Financial Services analysis: Could changes to the internal ratings based (IRB) regulatory framework result in substantial burdens for banks and national regulators? Michael Wainwright, partner in Dentons' Financial Services and Funds practice, comments on the European Banking Authority's (EBA) proposals aimed at tackling inconsistencies in the system.

Original news

EBA sets out IRB regulatory framework proposals, LNB News 05/03/2015 99

Key areas for improvement of IRB models, particularly the regulatory framework, have been set out in a discussion paper from the EBA on measures needed to ensure a robust and clear framework for IRB models. The discussion paper examines questions on how to implement the necessary measures in a consistent way and how to bring the changes forward, and includes an overview of regulatory measures currently under way. The consultation runs until 5 May 2015.

What is the background to the EBA's consultation?

The IRB approach to calculating bank capital was one of the major innovations introduced by the Capital Requirements Directive 2013/36/EU. It seeks to:

  • reduce systemic reliance on credit ratings issued by the large credit rating agencies by making banks calculate their own ratings
  • make bank capital more risk sensitive by basing capital calculations on the data banks use in their own risk management systems

The IRB approach was designed by the Basel Committee on Banking Supervision (BCBS) to be used by large internationally active banks, but the EU has opened up the framework to be used by banks of all sizes.

The system is not judged to be working well. It allows a great deal of flexibility and is unclear in many places. It is being implemented in different ways by a wide range of regulators and institutions. The resulting inconsistencies have called the whole system into question. As a result, the EBA is looking to make significant changes that could result in substantial burdens for both banks and national regulators.

What is the main scope of the consultation?

The discussion paper explains the problems as the EBA sees them and the challenge it faces in tackling those problems. In particular, it needs to achieve consistency and comparability across the industry, while allowing banks to continue to calculate their capital based on risk weightings they determine for themselves. To do this, it is going to need to:

  • identify key areas of uncertainty and clarify them
  • identify unjustified inconsistencies in approach and define what is acceptable
  • assess how national regulators are supervising the framework and achieve greater convergence of practice between those regulators
  • reduce complexity and flexibility by removing from the framework possible approaches that are little used in practice

The discussion paper sets out the EBA's proposed road map for change, including those issues it wishes to address as a priority and those that will be tackled at a later stage. The timeline to implement the most urgent items will be one to two and half years. The EBA envisages some banks will need to rebuild existing internal models as a result of the changes and regulators will need to review and approve the new versions. This is where the consequential work and cost will be incurred.

How do these provisions fit with other work being carried out by the EBA?

The EBA already has a mandate under various provisions in the Capital Requirements Regulation (EU) 575/2013 (CRR) to issue regulatory technical standards (RTS) clarifying and amplifying aspects of the framework. It can use the various RTS it is developing to introduce some of the changes it wishes to make. In other areas, it will need to lobby for legislative change to the CRR itself. Some of the changes discussed in the paper will depend on further work being undertaken by BCBS to develop and update the Basel III global standards.

What are the next steps?

The final date for responses to the paper is 5 May 2015. The issues dealt with in the paper are highly technical, but a great deal turns on them for both banks and national regulators. The tone of the paper suggests a genuine openness to feedback. It will be interesting to see what kind of response it generates.

Interviewed by Nicola Laver.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.