icaap benchmarking of the ecb analysis of the practices ......2020/09/23 · projections and...

ICAAP Benchmarking of the ECB

Analysis of the practices used by significant banks

#September 2020

PwC

Contents

2September 2020ICAAP Benchmarking of the ECB

Objective and approach of the analysis 03

Key findings & good practices of the ECB 06

Where you should improve your ICAAP now 41

Questions? Your contacts at PwC 44

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Objective and approach of the analysis

3ICAAP Benchmarking of the ECB

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Analysis of the ICAAP of 37 banks directly supervised by the ECBObjectives and approach

Objective Sample Approach

INSIGHT INTO THE ICAAP PRACTICES

37 BANKS DIRECTLY SUPERVISED BY THE ECB CUT-OFF DATE: APRIL 2019

The horizontal function of the ECB banking supervision conducted an analysis based on a sample of37 SSM-relevant institutions. The aim of the analysis was to gain an insight into the implementation of the ICAAP at the SSM institutions.

The sample is representative of the SIs and focuses on larger banks. Therefore, the selected sample includes all global systemically important banks (G-SIBs) and also covers all SSM countries as well as all banking clusters and almost all business models.

The analysis was carried out using a questionnaire. The content and structure is based on the ICAAP guidelines and the seven ICAAP principles.

4September 2020ICAAP Benchmarking der EZB

Publication of the "ECB report on banks' ICAAP practices" in August 2020 by the ECB

Banking Supervision

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The seven ICAAP principles of the ECBRegulatory requirements for the design of the ICAAP

01 The management body is responsible for the sound governance of the ICAAP

02 The ICAAP is an integral part of the overall management framework

03The ICAAP contributes fundamentally to the continuity of the institution by ensuring its capital adequacy from different perspectives

04 All material risks are identified and taken into account in the ICAAP

05 Internal capital is of high quality and clearly defined

06 ICAAP risk quantification methodologies are adequate, consistent and independently validated

07 Regular stress testing is aimed at ensuring capital adequacy in adverse circumstances

The bank's Internal Capital Adequacy Assessment Process (ICAAP) remains one of the top prudential priorities of ECB banking supervision.

In order to clarify the expectations of Significant Institutions(SI) with regard to the ICAAP, the ECB published the ICAAP guidance in November 2018.

The ECB carried out a structured analysis of the methods and procedures applied in the ICAAP for 37 SIs. The analysis was based on the ICAAP information provided by the SIs, including a questionnaire based on the ICAAP guidance and the seven ICAAP principles.


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Key findings & good practices of the ECB


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Principle 1 - The management body is responsible for the sound governance of the ICAAPResults at a glance

Compared to the first year of their submission in 2017 the CAS is now much more established, both in terms of its format and the content provided. However, these two aspects as well as the overall quality of the CASs are still heterogeneous across banks.

• CAS: Not all banks find a balance between size and conciseness. In addition, many banks do not address a number of selected issues that are generally considered important for assessing capital adequacy (e.g. ratios and identified weaknesses).

• Internal review and validation: The ECB considers that not all banks regularly review and validate their ICAAP. In addition, there is room for improvement at a number of banks in terms of proactively adapting the ICAAP to significant changes.

• The responsibility and involvement of the risk management function should be strengthened and further developed:1. At almost half of all banks, the risk management function does not have ultimate responsibility for

identifying and quantifying risks and performing stress testing. 2. Risk management function often plays a subordinate role in capital planning. 3. Internal Audit assumes (co-)responsibility in some core ICAAP aspects such as risk inventory or

validation.


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Principle 1 - The management body is responsible for the sound governance of the ICAAPFocus - Contents of the CAS

• The clear majority of banks address in theCAS the main changes in their ICAAP and the main stress testing activities and conclusions.

• However, in the CAS of more than half of the banks analysed, the key figures of the ICAAP, the main weaknesses of the ICAAP and how these weaknesses are addressed are not described in detail.

• Only one bank in three mentions or explains in the CAS all issues of importance from the ECB's point of view in order to draw a comprehensive overall conclusion on capital adequacy.

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24

9

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0 5 10 15 20 25 30 35 40

All topics

ICAAP weaknesses

Actions for maintaining capital adequacy

Description of ICAAP perspectives

Internal capital concept

Adequate capitalisation in NP

Major ICAAP changes

Key ICAAP metrics

Adequate capitalisation in EP

Risk quantification methodologies

Stress testing

ICAAP integration in risk management

Elaborated Mentioned, not elaborated

Note: NP - normative perspective; EP - economic perspective;

WHAT INFORMATION IS INCLUDED IN THE CAS?


