As we noted in our first blog, many financial institutions are considering a move to the Internal Model Method (IMM) due to increasing capital requirements and a need for higher reserves due to growing regulatory demands.  However, large-scale, regulatory-driven transformation projects, such as a move to IMM, call for a clear definition of what constitutes an effective implementation, and this definition should be articulated and clearly communicated from the top down. 

Before receiving regulatory approval for the use of IMM, banks are expected to demonstrate material progress in implementing their methodology.   To date, regulators have been non-prescriptive about “material progress” and how this progress ought to be defined and illustrated. An effective IMM program, therefore, hinges on leadership defining “materiality,” establishing agreement with regulators, and structuring an IMM program that, at minimum, achieves this defined threshold. 

Regulatory initiatives have a prescribed scope, which may be wholly or partially satisfied during a bank’s initial implementation phase.  The regulatory requirement for evidencing “material progress” often allows for management to articulate a plan that is tailored to the individual bank’s portfolio and systems construct.  Each bank should interpret these requirements as they relate to its own portfolio and existing infrastructure.  “Material” implementation progress should strike a pragmatic balance between full regulatory compliance and feasibility given resource constraints. 

Within the interim phases of IMM implementation, it may not be possible to document and examine all exposures across all asset classes. Therefore, the bank should set a reasonable threshold for exposure and product coverage that can match the spirit of the regulatory requirements, while providing margin for improvement during future phases of work.   The threshold for materiality should be at a level that demonstrates significant progress towards full compliance with regulations and asset class coverage. 

The definition of “materiality” should provide an objective lens through which to evaluate program progress.  For IMM, exposure coverage and effective modeling (valuation and simulation) are critical components of the implementation.   Coverage could be defined, therefore, as a percentage of positive mark-to-market, which would provide the purest view into absolute exposure coverage.  Alternatively, a bank may choose to measure materiality as a percentage of total eligible trades or percentage of total risk-weighted assets, both of which provide a nuanced variation on population coverage. 

If the actual coverage differs widely between measures, it may be useful to establish more than one materiality threshold.  We recommend that banks consider materiality from multiple angles, defining a suite of metrics and thresholds that provide the most comprehensive and objective assessment of progress.

In our next blog, we will look at the second step towards IMM implementation:  Setting Program Metrics. 

For more information, see SlideShare deck: “Considerations for an Effective Internal Model Method Implementation”

 

Visit www.accenture.com/RegulatoryCompliance for latest insights on regulatory remediation and compliance transformation.

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