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Table of Contents
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Current Developments Philosophy and Structure of Pillar II and the ICAAP Relevant Questions and Need for Action Ernst & Youngs Flexible ICAAP Framework
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Editorial
The developments and tremendous losses witnessed over the last 1824 months in the banking and financial markets have shocked bankers, politicians, people on the street and regulators alike. People, with due reason, are starting to ask: Why have financial regulation and the praised Basel II framework not been able to prevent this meltdown? Were the skeptics about Basel II right when they said that minimum capital requirements are an inadequate measure to control and manage risk? How will and must financial regulation evolve in order to prevent these mistakes happening in the future? Skeptics have already started digging the grave of Basel II and heralding its replacement with Basel 2.5 or Basel 3. Regulatory Trends Throughout many jurisdictions, we have observed regulators leaning toward more stringent capital requirements and closer observation of the regulated banks. In general, developments seem to be moving in the direction of the Second Pillar within the Basel II framework, whereby capital requirements are no longer fully based on the generic Pillar I calculations but more strongly influenced by the more differentiated requirements of the Internal Capital Adequacy Assessment Process (ICAAP), which gives more weight to the economic risk profile of the regulated financial institutions.
Economic Value Simultaneously, equity capital has become more and more scarce, making this strategic resource even more crucial. Hence, in order to support current and future growth ambitions, banks are evaluating the availability and allocation of equity capital more than ever before. In the current environment of economic stress, the consolidation underway in certain market segments may offer short-term business opportunities. In order to ensure the necessary funding to take advantage of any strategic opportunities that may arise, sufficient equity cushions need to be available. Additionally, approximating the capital requirements of a bank based on its economic risk profile allows the banks management to strike a better balance between the sometimes differing views of regulators, investors and the banks internal strategic business plans. Purpose of this Brochure The purpose of this brochure is to provide an overview of national and international developments and challenges related to Pillar II and the ICAAP. Furthermore, an outline is given of possible methods of addressing these challenges and the additional added value for financial institutions beyond regulatory compliance. For financial institutions who have not yet addressed the potential consequences or impacts of the ICAAP, this brochure may help in the establishment of a first overview and the initiation of further activities.
1. Current Developments
The downturn environment is placing considerable strain on the capital positions of firms subject to Basel II requirements. The capital base is at threat from falling income, mark-tomarket losses and rising defaults. Fresh capital is potentially difficult to raise and expensive to service. The current developments on the financial markets have emphasized the necessity for more stringent supervision of banks and their risk management activities. Alongside this, regulators are asking firms to perform increasingly robust stress testing in order to assess the range of scenarios that may hit. The complexity of such stress tests is compounded by the fact that, under Basel II, capital requirements for many firms could rise substantially during the downturn. Regulators are challenging firms to increasingly involve senior management in developing and reviewing stress testing and to embed this within the day-to-day running of the business. Moreover, supranational institutions like the OECD have announced methods to increase regulation and supervision of the global financial system, while discussion papers released by the BIS emphasize the extension of Basel II and, particularly, its Second Pillar. The stress testing exercises and Pillar II review activities currently being performed by the FINMA in Switzerland are further examples of such increased supervision. Overall, it can be said that the Second Pillar of Basel II (regulatory supervision with assessment of bank-internal capital adequacy) is receiving increasing attention. Pillar II and the ICAAP, unlike the First Pillar, are principlebased guidelines, and national regulators first had to incorporate these principles into national regulations and allow market standards to develop. This development has now taken place, and many regulators have already integrated reasonably sophisticated ICAAP directives into their supervised institutions. Initial reports are presently being reviewed by regulators. As opposed to the First Pillar (the minimum capital requirements), the Second Pillar does not differentiate between standardized and IRB banks. Rather, regulators are asking banks to strengthen the link between an institutions risk profile, its risk management and risk mitigation systems, and its capital. As such, the intensity and depth of the Pillar II review is proportionate to the nature, scale, complexity and systemic importance of the institution (its economic risk profile). Unlike our neighboring countries, so far Switzerland has not introduced any concrete ICAAP directives. Nevertheless, based on the aforementioned developments and the stress testing and review activities currently being performed by the FINMA in the Swiss market, it can be anticipated that more stringent requirements may follow and, eventually, that capital requirement levels may rise.
Core Messages
Pillar II and its ICAAP have been developed from a principle-based section of the original Basel II paper to a widely accepted market standard. The ICAAP directives currently applied have reached a reasonable level of sophistication and are generally seen as a valuable enhancement to the Pillar I minimum capital requirements. Differentiation between standardized and IRB banks is generally irrelevant in the ICAAP, and regulators focus on the economic risk profile of supervised banks. Switzerland has so far not introduced any concrete ICAAP directives, but the FINMA recently asked larger and complex Swiss banks to conduct stress testing within their institutions based on given indicators and scenarios. The results and possible actions have not been published at this point in time. Regulatory actions such as stress testing and Pillar II reviews may lead to increased capital requirements.
