Banks and financial institutions worldwide are mandated by host country regulators to adhere to improvised capital adequacy, supervisory review and evaluation process (SREP) and disclosure & compliance related requirements through revised Basel II & III guidelines. The maturity of Basel implementation differs from one jurisdiction to the other. While the US, EU, Australia, and South Africa have adopted advanced approaches under Credit, Market and Operational Risk for capital adequacy, countries in the Middle East and South East Asia are currently adopting Standardised Approach and are migrating towards Advanced Approach. In addition to capital charges computation under Pillar 1, banks are under increasing pressure for accurate disclosures and stringent compliance requirements such as AML, KYC, FATCA, MiFID II, Dodd Frank Act, etc.
When it comes to effort estimation, a large part of the bank’s focus is on complying with Pillar 1 and other compliance requirements. With Basel III gaining global importance, this focus has turned out to be more acute. To enhance the capital adequacy process, especially after the financial crisis, Pillar 1 should be supported well with the effective and transparent mechanism of Pillar 2 through ICAAP. The big question however is – but how?
Globally banks have been developing ICAAP documentation for SREP for several years now. But the focus on ICAAP continues to differ from jurisdiction to jurisdiction, depending on the choices of ICAAP framework design and its implementation challenges. Certain jurisdictions invest good attention on its coverage; however ICAAP is still in its nascent stages in several countries.
The coverage mainly includes sub-heads as Risk Governance & Strategy, Capital Planning, Stress Testing, Risk Assessment, Management & Control Processes. Effective Risk Governance and strategy planning will ensure effective implementation of other sub heads. Involvement of senior management, including the board of directors will ensure the processes are well orchestrated. The focus here should be on defining the responsibility, accountability and the extent of involvement of each stakeholder in identifying, assessing, managing and mitigating risk. Members must have an adequate understanding of the intricate nature of risks and its relationships with each other such as Credit Risk, Market Risk, Liquidity, etc. Also, risk reporting frequency and granularity should be designed such that meaningful analysis can be done in a time bound fashion.
The other key challenge is defining a comprehensive risk appetite statement, which is closely attached to the bank’s willingness to take risk in the course of achieving profit. Risk appetite statements should include a broader metric scale with parameters such as Target Capital, Asset Quality, Funding Capacity, Earnings Volatility and Risk-Returns Trade-Offs, Reputation, Customer Satisfaction, etc. and should not be confined to any one single metric such as Target Issuer Rating or NPA Level. This is easier said than done and risk appetite statements once framed should be integrated in the organisation’s culture.
In an effort to allocate capital to business limits, a bank is required to define a single measure of rate of return below which doing business will not make sense. Here the role of senior management is vital, as they are required to clearly define this measure as rate of return on economic capital, e.g. Rate of Return on Regulatory Capital (RORAC) or some other capital measure. This measure will be customised to each bank.
Next comes the strategic task of aligning capital planning with business planning. The assumptions of business growth across portfolio should be realistic and well deliberated and should also consider any unexpected deviations in the balance sheet and the P&L statement. The success of Pillar 2 is largely dependent on the robustness of a bank’s capital planning and budgeting process over a minimum 3 year time horizon. Banks should also institute an annual assessment of deviation in plans and establish contingency measures.
Banks must assess all material risks considered in its operations and should document the steps taken to measure, manage and mitigate them in detail. In certain cases, banks ignore risks which are deemed immaterial to their portfolio – a practice that must be discouraged. The immateriality status should be deliberated well within the bank and the rationales should be well documented. There should be a well-defined risk roadmap within the bank for covering them.
Another challenge which banks face is in the quantification of risks, including risks which are captured in Pillar 1 as well as those risks which are not fully captured under Pillar 1. The quantification techniques should be commensurate with the scope and complexity of the banking business operations. Moreover, non-quantified risks such as legal, strategic, reputation, settlement risks, etc. pose considerable challenges. A bank may choose to go for a qualitative scorecard based approach with aggregate score linked to certain capital provisions based on expert judgement. Another challenge is in assessing risk diversification benefits, where assumptions are often based on expert judgement and are difficult to validate. One should also consider the validity of such benefits under stressed conditions.
Another important task is the stress testing of capital adequacy, the severity of which depends on the bank’s individual stress testing policy. The involvement of senior management is vital here as they have to ensure integration of stress testing results into the bank’s operational decision making. Management must ensure that the stress testing should be undertaken with complete diligence and not be confined to a simple sensitivity test. There should be a good contingency plan in place for pre-defined levels of triggering of likely events.
Banks should also be able to identify additional capital (over and above Pillar 1 capital), keeping in view risks not covered under Pillar 1. This can be decided based on economic capital assessment, judgement of Risk experts or by relying on stress testing results.
ICAAP should be developed keeping in view the spirit of Pillar 2 and not solely for compliance. This exercise allows a bank to understand its capital position to support risk appetite, business growth and management strategy, under various economic and stress scenarios. A thorough ICAAP exercise is therefore a good opportunity for a bank to assess and put their house in order, prior to any potentially adverse business scenario.