Field project in financial markets and services ICAAP and ILAAP: a critical analysis 1 Introduction 2 What is ICAAP? 3 What is ILAAP? 4 Implementation 5 Review of regulators initiatives to harmonize ICAAP and ILAAP 6 Conclusion Cabu, Jeremy De Radiguès, Philippine Risopoulos, Théo 13 April 2016 SBS – EM Master in Business Economics Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer

Introduction– ICAAP and ILAAP A. BASEL III Framework B. Key Achievements ICAAP Capital Requirements Better Capital More Capital Liquidity Requirements Liquidity ratios Leverage Requirements Pillar I Assessment of the risks to Capital that have been identified as material for the institution. Supplemental Capital requirements of Pillar 2 Pillar II Risk Management and Supervision Supplemental requirements ILAAP Assessment of the risks to liquidity and funding that have been identified as material for the institution. Supplemental Liquidity requirements of Pillar 2 Market Discipline Revised disclosures requirement Enhanced disclosures Pillar III Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 1

What is ICAAP? – Definition & Legal Basis EBA Guidelines for SREP Definition: All the bank’s procedures and measures designed to ensure An appropriate identification and measurement of risks An appropriate level of internal capital in relation to the bank risk profile the application and further development of suitable risk management systems Rationale: Help supervisors and banks to identify additional risks that were not covered under Pillar I and that the bank is accordingly sufficiently capitalized Distinction: Economic capital vs. Regulatory capital ICAAP Legal Basis ECB Guide EBA Guidelines for SREP CRD IV Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 2

2 How is ICAAP assessed? – Risk to Capital A. ICAAP risks: Internal vs. External approach ICAAP sub-risks SREP? Standard Approach Internal Approach Counterparty risk ✔ Risk weights based on credit assessment from external rating agencies IRB approach Equity risk Risk weights based on risk indicators Credit concentration risk - Strict limitation or limitation by way of increased monitoring Market risks and FX in the trading book Sensitivities Based Methods, Default risk charge and residual risk add-on Historical, Gaussian or Monte - Carlo VaR model Operational Risk Single risk weight factor Advanced Measurement Approaches IRRBB Interest rate statistics, unique or combined Interest rate shift (s) Other risks ✖ Qualitative assessment, set of rules Source: FMA, ONB and BIS Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 2

Why is ICAAP useful? – For banks and supervisors A. For Credit Institutions ✔ Allow the bank to derive its risk bearing capacity ✔ Allow the bank to evaluate potential products or clients in terms of risk – adjusted capital measures rather than just in terms of risk profile Initial investment Annual net income Return decision Capital Charge Risky capital RORAC RORAC decision Equity Investment 1 1.000 € 40 € 2% 20 € 200% ✔ Equity investment 2 100 € 20% 200 € 50% Source: FMA, ONB B. For Supervisors ✔ Give the supervisor an exhaustive coverage of the credit institution’s risk exposure as opposed to the risks under Pillar I  ✔ Give the opportunity to the supervisor of assessing the risk bearing capacity of the institution ✔ Help the supervisor preventing insolvency in the banking industry  Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 2

What is ILAAP? – Definition & Legal Basis EBA Guidelines for SREP Definition: All the bank’s procedures and measures designed to ensure An appropriate identification and measurement, of risks to liquidity and funding An appropriate level of internal liquidity in relation to risk profile An appropriate management and monitoring of liquidity Rationale: Help supervisors and banks to put LCR and NSFR (Basel III Pillar I) into a risk governance framework Qualitative elements based on “Principles for sound liquidity risk management and supervision” (BCBS, 2008) Liquidity risk quantification: HQLA buffers, LCF plans, maturity gap, stress testing, projected balance sheet, Funds Transfer Pricing, etc. ILAAP Legal Basis BASEL III EBA Guidelines for SREP Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 3