ICAAP ICAAP
(Internal Capital Adequacy (Internal Capital Adequacy Assessment Process) Assessment Process)
SREP SREP
(Supervisory Review Evaluation (Supervisory Review Evaluation Process) Process)
Intended to be be proportional to Intended to proportional to the complexity and risk the complexity and risk exposure exposure
Intended to be be proportional to Intended to proportional to the overall risk situation of of the overall risk situation financial institutions financial institutions
Subsequently, the ICAAP Subsequently, the ICAAP side will bebe focused side will focused
Structure of Pillar II
When considering the second Pillar and its influence on regulated institutions, a distinction needs to be made between its two mayor components: the ICAAP (Internal Capital Adequacy Assessment Process) and the SREP (Supervisory Review Evaluation Process).
The SREP is reserved for the regulator, defines said instituPage 8 8 Page Pillar II ICAAP Pillar II / ICAAP tions regulatory/ review activities, and may take rather different forms depending on the jurisdiction and, as such, has limited influence on banks risk management activities. The ICAAP, on the other hand, carries great importance for banks since it assesses their capital adequacy levels based on their indigenous complexity and risk exposures. Hence, the ICAAP is usually described as a process owned by the bank and reviewed by the regulator as part of the SREP. As a result, banks usually focus on the ICAAP side in their implementation of Pillar II solutions. Consequently, section 4 will introduce Ernst & Youngs comprehensive yet flexible framework as to how banks may address the challenges posed by the ICAAP.
Pillar I
Minimum Requirements for Credit, Market and Operational Risks only
Pillar II
The Committee also wishes to highlight the need for banks and supervisors to give appropriate consideration to the Second Pillar. It is critical that the minimum capital requirements of the First Pillar are accompanied by a robust implementation of the Second Pillar, including efforts by banks to assess their capital adequacy and by supervisors to review such assessments. (Quote from Basel II Core Text)
Pillar I is only the first step on a journey in realizing the aims of Basel II.
7. Juli 2009 Page 6 Pillar II / ICAAP
The ICAAP under Basel II Ernst & Young 2009 5
Differentiation between standardized and IRB banks is generally irrelevant in the ICAAP, and regulators focus on the economic risk profile of supervised banks.
Board Oversight and Managements Actions Board Oversight and Managements Actions Investors & Owner Investors & Owner
CommunicaCommunication tion
Alignment Alignment
Regulators Regulators
7. Juli 2009
Page 1
Pillar II / ICAAP
Regulators use the outcome of ICAAP reviews to establish the level of capital requirements and, to the extent necessary, of additional supervisory actions.
Capital Planning
Capital planning is one of the ultimate tools for determining and maintaining an adequate level of capital. In order to be prepared for difficult economic environments, it is imperative that capital plans incorporate various potential scenarios and are made responsive to changes in the economy, market, competitive or political landscape, or other external factors. Hence, a solid combination of the finance and risk view has to be achieved.
Risk Monitoring & Management Information Senior Management Training & Controls Review Risk Concentrations Risk Controls including Limit Setting, Policies and Procedures Scenario Analysis & Stress Testing Risk Aggregation Risk Modelling Risk Dictionary
Credit Risk Country Risk Market Risk Interest Rate in Banking Book Liquidity & Funding Risk Operational Risk Insurance Risk Legal & Compliance Risk Reputation Risks Business/ Strategic Risks Tax Risks Environmental Risks Residual Risks
Page 13 Pillar II / ICAAP Proposed7. Juli 2009 enhancements to the Basel II framework; January 2009; p. 25 To provide a complementary risk perspective to other risk management tools such as Value at Risk (VaR) and economic capital, stress tests should be used to provide an independent risk perspective.
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Hence, banks will prefer to focus on well-defined stress testing frameworks which are tailored to their organization and their particular risk profile. Stress testing is generally seen as a vital component of the ICAAP framework. It allows the bank to estimate its loss potential under a variety of highly severe but still plausible scenarios, as well as to assess the respective impact on capital sources. One area that usually receives particular attention within stress testing is the field of concentration risk. Entity concentration techniques such as those currently applied as part of many regulatory frameworks do not suffice for Pillar II stress testing techniques and should be supplemented by more rigorous methods.
First approaches of Concentration Risk management have started with single names concentrations, which have also been reflected in most regulatory frameworks. Additionally, some regulators have started to introduce requirements regarding concentrations in economic sectors, which is in line which ICAAP requirements. This is supported by studies which have identified the field of sector concentration to be of significantly greater relevance than name concentration. Moreover, banks are increasingly starting to reflect concentrations in their portfolio of accepted collaterals due to credit risk mitigation techniques in their concentration risk measurement. Finally, as a major source of risk, concentration risk should be diligently reflected in a banks stress testing framework.
