The ECB is developing new guidance aimed at harmonising European banks’ approaches to their ICAAP and ILAAP processes. The new guidance is based on seven key principles and is expected to enter full force within two years. It will have a varying impact on different banks, but all are likely to require significant changes to their internal processes and reporting requirements. Management boards will also be expected to take full responsibility. Given the short timeframe, banks need start planning their responses now.
The Basel Committee requires banks to assess themselves the capital cushion and liquidity buffers they need to support current and future risks. The results of the Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP) as developed by the banks are reviewed by supervisors during the annual Supervisory Review and Evaluation Process (SREP).
In the years before the Single Supervisory Mechanism (SSM), Europe’s national supervisors have taken different approaches to reviewing banks’ ICAAP and ILAAP calculations. This is set to change. The ECB is developing comprehensive guidance for Significant Institutions, with the aims of improving convergence between ICAAP and ILAAP and enhancing harmonisation across the SSM.
The ECB published their initial expectations for a harmonized ICAAP and ILAAP in January 2017. The consultation period on the seven principles of the new guidance ends on May 31, 2017, and the ECB may make further changes in response to the 2017 Supervisory Review and Evaluation Process (SREP). Banks will need to implement the principles by the end of 2018. Given past experiences with draft EBA and ECB guidelines, we believe that full compliance will be expected for the SREP in 2019. The seven principles of the new guidance can be summarised as follows:
These principles are unlikely to change materially, and give us a good idea of the impact of the ECB’s new approach. We see several potentially significant consequences for banks.
First, the harmonising effect of the new guidance means that its impact will vary widely between national markets. Banks whose national supervisors have taken a different view from the ECB’s planned approach may need to make significant changes. To a varying degree, these changes include a re-design of the KPIs and KRIs used in capital and liquidity management. We expect the regular updates of three year business plans, capital plans and liquidity plans under normal and stressed scenarios to be a significant challenge, especially when combined with incorporating these KPIs and KRIs into the limit systems that banks use for day to day operations.
Second, two processes - ICAAP and ILAAP - that many banks currently perform separately will become closer, or even become merged. This reflects the reality that weaknesses in capital and liquidity are often mutually reinforcing. However it will pose some challenges, as ICAAP and ILAAP are frequently managed by different functions within a bank.
Third, the requirements for internal consistency could have a disproportionate impact on large cross-border banks and financial conglomerates. Diversified or decentralised groups may need to do much more work than others to ensure consistency and reconciliation.
Lastly, the ECB is raising the bar in terms of management responsibility. ICAAP and ILAAP are often approved at one or two levels below the board. In future, management boards will need to take responsibility for their submissions to supervisors.
In summary, the new guidelines on ICAAP and ILAAP give Significant Institutions a lot of food for thought. Some will need to make a number of technically complex changes across several functions and subsidiaries. Furthermore, these changes need to be assessed and planned urgently if banks are to achieve full implementation by the end of 2018.