Why is ILAAP useful? – For banks and supervisors A. For the banks ✔ Allow the bank to adequately determine its liquidity and funding risk- bearing capacity and risk tolerance ✔ Align the liquidity risk management with its strategic and operational processes B. For the supervisor ✔ Allow the supervisor to assess liquidity and funding risk-bearing capacity of the supervised and assess if liquidity risks require additional risk controls ✔ Clarify the dialogue on liquidity risks between the supervised and the supervisor Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 3

Varying implementation practices Heterogeneity in required capitalization Different definitions of available financial resources : use of regulatory funds vs additional adjustment such as future expected earnings Different weights of the risks by regulators: e.g integrate business risk in stressed planning assumptions vs separate risk category Different degrees of individual capital guidance by national superviors Varying influence of national supervisors to integrate ICAAP on bank’s core internal management Different use of the ICAAP results for the SREP ILAAP Few implementation practices (DNB, BoE). First submission of EBA templates by 30 April 2016. Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer

Review of regulators initiatives to harmonize ICAAP & ILAAP (I/III) A. Timeline of regulatory work from supervisors 2014 2015 2016 Application of the SREP Guidelines SREP Guidelines Common Guidelines for ICAAP and ILAAP information collection Provision of ICAAP and ILAAP data Guide to Banking Supervision Application of the ICAAP and ILAAP Guidelines B. Key contributions ✔ Facilitating a consistent approach to ICAAP and ILAAP under the SREP ✔ Incorporating the banking industry concerns trough consultations ✔ Understanding the SSM expectations on ILAAP and ICAAP ✔ Understanding and Harmonizing information collection on ICAAP and ILAAP Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 5

5 Review of regulators initiatives to harmonize ICAAP & ILAAP (II/III) A. SREP guidelines B. Guide to banking supervision Determine competent authority in charge of reviewing periodically the SREP framework according to the categorization of the institution Alignment of ICAAP and ILAAP with institutions’ risk profiles and strategic management practices “ Review of soundness, effectiveness and comprehensiveness of ICAAP ECB directly responsible for large and global credit institutions and indirectly for small institutions trough the NCA’s C. GL on collection of information related to ICAAP and ILAAP for SREP purpose D. Supervisory expectations on ICAAP and ILAAP and harmonized collection Divergent requirements for the relevant information may hinder harmonization of the SREP Review of 2015 showed that the information sent by credit institutions not in line with SSM expectations Differences and similarities between own funds requirements and ICAAP have to be clearly stated to enable the supervisor to compare the outcomes EBA has communicated several clarifications but also templates relating to SSM expectations on ICAAP and ILAAP Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 5

Review of regulators initiatives to harmonize ICAAP & ILAAP (III/III) A. Banking Industry Association issues B. Clarification from the supervisors ✖ Deeper dialogue between supervisors and institutions throughout the SREP ✔ EBA: this was not intended and should be further clarified ✖ Clearer guidance on the assessment of ICAAP ✔ EBA clarified that the starting point of the SREP is surely the ICAAP ✖ Pillar 2 should not be considered as a kind of Pillar-1-plus ✔ EBA advocates a continuation of principles-based approach for Pillar 2 ✖ Diversification benefits should be considered ✔ Intra – diversification is allowed but not inter – diversification ✖ References to ILAAP too qualitative and general ✔ The ECB published a template for sending ILAAP information ✖ Use of supervisory benchmarks ✔ Expected to continue applying benchmarks to set a level playing field ✖ Tight expected timeline and implementaton Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 5

6 Conclusion A. Key challenges While banks agree on the need to harmonize ICAAP and ILAAP framework, they deem that the overall design of the guidelines still exhibited certain issues to be addressed Find the right equilibrium between the conflicting objectives of strengthening the harmonization of regulatory procedures and reflecting adequately and proportionally institution-specific risk practices and risk profile B. Potential recommendations Perhaps, further develop a clearly quantified standard external ICAAP model Draft more precise and quantitative guidelines for ILAAP Further enhance the dialogue on the parameters of ICAAP and ILAAP risks that are still not concretely defined Field project – F. Francotte, Y. Boudghene, E. Boyer, E. De Keuleneer 6