Source: ECB

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Principle 1 - The management body is responsible for the sound governance of the ICAAPFocus - Roles and responsibilities

• In about half of the banks, the risk management function is the sole owner of the central ICAAP processes. The exception is capital planning, which is mainly the responsibility of the finance function.

• The business or market divisions play an important role in identifying risks and developing risk quantification methods. In approximately one in three or one in four banks, the business or market divisions are jointly responsible with risk management.

• In a few banks, the internal audit department also assumes co-responsibility for some ICAAP core areas (e.g. risk identification and internal validation of risk quantification methods).

Responsibilities of the internal functions over the selected ICAAP core areas

Note: Figures may not add up to 37, because in some cases, ownership was not clear from the available ICAAP information, for example, in the cases of committees where the members were not clearly identifiable.

20 2021

6

18

14

21

2

8

2

14

12

76

10

3 3

6 6

17

2

6

0

5

10

15

20

25

Internal review Development ofrisk quantification

methodologies

Risk quantificationmethodology

validation

Capital planning Risk identification Stress testeconomic

perspective

Stress testnormative

perspective

Risk management Co-owned by risk management and business area Co-owned by risk management and others (not business area) Finance


Source: ECB

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Principle 1 - The management body is responsible for the sound governance of the ICAAPGood practices observed by the ECB

CAS Responsibility and involvement of internal functions

1. All members of the management body jointly sign the CAS.2. Well-structured and concise presentation of capital planning

figures in the CAS, including the projected figures for capital and risks in the base scenario and in several different adverse scenarios In addition, a link is established to the institution-specific risk appetite and the internal and external capital requirements.

3. A description of the main weaknesses of ICAAP, including ananalysis of how these weaknesses may impact the assesment of capital adequacy, and a statement onwhen and how these shortcomings will be remedied.

1. Establishment of strong and independent internal validation units to review the ICAAP annually from both a quantitative and qualitative perspective.

2. Establishment of roles, responsibilities and the overall review process in line with the three-lines-of-defence concept. The results of the review are presented to the Management Board and the Supervisory Board at least once a year.

3. Development of a validation plan with changing validation frequency. The frequency of validation for a risk quantification method depends on the relevance of the respective risk and on the observed values of certain predefined and regularly monitored indicators.


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Principle 2 - The ICAAP is an integral part of the overall management frameworkResults at a glance

It was observed that many banks integrate the ICAAP into their overall management framework. However, weaknesses have been identified with respect to the connection between the ICAAP and other strategic processes such as the internal liquidity adequacy assessment process (ILAAP), as well as the use of the ICAAP for decision-making.

• Spreading the description of the ICAAP architecture across several documents affects the comprehensibility and clarity of the interaction between different elements of the ICAAP and the establishment of clear links between the ICAAP and the bank's overall management framework.

• The ICAAP is rarely integrated into managing risk and return. • For most banks, limits are set at the level of total capital and not broken down to

individual risk categories. This means that timely and effective risk management cannot be guaranteed.

• The reporting of current ICAAP figures to the management body is not sufficiently frequent (less than quarterly) in some banks. Even less frequently forward-looking projections and results of stress tests are reported. As a consequence. the management body may receive the ICAAP-related information too late to manage the adequacy of the bank's capital effectively and proactively.


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Principle 2 - The ICAAP is an integral part of the overall management frameworkFocus - ICAAP Architecture

• The vast majority of banks describe in the documentation how the core elements of the ICAAP are linked.

• Almost all banks are considering integrating Risk Appetite Statements (RAS) and management reporting into the ICAAP architecture.

• Two thirds of the banks comment on how the results of the ICAAP are used for decision making.

• About half of the banks describe the link between ICAAP and ILAAP.

Source: ECB

DOCUMENTATION OF ICAAP ARCHITECTURE

THE ICAAP ARCHITECTURE DOCUMENT EXPLAINS THE CONNECTION BETWEEN THE ICAAP ...

12

12

11

2

Yes, in a separate documentYes, as a separate chapter in a broader documentYes, but spread across internal documentsNo

12

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29

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31

28

32

27

14

9

5

12

5

8

5

7

0 5 10 15 20 25 30 35 40

All areas

And the ILAPP

And the recovery plan

And decision making

And the RAS

And strategies

And management reporting

Key elements



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Principle 2 - The ICAAP is an integral part of the overall management frameworkFocus - Risk reporting

• The majority of the banks report on a quarterly basis on the ICAAP and the implemented indicators; a quarter of the banks report on a monthly basis.

• A number of banks do not report regularly or not at all on key ICAAP indicators, both from an economic and a normative perspective. Particularly forward-looking information is reported less frequently. Overall, this poses a major threat to banks' ability to act, especially if unexpected dynamic changes occur.

