Proportionality in credit risk: Simplifying processes without weakening controls
The debate on proportionality is often presented as a trade-off between efficiency and control. In reality, the most effective regulatory and supervisory frameworks are not those with the highest number of requirements, but those that focus attention on activities that truly contribute to effective risk management.
Recent initiatives from the European Central Bank (ECB) and the European Banking Authority (EBA) provide a concrete example of this principle. The recently published documents (1, 2, 3) all point in the same direction: reduce unnecessary complexity while preserving relevant controls.
For mid-sized institutions, these developments provide useful guidance on where simplification can create value and where strong governance remains essential.
Proportionality in credit risk ultimately means simplifying processes while keeping controls intact.
- ECB and EBA reforms shift toward risk‑based supervision, concentrating oversight on changes that affect risk measurement and capital adequacy.
- New frameworks remove non‑value‑adding complexity, especially around IRB model change approvals, reducing burden without weakening prudential standards.
- Core controls (independent validation, strong governance, and data quality) remain non‑negotiable, even as procedural steps are streamlined.
- Institutions must show that simplified processes maintain or improve model performance and control effectiveness, without increasing deficiencies or supervisory findings.
Which processes add complexity without improving decisions?
One of the clearest examples is the approval process for internal model changes.
Historically, a large number of changes to IRB models were classified as material and therefore subject to lengthy supervisory approval procedures. Banks often had to maintain both the existing and revised model while waiting for approval, creating significant burden and delaying model improvements.
Simplification should target process complexity, not control effectiveness.
The ECB’s new approach addresses this issue by allowing banks, under specific conditions, to implement material model changes shortly after submitting a complete application package rather than waiting for the full supervisory assessment. Similarly, the EBA has revised its materiality framework to reduce the number of changes that require prior approval, placing greater emphasis on quantitative thresholds and limiting qualitative triggers to fundamental changes.
These initiatives are based on an important principle: not all model changes have the same prudential relevance. Treating routine model maintenance in the same way as a complete model re-development can create significant complexity without generating benefits in terms of risk management.
A second source of complexity is the presence of fragmented rules and guidance over time. The EBA's discussion paper highlights opportunities to consolidate requirements and definitions across the credit risk framework. Today, institutions often need to navigate multiple overlapping requirements to achieve the same supervisory objective, in these cases simplification can increase efficiency without reducing risk sensitivity.
Simplification should focus on material risk
The common thread across the recent ECB and EBA initiatives is a shift from procedural supervision towards more risk-based supervision.
Rather than applying the same level of supervision to every change, supervisory attention is directed more towards activities with the greatest potential impact on risk measurement and capital adequacy. Material model changes to risk parameter estimation and fundamental revisions to the definition of default continue to receive close supervisory attention, while routine maintenance activities may be subject to lighter processes.
This approach is particularly relevant for mid-sized institutions where the challenge is rarely a lack of controls. More often, it is ensuring that scarce resources are allocated to activities that create the greatest value from a risk management perspective.
What should never be simplified?
While procedural requirements can often be streamlined, certain governance elements must remain non-negotiable.
- Independent validation and challenge: As supervisory frameworks become more risk-based and rely less on extensive ex-ante approvals, the importance of internal validation increases. Independent review remains essential to ensure that models are conceptually sound, compliant with regulatory requirements, and appropriate for their intended use.
- Robust model governance: Institutions must continue to demonstrate that model changes are appropriately documented, tested, independently reviewed, approved through formal governance structures and monitored after implementation.
- Data quality and monitoring: Regardless of how streamlined the approval process becomes, institutions must maintain robust controls over data quality and model performance monitoring.
What evidence demonstrates that controls remain effective?
The first source of evidence is model performance. Institutions should be able to demonstrate that risk estimates remain stable, accurate, and aligned with observed outcomes following implementation of model changes.
The second is the effectiveness of internal control functions. Independent validation findings, audit results, and remediation tracking provide evidence that model risks continue to be identified and managed appropriately.
Third, institutions should be able to demonstrate that simplified processes have reduced administrative burden without increasing deficiencies, supervisory findings, or implementation errors. In other words, the quality of outcomes should remain unchanged or improve, even if the process itself becomes more efficient.
Conclusion
Recent developments in the credit risk framework provide a practical illustration of how proportionality should be applied in banking supervision.
The ECB's initiative on internal model supervision and the EBA's work on material model changes and credit risk simplification do not seek to weaken prudential standards. Rather, they aim to eliminate unnecessary burden.
The key principle is that simplification should target process complexity, not control effectiveness. Activities that delay implementation without improving risk assessment can be streamlined. Independent validation, sound governance, data quality controls, and management accountability cannot.
For mid-sized institutions, proportionality is therefore not about doing less but rather about directing scarce resources towards the activities that contribute most to risk management.
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