Category: Rating Agency

IRB vs standardized models: European Commission looks at output floor and ECAI ratings

Two more years to go,  but the path is outlined. 

With the proposal of 27th October, the European Commission has confirmed the set of rules that will tighten banks' minimum capital requirements and limit the use of IRB (Internal Rating Based) assessment models.

Gianni Zorzi, professor of Risk Management and International Finance at the University of Udine and Head of Compliance for modefinance, explain: "The European Commission aims at bringing greater consistency between the valuation models adopted by banks to calculate their Risk-Weighted Assets (RWA). The proposal confirmed the introduction of a permanent aggregate "output floor" which will set a minimum level for capital requirements calculated through IRB models, the outcome of which may not fall below 72.5% of that estimated under the current standardized SA-CR approach".

Should the proposal be confirmed next year, banks will have a five-year transition period - from 2025 to 2030 - during which the adherence percentage set by the output floor will gradually increase. Thus, from 2025 onwards, banks will no longer be able to rely solely on their internal rating models, but will also be required to use the standardized approach as a touchstone, involving the recourse to external ratings developed by the ECAI rating agencies to determine credit quality and capital buffer.
But what does such a change entail?

placehold

How much will the new regulation cost to banks?

To dilute the impact of the new regulation on bank capital, the proposal envisaged transitional relief until 2032. At the end of this period, the new system will lead to an increase in overall capital requirements of between 8% and 9%, according to estimates by European Commission Vice-President Valdis Dombrovskis.

But banks will also have to bear hidden costs. The adoption of standardized methods for calculating capital requirements is currently extremely limited due to the costs and time required to issue a rating. Instead, at the end of the transition period, banks should use ECAI ratings to calculate capital requirements for most of their exposures.

"The adoption of a standardized model should not result in a slowdown of the rating procedures, which would inevitably result in congestion of the banking system and prolongation of credit disbursement times" - comments Chiara di Piazza, Senior Rating Analyst and head of the ECAI rating project. " Thanks to modefinance's expertise in the automation of credit rating processes, we have developed a fast rating process that allows us to obtain a fully valid ECAI rating for the calculation of RWA within a few hours.

A Fintech approach to ECAI rating issuance

An internal procedure that traces the issuance of a traditional Credit Rating, yet largely automated through the use of proprietary Fintech methodologies; this is the underlying concept of modefinance's ECAI rating process. The Tigran portal, already in use by banks and financial institutions and recently patented for the flexibility and uniqueness of the platform, has been adapted to the specific needs of financial analysts. The solution performs an automated analysis workflow subjected to the constant control of the analyst, who always has the possibility, at any stage of the process, to add qualitative assessment and overwrite the analysis result.

The procedure results in the issue of an unsolicited public rating, fully compliant with the regulations established by the European Supervisory Authorities, which have recognized the equal quality of modefinance's solicited and unsolicited ratings. Ratings are communicated to the rated party and distributed by subscription to the bank, which can thus benefit, in terms of both cost and timing, of a regulated and AI-based assessment process.

"Through this procedure" - Di Piazza says - "we can provide banks with an assessment of an entire portfolio within 1-2 weeks, in addition to the monitoring of assessed position".

Whether the path is already defined or yet to be mapped out, we are ready to step on it.

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