Regularly reported ICAAP information - normative and economic perspective

Notes: the absence of forward-looking information under the economic perspective is due to the design of the analysis - ICAPP packages and risk reports were not analysed for that aspect. Accordingly, the analysis results presented here does not mean that such information is not being internally reported. Source: ECB

36 3226 25 24 24

1930 28 27 23 22

1525

13 17 2011 11 7

0

10

20

30

40Current situation Forward-looking projections

NORMATIVE PERSPECTIVE ECONOMIC PERSPECTIVE (only current situation)


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Principle 2 - The ICAAP is an integral part of the overall management frameworkGood practices observed by the ECB

Description of the ICAAP architecture Reporting & Limit System

• Description of the ICAAP architecture in a well structured overview document with direct references to other more detailed documents

• The ICAAP architecture overview document provides full transparency for the interfacesbetween the different ICAAP elements and between the ICAAP and the other key processes in the bank.

a) Implementation of a concept to increase the reporting frequency and reporting granularity for specific risks in a crisis The concept is based on the risk level and the potential dynamics of change. In particular, when assessing the results of the stress test, it may be useful for management to receive the results more frequently during periods of stress and to see the contributions of each risk type to the normative or economic capital requirements in order to make the appropriate targeted decisions.

b) For reporting purposes, some banks use a limit system in which the distance to the next traffic light threshold is simultaneously displayed via a traffic light logic in addition to the capacity utilisation.

Indicative example of an enhanced traffic light system

low medium high


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Principle 3 - The ICAAP contributes fundamentally to the continuity of the institution by ensuring its capital adequacy from different perspectivesResults at a glance

While some of the key features of the ICAAP perspectives are implemented by all banks, there is much room for improvement under both perspectives.

• No clear description of the general concepts and objectives in the two perspectives• Lack of interaction between the normative and economic perspectives. The insights gained in one

perspective are rarely used and taken into account as input in the other perspective. • With regard to capital planning, weaknesses in the number and severity of adverse scenarios were

identified. In addition, many banks have not systematically taken into account the expected changes in legal, accounting or regulatory requirements in their capital planning.

• Management buffera) Only half of the banks set threshold values for the management buffer in the economic perspective.b) Internal capital thresholds are often set by management intuition rather than on the basis of a

thorough assessment of all aspects relevant to the bank's business model


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Principle 3 - The ICAAP contributes fundamentally to the continuity of the institution by ensuring its capital adequacy from different perspectivesFocus - Establishing normative and economic perspectives

• Three out of four banks have an elaboratednormative ICAAP perspective, while in terms of the economic perspective this is only the case in less than half of the banks.

• The normative perspective is better established than the economic perspective, both in terms of explaining the basis of both perspectives and in terms of describing the objectives underlying them.

• For both perspectives, however, only about half of the banks explained their approaches in detail.

Establishment of a normative and economic perspective

Source: ECB

28

15

2018

9

19

14 13

0

5

10

15

20

25

30

Normative perspectiveestablished

Economic perspectiveestablished

Normative perspectiveobjective

Economic perspectiveobjective



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Principle 3 - The ICAAP contributes fundamentally to the continuity of the institution by ensuring its capital adequacy from different perspectivesFocus - Management buffers and internal thresholds for minimum capital requirements

• Almost all banks have defined a management buffer in the normative perspective; in the economic perspective, only slightly more than half of the banks use a management buffer.

• The management buffer is usually determined by the CET1 ratio; however, many banks also use other ratios (Tier 1, total own funds, MREL, leverage ratio or other ratios) to derive or determine the management buffer.

• There are differentiated procedures for determining the management buffer. Some banks use an internal assessment procedure, take market expectations into account or fix the buffer on the basis of risk appetite or by taking uncertainty premiums into account.

Considerations on the definition of management buffers and minimum internal capital

Source: ECB

4 4 2 3 3 38

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35

Normative Economic Normative Economic Normative Normative Economic Normative Economic Normative Economic


Based on assessment of

relevant aspects

Consider markets', investors' and counterparties' expectations

Consider possible MDA-related

restrictions

Consider depositors' expectations/trust

Consider uncertainties around

projections

Consider the institution's risk

appetite


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Principle 3 - The ICAAP contributes fundamentally to the continuity of the institution by ensuring its capital adequacy from different perspectivesFocus - Time horizon of capital planning

• All banks carry out capital planning in the normative perspective, while half of the banks also consider the economic perspective in their capital planning.

• From both perspectives, the time horizon most frequently used for capital planning is three years.

• A significant number of banks also plan their capitalisation over four or five years.

