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From Banking and Finance Law Daily, October 14, 2014

Fed and OCC expect reasonable notice regarding changes to capital models

By John M. Pachkowski, J.D.

The Federal Reserve Board and the Office of the Comptroller of the Currency have released guidance to banking organizations regarding the supervisory expectations for when and how the banking organization should notify supervisors of material changes to its advanced systems or modeling assumptions—model changes under the advanced approaches risk-based capital rule. The guidance was developed by the staff of the Fed and OCC.

This guidance—BCC 142 and GAA 2014-02—applies to all model changes that could have a material impact on risk-weighted assets (RWA) for the overall banking organization or for any exposure type. Examples of model changes include:

  • changes in definitions of default or downturn periods underlying quantifications of probability of default, loss given default, or exposure at default;

  • changes in definitions of units of measure underlying operational risk models;

  • changes in reference data or data filtering procedures used in modeling or risk parameter quantification;

  • changes in risk rating or segmentation procedures; or

  • changes in statistical techniques or underlying modeling assumptions.

The agencies’ latest guidance builds upon existing supervisory guidance that they had issued on model risk management—SR 11-7 and OCC Bulletin 2011-12. That 2011 guidance emphasized the importance of appropriate governance policies and controls over a banking organization's model risk management framework, including systematic processes with appropriate senior management overseeing model changes over time. Also, the agencies’ capital rules—12 CFR §3.123(a) and 12 CFR §217.123(a)—requires that a banking organization notify its primary federal regulator when it makes any significant change to its modeling assumptions or any change to an advanced system that would result in a material change in its RWA amount for an exposure type.

Notification. Going forward, banking organizations are to provide the Fed or OCC with reasonable advance notice of planned model changes. Ideally, the agencies expect at least 30 days’ notice before the start date of the calendar quarter in which the changes are to become effective. Also, when giving notice, a banking organization is expected to provide the agency with relevant supporting information.

Once the agency receives notice, it will review the supporting materials and will seek to provide preliminary feedback to the banking organization within 90 to 120 days. The agencies stress that this preliminary supervisory feedback should not be interpreted as a final determination that the model changes comply with the qualification requirements or as limiting in any way the ability of supervisors to conduct future reviews of the changes. They also noted that, in some cases, the preliminary feedback may include a recommendation that the planned changes be deferred until an in-depth review can be carried out by supervisors.

Finally, to facilitate resource planning and timely feedback, the Fed and OCC encourage banking organizations to begin coordinating planned model changes with supervisors well in advance of the 30-day notice period. This includes working with resident examiner teams to avoid implementation schedules for which preliminary supervisory reviews would overlap with major supervisory activities, such as the annual Comprehensive Capital Analysis and Review.

Documentation. In addition to reasonable notice, a banking organization should provide the following information to the Fed or OCC:

  • a description of each model change and its rationale/justification;

  • quantification of the potential impacts of the planned model changes, both individually and cumulatively, on RWA by relevant exposure type and for the banking organization overall; and

  • relevant developmental documentation and validation and audit reports, including a cumulative history of how model changes in recent years have affected RWA for the relevant exposure type.

In addition, the agencies’ guidance noted that banking organizations should maintain an ongoing inventory of historical and planned changes to systems used in quantifying RWA under the rule. The inventory should include appropriate supporting documentation on the type of change, rationale, developmental evidence and testing results, and cumulative RWA impact analysis over a multiyear horizon. This inventory and supporting documentation should be made available to supervisors on request.

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