financial institutions from the regulators with regards to IRB models will be gradually increasing. Examples such as the consultative document, from Basel Committee, on Banking Supervision ‘Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches’ might mark this beginning. Regulators are strongly advocating broader convergence of IRB frameworks across the markets.

Their main reason for this is too much flexibility on existing IRB frameworks regarding various definitions, assumptions, and fulfilment of requirements. This results in very different capital requirements and too little comparability of risk weights as well as risk modelling practices across even the same market peers, at the same time, for the same portfolios. This variability strengthens suspicions regarding model-risk phenomena, various inconsistencies in the assumptions or methods chosen and the lack of trust in existing IRB frameworks in general. This is the main driver for moving towards standard approach and envisioning this alternative as an inevitable solution for some of portfolios like LDP, large corporate, and maybe some others in the future.

How would you say banks are using their IRB models as a base for developing their IFRS9 models?

The essence of the IFRS 9 regulation is that financial institutions will be recognizing impairment amounts based on the best estimate of the expected credit losses. All assets will be divided into three stages: (1) assets with no significant increase in credit risk, (2) assets with significant increase in credit risk and (3) credit impaired assets.

IFRS 9 framework could directly leverage from the existing IRB framework by reusing some of  the existing IRB models with small or even without any adjustments, like LGD, including forward-looking elements or using 12 months PD directly unchanged for stage (1) assets. In addition to the list of existing IRB models, some new IFRS9 specific components should be developed for the IFRS9 purposes, such as lifetime PD, specifically needed for stage (2) and (3) assets, or prepayment model.

From my point of view, IFRS 9 framework should be seen as a broader generalization of existing IRB framework and its elements. IFRS 9 just has some additional purposes and applicability.

What would you like to achieve by attending the 3rd Edition IRB Models, the Standardised Approach for Credit Risk, and Capital Floors Conference?

The main priority would be the productive exchange of views and experiences regarding the latest upcoming changes of IRB regulation. I would also like to participate in the discussions and get a fresh perspective on IFRS9 implementation challenges and successes.