Capital planning: role of ICAAP perspectives and time horizons covered

Source: ECB

WHICH PERSPECTIVE DOES THE CAPITAL PLAN CAPTURE

YEARS COVERED BY THE CAPITAL PLAN

1720

0

5

10

15

20

25

Bothperspectives

Normativeperspective

only

Economicperspective

only

26

5 6

10

5

2

0

5

10

15

20

25

30

1 2 3 4 5

Normative perspective Economic perspective

years


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Principle 3 - The ICAAP contributes fundamentally to the continuity of the institution by ensuring its capital adequacy from different perspectivesGood practices observed by the ECB

Mutual information Management measures

• Comprehensive analysis of the potential effects of economic risks from a normative perspective. Both qualitative considerations and quantitative impact analyses are taken into account.

• Furthermore, clear conclusions are drawn on how the results of the analysis are viewed in the normative perspective.

• Provision of full transparency regarding (potential) management measures that can be taken into account in capital planning and stress testing This includes for example1. a list of different (possible) management measures and justifications for when they are used; 2. the quantitative effects of the individual measures in the different scenarios and from the two

perspectives; 3. the results with and without consideration of these management measures and a clear statement of

which measures should be implemented and when.• Inclusion of a table into the CAS showing, in a transparent manner and for each risk type of the

economic perspective, how and to what extent they will separately affect the Pillar 1 capital projections in the baseline and adverse scenarios in the normative perspective

• Review what impact the scenarios and other assumptions (e.g. company growth, dividend policy, tax rates) used for the capital projections in the normative perspective would have on capital adequacy from an economic perspective, with a view to adjusting any necessary measures accordingly.


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Principle 4 - All material risks are identified and taken into account in the ICAAPResults at a glance

Processes for the identification of material risks are established and regularly performed. For many banks, however, there is room for improvement regarding forward-looking, pro-active risk identification, the use of a "gross approach", and the concepts used for deciding on materiality with regard to both the scope of material entities and risk types.

• One third of the banks do not have an elaborated procedure to identify risks in advance. One bank in five does not carry out a systematic forward-looking risk assessment, in particular before launching new products or entering new markets. More than half of the banks do not have a procedure in place to identify risks arising from exposures to shadow banking institutions.

• With regard to the banks' materiality concepts, there is also room for improvement both for the classification of risks as material and for the decision on whether a business unit should be included in the ICAAP. An elaborated materiality concept with concrete materiality criteria is required to ensure a structured and consistent identification of material risks.

• Based on the risk identification procedures, many banks must also further develop their current approaches to identifying and managing risk concentrations, particularly inter-risk concentrations.


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Principle 4 - All material risks are identified and taken into account in the ICAAPFocus - Risk identification process

Only one bank in five identifies its risk in a forward-looking and proactive manner, systematically taking into account risks from exposures to shadow banks and at the same time pursuing a gross approach. All others, i.e. the vast majority of banks, do not have well developed approaches for at least one of these aspects:• One bank in five does not assess risks

systematically and proactively.• More than half of the banks do not have a

procedure for identifying risks arising from exposures to shadow banks.

• Around two-thirds of the banks apply a gross approach to risk identification that is in line with the ECB's expectations, i.e. they consider the risks without taking account of risk-mitigating factors. The remaining banks (around one third of the banks) do not follow a pure gross approach.

Main features of the risk identification processes in banks

Source: ECB

THE RISK IDENTIFICATION PROCESS IS ...

3127 26

16

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30

35

Ensuring proactiveadjustments

Following a grossapproach

Performed in a forward-looking manner

Considering shadowbanking exposures

Implementing all the fourprevious aspects


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Principle 4 - All material risks are identified and taken into account in the ICAAPFocus - Materiality concept

To identify key business units:• Most banks include equity investments and

other related entities in their risk identification processes. However, less than half of these banks select the entities included in their ICAAP based on predefined materiality criteria.

To identify significant risk types:• The use of an elaborated materiality concept is

more common from an economic perspective than from a normative perspective. It is remarkable, however, that almost half of the banks do not have an elaborated materiality concept under the normative perspective, whereas this is the case for one third of the banks under the economic perspective.

Main features of the risk identification processes in banks

Source: ECB

RISK MATERIALITY CONCEPTS BANK USE IN THEIR ICAAPS

CRITERIA FOR INCLUDING ENTITIES INTO THE ICAAP SCOPE

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Concretecriteriadeinfed

Quantitativematerilitycriteria

Qualitativemateriality

criteria

Other

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Normative Economic Normative Economic Normative Economic Normative Economic


Definition of materiality provided

Quantitative materiality criteria

Qualitative materiality criteria

Other materiality criteria


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Principle 4 - All material risks are identified and taken into account in the ICAAPGood practices observed by the ECB

Prospective risk assessment Combination of the top-down and bottom-up approach

• Inclusion of a forward-looking assessment in the risk identification process. The prospective assessment shall be carried out regularly and on an ad hoc basis (in particular before deciding on changes in business strategy) to identify potential threats that could affect the viability of the business plan or strategic objectives.

