Introducing IRB: are the benefits larger than ever before?

IRB was introduced into the capital framework by the Basel Committee for Banking Supervision (BCBS) in Basel in 2004 and has since become an integral aspect of risk management for many large institutions. IRB allows firms to use their internal risk management practices and models to calculate a more accurate capital requirement than the simple risk weight percentages prescribed by the Standardised Approach (SA). Ben Clark explores the benefits of IRB in further detail in this blog. 

Over the last few years, changing regulations have dominated many firm’s agendas, with compliance being a priority over profitability. With IFRS 9 going live in 2018, firms should be able to switch their focus back to growing their businesses in an era of mounting competition.

Moving to IRB status is one of the key ways for firms to increase profitability by optimising their capital requirement, allowing them to increase the amount they have available to lend. All of which benefits the institution’s shareholders, customers and the wider economy.

As well as the significant capital savings, and in addition to acting as a certificate of sophistication for a firm, IRB also opens up a number of other significant benefits, ranging from improved internal risk management processes to enhanced data and system capabilities. These benefits may have existed since IRB was originally introduced, however, the last two years have brought refinements in regulation which will have shifted the cost-benefits ratio in favour of IRB for many firms.

Here are just a few of the benefits:

1. The capital benefit 

In comparison to the Standardised Approach, IRB delivers significant capital benefits due to more accurate considerations of a firm’s underlying risk profile. The size of this capital benefit will vary depending on:

1.        The quality of the models built
2.        The data available and the representatives of this to the firm’s current portfolio
3.        The type and variety of lending
4.        The underlying risk of each firm’s portfolio

The change in capital requirements has two impacts on a firm’s competitiveness: it increases the amount available to lend through reduced capital costs and increases the firm’s competitiveness in certain areas. 

2. Increased internal expertise

Successful capital management teams must develop expertise in capital theory, the regulation and the risk profile of their portfolios in order to optimise their capital requirements. The better understanding a firm has of the regulations, the level of risk in their portfolio and the models which calculated their capital requirement, the more they are able to remove surplus conservatism.

3. Model and theoretical understanding

In order to develop and use successful IRB models, firms must ensure they understand the theory behind the models. During the IRB process, the risk team will become experts in how models work, their limitations and where judgement can be applied. As IRB models are developed, executed and monitored against performance, the internal knowledge will continue to grow.

The exhaustive model and process review by audit and the regulator will ensure a high-quality implementation is produced. This reduces the risk of the firm falling behind their competitors and losing this as a competitive advantage.

4. Risk Profile knowledge

Whilst building, validating and implementing IRB models, the management team will increase their knowledge of their risk profile. This allows a better understanding of how their books will move over time and which areas are likely to increase their knowledge of their risk profile. Improved understanding of risk can be utilised to offer more risk sensitive pricing, more efficient collections and recoveries process, better utilisation of undrawn exposures and more targeted additional lending strategies.

5. Improved model and system synergies

There are strong links between the IFRS 9 requirements and the IRB model. Additionally, the models feeding the IRB calculation are required to be used in the firm’s day-to-day risk management practices.

Under IRB, the capital, impairment, acquisition and back book management models all become intrinsically linked. These links mean that synergies can be found between the models themselves, the data that feeds them and the systems they are executed on.

Synergies can lead to cost savings in three ways:

1. Resources – instead of requiring individual teams for each of the four processes, modelling and risk management teams will become experts in all areas. The structure of the institution’s can be optimised to make efficient use of this knowledge which reduces the resources required to develop, validate and execute each process

2. Systems – the models themselves are linked so it opens up the possibility to implement all models into one system with the potential for more efficient model execution environment. This can dramatically reduce the costs of maintaining and developing multiple systems as well as the governance associated with multiple model runs

3. Data – as the models become interlinked, the data required to feed the models will converge. This means a more simplified data structure resulting in reduced costs to develop, enhance and maintain.