Liquidity Risk
Access to sufficient liquidity is the lifeblood of each and every institution. Hence, the implementation of a robust liquidity risk management framework ensuring the continuous maintenance of sufficient liquidity and the ability to withstand a liquidity crisis are key elements of a suitable ICCAP framework. Accordingly, Senior Management is in charge of establishing liquidity risk tolerance levels as well as adequate contingency funding plans. The main focus of attention in actively managing liquidity risk should be on conducting liquidity stress tests (institution-specific as well market wide crisis scenarios) to assess the potential impact of extreme events and maintaining a liquidity buffer to raise liquidity within a short timeframe in the case that funding sources are no longer available.
Reporting
Finally, in order to keep not only governing bodies but also risk and line management adequately informed about the banks risk profile and the impact of current and anticipated market developments, a comprehensive risk reporting suite is required. As with any risk reporting, it is vital to make the information and insights responsive to key risk indicators.
Risk Concentration
The necessity for and the clear added value of diligent concentration risk management solutions has been widely recognized by regulators and practitioners alike. A study conducted by the BIS2 reveals that credit concentration risk, usually in real estate, was cited in nine out of the 13 episodes of bank failures in mature economies.
2 Bank for International Settlements; Working Paper No. 13; Bank Failures in Mature Economies; April 2008; page 66
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Finding the suitable service and financial instrument for each client: every financial advisors most Capital Adequacy Meeting the Requirements of the Second Pillar within the Basel II Framework important service
This brochure outlines the current developments in the field International supervisory practice on Investment of Pillar II and the ICAAP and their respective importance for banks management boards. Beyond regulatory pressure, the Suitability is distinguished by attention to detail and economic added value of a sound ICAAP framework is signifia high degree of differentiation. Regulations are cant and can be attained with reasonable effort. no detailed following a global convergence trend, yet
What is the appropriate way to fulfill these tasks? standards. However, as attention on these areas intensifies, more concrete standards are expected view of In this brochure, we summarize ourto evolve.the potential need for action in five topics:
regulatory guidelines financial crisis as well to date. In response to the presentexist in Switzerland as in light The Federal current Swiss regulation thus offers cover of the fact thatSupreme Court ruling does not fullya suit all aspects relevantof reference for the duties of finan able framework to Pillar II / ICAAP, the FINMA decided to take action.institutions in the field contacted and cial services Various Swiss banks were of investment informed The the FINMA will conduct Pillar II identified advice. that Federal Court has expressly review activities throughout 2009. The result of these reviews may the following obligations: lead to increased capital requirements. Disclosing detailed guidance on some of the major ICAAP Internationally,risk Interviewing clients on their degree funding risk topics such as stress testing and liquidity andof knowledge is evolving. At the moment, the available regulatory guidand risk tolerance
Investment adviser training framework provides a Our standardized yet flexible ICAAP
Ernst & Young has successfully completed a large number of ICAAP projects with a variety of banks worldwide. As such, Client investment profile and product classification Ernst & Young is well placed to advise and support any bank Risk disclosure and verifiability that is reflecting on its Pillar II strategy, is in need of conPortfolio solutions, or would like to compare its present crete ICAAPdiversification standards approaches against current institute level standards. Concentration risks at market practice
Dealing withyour bank. We would beright wayto discuss the these topics in the delighted can cific needs of significantlyfor your bank with you in person and identify best strategy mitigate the risks facing your company andbest way to the quality in your future ICAAP and risk the enhance support you of your investment advice.
management endeavors.
Contact Zurich Iqbal Khan, Partner, Financial Services iqbal.khan@ch.ey.com, tel. +41 58 286 42 54
Your contacts roger.senteler@ch.ey.com, tel. +41 58 286 33 76 Zurich Christian Rthlin, Financial Services, Legal Bruno Oppliger, Partner christian.roethlin@ch.ey.com, tel. +41 58 286 35 38 Phone +41 58 289 46 67 e-mail bruno.oppliger@ch.ey.com Alessandro Lana, Financial Services, Risk Thomas Schneider, Partner Phone +41 58 289 33 18 e-mail Geneva thomas.schneider@ch.ey.com
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Daniel Martin, Senior Manager stephane.muller@ch.ey.com, tel. +41 58 286 55 95 Phone +41 58 289 37 18 e-mail daniel.martin@ch.ey.com
Barbara Ofner, Financial Services, Legal barbara.ofner@ch.ey.com, tel. +41 58 286 32 07 Geneva/Lugano
Stphane Mller, Partner Matthieu de Wolff, Financial Services, Risk Phone +41 58 289 55 95 matthieu.dewolff@ch.ey.com, tel. +41 58 286 55 49 e-mail stephane.muller@ch.ey.com Matthieu de Wolff, Manager Mario Phone Mosca, Partner,55 49 +41 58 289 Financial Services e-mail matthieu.wolff@ch.ey.com mario.mosca@ch.ey.com, tel. +41 58 286 58 66
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Investment Suitability Ernst & Young 2009 The ICAAP under Basel II Ernst & Young 2009