• Implementation of a procedure for quarterly reassessment of the materiality of risks (in addition to the annual risk identification) in the light of evolving changes in its business and operating environment. This includes in particular a reassessment of risks that were previously not identified or identified as immaterial.

First stage: The Group Risk Committee develops a global risk driver map that comprehensively identifies and assesses a number of risk drivers from a group perspective based on their severity. Second stage: The local risk management function of the group units assesses the extent to which these global drivers are relevant to them, how the risk drivers might materialise in risk events and what other local risk drivers it is confronted with. Third level: The local risk management function determines which risks are significant from a local perspective and includes them in its local ICAAP risk inventory.

The combination of the top-down and bottom-up approachenables cooperation between group and local risk management functions.


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Principle 5 - Internal capital is of high quality and clearly definedResults at a glance

More than half of the banks do not have an elaborated approach for properly defining their internal capital. Before including capital components in internal capital, most banks do not systematically analyse them, [...]. As a consequence, economic capital adequacy may be overestimated.

There are clear deficiencies in the way institutions include capital positions in their internal capital and justify their inclusion. The inclusion of ineligible capital may lead to an overestimation of internal capital and thus to an incorrect assessment of capital adequacy in the economic perspective.a) More than half of the institutions did not elaborate on the definition and methodology of

their internal capital in their documentation.b) Lack of systematic analysis of capital positions before they are included in internal

capital. In particular, the two main features of the economic perspective- going concern assumption and - the concept of economic value

are rarely adequately considered in the analysis of the eligibility of the position as internal capital.


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Principle 5 - Internal capital is of high quality and clearly definedFocus - Approach to determining internal capital from an economic perspective

• Less than half of the banks have clearly defined the term "internal capital" in their ICAAP from an economic perspective. For most banks the definition is not elaborated.

• More than two thirds of banks use regulatory capital as the starting point for their internal capital definition, while almost one third of banks use balance sheet capital as the starting point.

• No bank in the sample uses a net present value only approach.

Definition of internal capital: starting point and state of elaboration

Source: ECB

DEFINITION OF INTERNAL CAPITAL STARTING POINT FOR INTERNAL CAPITAL DEFINITION

27

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0

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10

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25

30

Regulatory own funds Accounting values

15

19

10

2

4

6

8

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12

14

16

18

20

Elaborated Exist, but notelaborated

No


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Principle 5 - Internal capital is of high quality and clearly definedFocus - Comparison of internal and regulatory capital levels

• Most banks have an internal capital level at or above the CET1 level. On average, internal capital is 16% higher than CET1. Comparing this with total regulatory capital, the difference is smaller; on average, internal capital is 4% lower than total regulatory capital.

• Banks using balance sheet capital as a starting point tend to have a higher internal capital level compared to the CET1 level (129% on average) than banks using regulatory capital as a starting point (111% on average). This is consistent with the fact that regulatory filters, deductions and other adjustments tend to result in a lower value of own funds compared to the balance sheet value of equity.

Comparison of internal and regulatory capital levels, differentiated according to the starting point used for the internal definition of capital

Source: ECB

RELATION BETWEEN INTERNAL CAPITAL AND REGULATORY OWN FUNDS

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

IC/CET1 - regulatory starting point (average = 111%) IC/CET1 - accounting starting point (average = 129%)

Rat

io in

per

cent

age

IC/total own funds (average = 96%)

IC/CET1:average: 116%median: 110%


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Principle 5 - Internal capital is of high quality and clearly definedFocus - Taking into account the two main characteristics of the economic perspective when defining internal capital

• Only about half of the banks take into account the two main features of the economic perspective (going concern assumption and the concept of economic value) when making decisions on the inclusion of capital positions in internal capital.

• When the two criteria are taken together, only one bank in ten takes both aspects into account when defining its internal capital.

Consideration of the going concern assumption and the concept of economic value in the definition of internal capital

Source: ECB

CONTINUITY ASSUMPTION AND ECONOMIC VALUE CONSIDERATION

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15 1513

9 9

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0

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15

20

25

Continuity assumption Economic value consideration Both considerations

Elaborated Mentioned, not elaborated No


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Principle 5 - Internal capital is of high quality and clearly definedGood practices observed by the ECB

Definition of internal capital Concept of economic value

• Clear definition of the capital positions that the bank considers appropriate to cover risks from an economic perspective (assessed against predefined criteria)

• These criteria include 1. the ability to absorb losses on a going concern basis; 2. marketability in a crisis scenario (i.e. the ability to sell assets without

significant discounts); and 3. consistency with risk quantification from an economic perspective (the

concept of economic value). • In addition, the bank monitors the best practices used by other banks in

order to continuously challenge its own approach.

