The PRA has announced they will publish a Discussion Paper (DP) during mid-summer with options to help mid-sized banks to grow by adjusting some barriers to gaining permissions to build Internal Ratings Based Models for residential mortgages.
Jaywing recognises the considerable cost and effort to build, implement and maintain rating systems and welcomes the news that the PRA will provide mid-tier firms options to help them.
In this blog, we examine some of the most challenging areas for mid-tier firms and speculate on which areas may be implemented proportionately to help achieve permission and ultimately level the playing field.
Increasing competition whilst maintaining standards
The IRB approach which allows banks to use their own internal models to assess credit risk and determine capital requirements is typically the reserve of the large more sophisticated institutions. These institutions benefit from lower capital charges, greater sensitivity reflecting risk management capabilities.
PRA introduced the modular application approach with a desire to improve the efficiency, consistency and transparency of the IRB application process. A desired outcome was to make the process more manageable and predictable for firms thereby encouraging applications and increasing competition.
The introduction of the modular application combined with the investment in credit risk modelling required for IFRS 9 and the potential impacts of the Basel 3.1 reforms on mid-tier firms generated a plethora of IRB programmes being spun. However, the IRB requirements meant a long and uncertain journey towards compliance with firms underestimating the challenges they would face.
The latest moves by the PRA should address some of these challenges and increase the feasibility of achieving IRB permission.
Challenges for mid-tier firms
In our experience, there are several shared challenges across the aspirant firms.
1. Data availability and representativeness
Data is an essential part of both the modelling and the rating systems. The need to have a substantial amount of reliable and representative historical data with significant changes in default rates is a barrier for firms and can lead to excessive conservatism.
This is particularly relevant for firms without substantial history in modelling the probability of default, the downturn loss given default, and the cyclicality of the rating systems.
🔎 Impact
The data gap leads to the adoption of conservative approaches and additional capital requirements reflected within the Margins of Conservatism requirements. A particular issue for firms with limited internal loss data is that they will need to rely on the conservative probability of possession given default rates (set at 100% where default volumes are very low and 100% where the volumes are greater but still not considerable), reducing the perceived benefits of IRB.
2. Model development, governance, and validation
IRB models are complex and must meet the regulatory requirements. Firms often need to:
- Increasing the specialist knowledge required to develop, maintain and monitor the rating systems.
- Introduce and evolve independent validation.
- Create mechanisms to enable swift response to findings from reviews or from updated regulatory requirements.
🔎 Impact
This leads to a need for skilled resources which is often stretched across multiple priorities (e.g. SS1/23 requirements for model risk management, climate risk modelling, IFRS 9 modelling and assessment of models in changeable economic circumstances). Firms often struggle to find the resources and manage these priorities leading to delays in their IRB journey.
3. Integration of the models
IRB models must form an essential role in internal risk management and decision-making processes. Use is expected for at least three years across:
- Credit decisions
- Lending Policies
- Risk appetite
- Credit Risk monitoring
Applying the models within these areas often requires substantial changes to processes and investment in systems and often cultural shifts. [CI3] There are specific governance requirements and information that needs to be produced and reviewed to demonstrate the required sophistication.
🔎 Impact
These changes are often underestimated and represent a significant obstacle for firms. Defining the intended use up front helps hugely noting that use can begin with broadly in line with IRB requirements.
4. Good governance and documentation
Good governance and understanding of the rating-systems is an essential part of IRB compliance requiring:
- Clear roles and responsibilities
- Comprehensive oversight
- Extensive documentation and controls.
🔎 Impact
These elements are required to be demonstrated through at the use and experience period often requiring significant resources to be deployed whilst the permissions are being sought.
Adjusting barriers: What might the PRA do?
There needs to be realism in relation to where the PRA may help mid-tier firms. Ultimately, Basel 3.1 and IRB are international standards, and the PRA will have limited desire to create a situation where UK institutions are held to lower standards or a position where mid-tier firms have a significant advantage. The PRA could consider adjusting a few barriers:
Lowering the data burden: Accepting increased use of proxy data for firms without the history whilst history is built up.
Staging roll-out: Refining expectations regarding roll-out to enable roll-out within the same asset class may help firms with mixed residential mortgage portfolios achieve compliance.
Enhanced dialogue and feedback: It was encouraging to see the round table events held last year. Mid-tier firms would benefit from closer regulatory engagement through the model lifecycle so and red flags can be addressed early on. Publication of acceptable and non-acceptable practices as the PRA complete in relation to thematic reviews would assist firms greatly.
Regardless of the areas the PRA target the intent to help mid-tier firms is welcome and we look forward to the discussion paper.
How Jaywing can help
Jaywing has comprehensive regulatory risk expertise across IRB from model development and validation through to governance and implementation.
To find out more get in touch.