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ECB risk model review may replace Basel IV, but will still hit bank capital

The ECB is stepping up its own audit of banks' risk models amid concerns that a global deal will falter, but despite its lighter-touch approach Europe's lenders still face having to hold more capital.

The ECB inquiry, initiated in 2015, is being kicked into high gear as of April 2017, with delegates embedding in bank offices, in a move seen by analysts as compensation for a deadlock in the Basel Committee on Banking Supervision.

The Basel disagreements, which have worsened since the election of U.S. President Donald Trump, have paralyzed an international effort — unofficially dubbed "Basel IV" — to rework rules on how banks gauge the riskiness of their assets when calculating capital requirements.

European banks lobbied hard against Basel IV, which they feared would force them to hold hundreds of billions of euros in additional capital by limiting deviations between in-house risk models and standardized calculations devised by regulators. The ECB's targeted review of internal models, or TRIM, looks set to soften the blow, but capital holdings may still fall short, with Italian banks worst hit, sources said.

"The TRIM program is an alternative game plan which assumes that Basel IV will not be agreed on for a number of years," one source familiar with the ECB's thinking said. "Its findings and the resulting benchmarking-based adjustment process for individual banks will likely be presented as a completely new alternative to the Basel IV credit suggestions.

"I would read it as an attempt to kill off the Basel IV new standardized methods and floors on internal models," said the person, requesting anonymity due to the sensitivity of the matter.

Across the Eurozone banks are using about 7,000 internal models to measure risk of credit default and counterparty risk, and to estimate the value of the assets against which capital requirements are calculated. TRIM, involving 68 banks in 15 countries, will investigate unwarranted variations between different companies' modeling and present conclusions in 2019, consuming an estimated 15% of the EU's Single Supervisory Mechanism's budget.

"This will require a great deal of transparency given the current market skepticism towards models," Moody's said, adding that the review is overall a "credit positive." It will "help to reduce RWA variability, and, in so doing, restore confidence in the models, which have sometimes been seen as underestimating risk."

Blunt instrument

While the ECB aims to find out if some banks are using their internal models to massage down their capital requirements, the central bank may steer clear of an output floor, a second source briefed on the matter said.

European officials and bankers consider output floors to be a blunt instrument, which might not allow room to discriminate between assets which are riskier to own in some markets than in others. Banks with big mortgage books could be hit especially hard by output floors, despite historic low default rates in countries such as the Netherlands.

"In Europe's divergent banking markets internal models serve a very good purpose," the second source said. "In the U.S., for example, the landscape is more harmonized and internal models are not needed as much."

Some banks will probably have to increase their capital reserves, but to a lesser extent than under Basel IV, the sources and Moody's said.

"It is far too early to speculate which banks would be most affected, but needless to say the ones like the Italians that consistently understated NPL provision needs will be affected," the first source added.

"For it to have any credibility the banks with less than 10% risk weighting for mortgages need to be seen to be affected — in the eurozone that means [some] Dutch, Belgian, French, but they will likely be less affected by TRIM than by the last text of Basel IV."

The largest banks use as many as 50 different internal models simultaneously, all of which will be pored over during TRIM. The ECB will not disclose individual results of the inspection.

"We expect TRIM to result in some RWA inflation," Deutsche Bank analysts said in a report, pointing to Italian banks that currently assign a zero risk-weighting to many of their nonperforming loans.

Ireland's Permanent TSB Group Holdings Plc has already set aside roughly €600 million as a buffer against the potential findings of TRIM, the bank said at the beginning of March.

Swedish banks, which would be severely affected by the adoption of Basel IV's current proposals, do not feature in TRIM, as Sweden is not part of the eurozone.

The review will improve discipline in the banking sector because it will improve the comparability of regulatory capital ratios, said other analysts, pointing out that the managers of banks found wanting could see their reputations tarnished.

"Any hike in requirements would come as a blow for bank management teams," said S&P Global Ratings, adding that it was also possible that for some banks RWAs might go down as a result of the review.

The ECB said its objective was not to see RWAs increase overall.

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.