The systematic and granular analysis of the bank'sassets and liabilities according to the concept of economic value in order to determine the impact on internal capital (increases and decreases in assets and liabilities).


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Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedResults at a glance (1/2)

Banks mainly rely on regulatory approaches and on statistical models for quantifying risks under the economic perspective. While most banks do adjust their regulatory methodologies, in a number of cases regulatory methodologies are directly applied without making any adjustments, meaning without tailoring them to the bank's individual risk profile.

Using regulatory risk quantification methodswithout adjusting for the economic perspective can lead to problems because regulatory methods do not fully capture the risk profiles of banks. This also applies to banks using their internal Pillar 1 models, as even these methods are based on several assumptions and parameters defined by the supervisor and may not cover all the specificities of banks' individual risk profiles.

A typical model assumption that can pose a problem is insufficiently long holding periods in the context of risk quantification for positions exposed to market risk. In most cases, the assumed holding period is less than 250 trading days, with ten days holding period being the most commonly used assumption

Regardless of which risk quantification methods banks choose, they are expected to base their risk quantification method on the concept of economic value and to tailor it to the bank's individual risk profile.

Although banks are generally free to choose any holding period they wish, holding period assumptions that are too short can lead to the risk being underestimated; in principle, a holding period shorter than the general risk horizon (1 year) is based on the assumption that the bank would or could close its market risk positions early and that no further losses can occur over time.


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Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedResults at a glance (2/2)

Overall, ICAAP figures under the economic perspective are materially higher than Pillar 1 requirements, however concerns still remain regarding the reliability of the quantification methodologies being used.

• Another point observed concerns the quantification of the IRRBB. At half of the banks, either a combination of present value (EVE - economic value of equity) and income value-oriented approaches or a purely income value-oriented approach is used to quantify the IRRBB in the economic perspective. This is a rather surprising result from the supervisors' point of view, as the distinction between interest-related effects on the income statement and balance sheet (earnings risk measures) and the impact of interest rate changes on the present value of assets and liabilities (EVE risk measures) was used as an example in the ECB ICAAP guidance to explain the different nature of the normative and economic perspectives.

• In principle, banks can incorporate inter-risk diversification effects into their decision-making, but they should ensure that they maintain sufficient internal capital even in times of stress, when correlations can change dramatically. Not all banks treat inter-risk diversification effects in a sound manner. This conclusion should be seen in the context of the fact that almost half of the banks do not systematically identify the threats resulting from inter-risk concentrations, including those banks that, on the other hand, claim the benefits of inter-risk diversification effects.


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Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedFocus - Proportion of risk quantification methods applied

• For market, credit and operational risk, banks mainly use (mostly adapted) regulatory approaches and internal statistical models.

• There is no clear preference for specific models with regard to the risk quantification method forIRRBB.

• While Pillar 1 risks are always quantified as separate risk categories, IRRBB is integrated into market risk at around one in ten banks.

Risk quantification methods for pillar 1 risks and IRRBB in the economic perspective

Source: ECB

SHARE OF RISK QUANTIFICATION METHODOLOGIES USED PER RISK TYPE

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Credit risk Market risk Operational risk IRRBB

Internal statistical model Pillar 1/regulatory IRRBB outlier test Pillar 1 amended

Internal scenario analysis/stress tests Integrated in market risk Other

Perc

enta

ge o

f ban

ks


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Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedFocus - Proportion of internal statistical models applied

Banks use statistical models for risk quantification, • Monte Carlo simulation is the most commonly

used approach for credit and operational risk, • while VaR methods with historical simulation are

more common for market risks.

Frequency of internal static models applied by risk type

Source: ECB

10

3

6

32

7

2

41 1

5 56

3

0

2

4

6

8

10

12

Credit risk Market risk Operational risk IRRBB

VaR - Monte Carlo simulation VaR - historic simulation Stressed VaR Expected shortfall Other risk measures


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Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedFocus - Holding period in market risk

• In quantifying market risk, most banks use a holding period of less than 250 trading days as a model assumption.

• The most common assumptions are ten days and 250 days. Some banks use a combination of a relatively short holding period (less than 250 days) and a less conservative 99% confidence interval.

Holding period assumption used to quantify market risks

Source: ECB

HOW MANY TRADING DAYS ARE ASSUMED?

2

8

1

4

1

8

0

2

4

6

8

10

1 10 20 50 174 250

Number of trading days


PwC

Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedFocus - Approaches to the projection of capital figures and TREA

• From a normative perspective, banks primarily use stress tests and scenario analyses to project their own funds and the TREA [Total Risk Exposure Amount] in adverse scenarios. A few banks also use expert estimates.

