The Internal Model Method (IMM) was developed under Basel II (2004) as a means to better measure banks’ capital requirements for various counterparty credit risk scenarios. Before the introduction of IMM under Basel I (1988), banks commonly employed the Standardized Method (SM) to calculate required reserves. This method is often criticized as too simplistic for the larger financial institutions due to its heavy reliance on external ratings-based information such as that from Fitch, Moody’s, or S&P. Critics maintain that a better approach would be to use firm-specific scenarios and information that is tailored to each bank and their trading activity (i.e. each bank’s trading book is different and a blanket approach does not always account for every counterparty scenario). Thus the IMM was developed to create a more risk-sensitive approach that is aligned with each firm’s internal risk management policies.
Banks choosing to use the IMM must gain regulatory approval due to its inherent complexity compared to the SM. One of the overriding requirements for approval is that banks be able to recognize, measure, control and validate their counterparty credit risk for one year into the future. This is referred to as Potential Future Exposure (PFE) by the Committee and different than the SM approach, which only considers credit risk for current default value.
The most common method used to calculate PFE is by Monte Carlo simulation and a wide variety of stress scenarios on trading books. Stress scenarios can include, but are not limited to, varying interest rates, market swings, and currency fluctuations. The reserve requirement produced from the simulations is then subject to review by the regulatory agencies who perform their own stress test scenarios to validate the banks IMM. If the regulatory agencies find flaws in the bank’s models then banks are likely to have their IMM license revoked until the model has been re-calibrated to required standards.
Due to the new capital requirements coming in place under Basel III (2010), US banks recognize the blanket approach under the SM of applying reserve requirements to similar trades is creating higher reserves than would be the case using the IMM. By adopting the IMM they will be able to hold fewer reserves and use the freed capital for investment purposes. Finally, adopting the IMM is in line with the interests of the Basel Committee since one of the overriding reasons for development was to encourage best practices for evaluating risks throughout the financial industry.