• About one in five projections in the normative perspective is based on risk figures from the economic perspective, either directly or after adjustments.

Approaches to the projection of capital figures and TREA in the adverse scenarios in the normative perspective

Note: For credit, market and operational risk, future own funds ratios are impacted through changes in own funds levels and TREA, whereas for IRRBB, the chart refers exclusively to the projected impact of the risk on future own funds levels, as there is no Pillar 1 TREA for IRRBB. Figures may not add up to 37 because multiple answers selection was possible. Quelle: EZB

HOW ARE THE FUTURE OWN FUNDS AND TREA AMOUNTS DERIVED FOR THE ADVERSE SCENARIO PROJECTIONS?

7 73 2

1 1

1

16

4

4 1

75

3

22

18

1118

0

5

10

15

20

25

30

35

40

45

Credit risk Market risk Operational risk IRRBBExpert judgement Linear regression based on historic amountsIncrease of current risk amount by fixed relative amount Adjusted economic perspective valueEconomic perspective value Stress test results/scenario analysis


PwC

Principle 6 - ICAAP risk quantification methodologies are adequate, consistent and independently validatedGood practices observed by the ECB

Risk quantification method

AN OBSERVED GOOD PRACTICE FOR THE RISK QUANTIFICATION METHOD WAS• maintaining an inventory of all ICAAP methods used to quantify risk, including

for risks that are not easy to quantify.• In addition to a description of the methodological approaches and the parameterisation, the

inventory also provides information on the validation history and limit allocation, limit use, thresholds, etc. This provides the management body with a good overview of the degree of conservatism applied in risk quantification methods in relation to risk appetite.


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Principle 7 - Regular stress testing is aimed at ensuring capital adequacy in adverse circumstancesResults at a glance

On the positive side, all banks are performing internal stress tests that are forward-looking over a sufficiently long-time horizon. While internal stress-testing under the normative perspective is well established, stress-testing is underdeveloped under the economic perspective.

Adverse scenariosa) most banks evaluate only one or two adverse scenarios

in the normative perspective.b) the severity of the adverse scenarios has increased

compared to 2015 However, this still seems to be too low at many banks.

As a result, banks could face far more serious consequences in a real stress situation without having sufficient capital buffers or appropriate management measures.

There is still room for improvement on how quickly banks recognise potential changes in their business environment and how quickly they respond to new threats. The weaknesses identified are:a) Many banks do not systematically monitor emerging threats.b) Review and implementation of the stress test and reporting is only annual.c) The ad hoc stress testing process appears to be underdeveloped.

Reverse stress testBanks typically use a breach of the TSCR primarily as the predefined result of the reverse stress test from a normative point of view. In reality, banks' business models may become unprofitable at a higher capital level (e.g. at the level of the management buffer). It is therefore expected that banks will consider the level of capital required to continuebusiness and define their scenarios based on this level in their reverse stress tests.


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Principle 7 - Regular stress testing is aimed at ensuring capital adequacy in adverse circumstancesFocus - Number of adverse scenarios

• All banks have at least one adverse scenario in the normative perspective. Two adverse scenarios are most frequently used.

• In the economic perspective, about half of the banks have at least one comprehensive adverse scenario. One in five banks assesses more than two scenarios.

Number of comprehensive adverse/stress scenarios used according to ICAAP perspectives

Source: ECB

10

13

8

42

67

4

1 1 10

2

4

6

8

10

12

14

1 2 3 4 5 6 7 8

Normative perspective Economic perspective

Number of stress scenarios


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(1.2)%-(0.8)%

(0.4)%-0%

0.4%-0.8%

1.2%-1.6%

2%-2.4%

2.8%-3.2%

3.6%-4%

4.4%-4.8%

5.2%-5.6%

6%-6.4%

6.8%-7.2%

7.6%-8%

8.4%-8.8%

9.2%-9.6%

10%-10.4%

10.8%-11.2%

11.6%-12%

12.4%-12.8%

13.2%-13.6%

>14%

Principle 7 - Regular stress testing is aimed at ensuring capital adequacy in adverse circumstancesFocus - Severity of adverse scenarios

• The observed levels of capital consumption by the scenarios are well below the comparable average results of the EBA stress test in 2018. This standard scenario was based on a typical severe economic downturn, but was conceptually not tailored to the individual vulnerabilities of banks.

• It is assumed that many banks use adverse scenarios for their internal stress testing that are not severe enough (crisis-like) or that the implementation of the scenarios is not sound and realistic in terms of capital implications.

Severity of adverse scenarios from a normative perspective

Buckets for maximum CET 1 depletion (in percentage points)

Num

ber o

f ban

ks p

er d

eple

tion

buck

et

MAXIMUM CET1 DEPLETION

0

1

2

3

4

5

6

ICAAP Average 2015 (3%)

ICAAP Average 2019 (3.3%)

EBA 2018 stress test

(4.8%)

Note: The chart shows "gross" depletions, i.e. management actions are not factored in, according to the documentation submitted in the ICAAP packages. X-axis: values in parentheses indicate negative CET1 depletions, i.e. an increase in CET1 levels. Source: ECB


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Principle 7 - Regular stress testing is aimed at ensuring capital adequacy in adverse circumstancesFocus - Frequency of stress testing

• Typically• a review of scenarios used, • the implementation of the reverse stress

tests, and• reporting on the results of the stress tests

takes place annually. • An exception is the implementation of stress

tests in the economic perspective. These are carried out more frequently than annually at more than half of the banks.

Frequency of implementation, review and reporting of stress tests

Note: These percentages were calculated on the basis of the number of banks for which the respective category is relevant and also where information regarding frequencies is available, e.g. for economic perspective stress testing which is only done by 20 banks, frequencies were documented by 19 banks in total. Source: ECB

Percentage of banks

FREQUENCIES FOR CONDUCTING ...

2

2

2

1

2

1

5

2

6

7

4

10

2

3

2

3

25

9

15

8

19

26

20

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Reverse stress testing

Reporting of ST results (EP)

Review of EP ST scenarios

Economic perspective ST

Reporting of ST results (NP)

Review of NP ST scenarios

Normative perspective ST

Monthly Quarterly Bi-annualy Yearly


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Principle 7 - Regular stress testing is aimed at ensuring capital adequacy in adverse circumstancesGood practices observed by the ECB

Reverse stress test Interaction of ICAAP and ILAAP

Construction of a combined solvency and liquidity scenario for the inverse stress test, including the interdependencies and signal effects between solvency and liquidity The stress horizon is 12 months to include spill-over effects between solvency and liquidity stress

Implementation of a process for systematically taking into account the effects resulting from the ILAAP stress tests or defined liquidity shocks in the ICAAP stress tests

Inverse stress tests are not just a mathematical exercise in which individual risk factors are amplified in such a way that a predefined result is achieved, but a tool which can be used to discuss the most important weaknesses which, in a plausible combination, lead to the business model not being profitable and require action by management and, if necessary, subsequent measures.


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Where you should improve your ICAAP now


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Governance

Capital Adequacy Statement• Ensuring the completeness and understandability of the Capital

Adequacy Statement• Transparent presentation of capital planning; in particular detailed

presentation and breakdown of the effects of significant (economic) risks on the capital projections in basic and adverse scenarios of the normative perspective

Capital planning • Deeper involvement of the risk function in capital planning

ICAAP validation • Development of a validation plan with risk-induced validation

frequency• Establishment of an independent validation unit for the annual

quantitative and qualitative review of the ICAAP

Where you should improve your ICAAP now!Governance, ICAAP as a control instrument, normative & economic perspective

ICAAP as a management instrument

• Comprehensive, forward-looking reporting on the economic and normative perspective

• Concept to increase the frequency and granularity of reporting for the specific risks of a crisis

Normative & economic perspective

• Increasing the severity of adverse scenarios and taking full account of expected legal or regulatory changes

• Definition of a management buffer and implementation of capital planning also from an economic perspective

• Better description of potential management measures


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Risk inventory

• Forward-looking risk inventory and quarterly reassessment of the materiality of risks

• Combination of a top-down and bottom-up approach when conducting the risk inventory

Where you should improve your ICAAP now!Risk inventory, internal capital, risk quantification, stress testing

Risk quantification

• Sound and comprehensible justification of the holding periods of positions exposed to market risk

• Setup and maintenance of an inventory of all ICAAP risk quantification methods used

Stress Testing

• Ensuring the connection of the ICAAP and ILAAP stress tests (e.g., recognition of spill-over effects)

• Definition and design of the inverse stress test based on the level of capital required to continue operations (instead of TSCR)

Internal capital

• Systematic derivation of internal capital under the going concern assumption (loss absorption under the going concern premise) and the concept of economic value


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Questions?Your contacts at PwC

WP StB Michael MaifarthPartner Mobile: +49 170 7865727Email: [email protected]

Alexander KottmannDirectorMobile: +49 170 4738250Email: [email protected]

WP Dieter LienlandSenior ManagerMobile: +49 171 5532631Email: [email protected]

WP Matthias EisertPartnerMobile: +49 160 8953260Email: [email protected]

icaap benchmarking of the ecb analysis of the practices ......2020/09/23 · projections and...

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