With banks performing a key role in financing households and businesses, it is crucial that they are sufficiently resilient to play their part – both in good times and in bad. The financial stress caused by the coronavirus (COVID-19) pandemic has further underlined the need for banks to identify and effectively manage their risks to ensure they have sufficient capital to absorb losses and steer their business models through periods of adversity. Pivotal to this is the internal capital adequacy assessment process (ICAAP), which helps banks to make well-founded business and risk management decisions and maintain an adequate capital position.
ECB Banking Supervision has taken several actions to support banks in developing the ICAAP as a valuable management resource. In 2018 it published the ECB Guide to the internal capital adequacy assessment process to provide transparency on the ECB’s expectations regarding banks’ ICAAPs. More recently, the ECB carried out an analysis of banks’ ICAAP practices, looking at where the sampled banks stood in relation to its expectations. The findings from this analysis have now been published in the ECB Report on banks’ ICAAP practices. ECB Banking Supervision acknowledges that banks have made considerable effort and significantly improved their ICAAPs in recent years. There is, however, more to be done.
While the analysis revealed several relatively underdeveloped ICAAP areas, which all deserve attention, there are three main areas for further improvement. First, many banks face material data quality issues, which could stand in the way of them making well-informed decisions based on quickly retrievable and reliable data, thereby hampering the quality and effectiveness of their ICAAPs.
Second, many banks show significant room for improvement with regard to the economic internal ICAAP perspective – a perspective which is based on bank-internal, economic value-based considerations of capital and risks, rather than building on accounting or regulatory provisions. Failure to properly identify and quantify all material economic risks may hinder banks’ ability to manage their economic capital adequacy and could therefore weaken their financial resilience. That, in turn, could threaten banks’ continuity, as a deterioration in their economic value may erode the trust that market participants and depositors place in them, even if their regulatory capital ratios remain at solid levels. Aspects of the economic perspective that need to be improved include determining internal capital, quantifying economic risks and taking the economic perspective into account in decision-making. The ECB recognises that banks may struggle with the concept of the economic perspective and will continue to support them in this area.
The third key area of concern is that stress testing has yet to become an effective, integral component of banks’ risk management practices. The current pandemic has once more underlined that banks are exposed to a wide range of threats that may materialise unexpectedly. However, many banks do not systematically monitor their environment to identify new threats early enough. Stress testing is often considered a regular annual exercise rather than a powerful risk management tool that would enable them to respond quickly when needed.
Regarding the progress that banks have made in improving their ICAAPs, the report provides examples of good practices observed by the ECB and identifies a number of ICAAP areas in which practices have been broadly established across banks. For instance, banks have regular risk identification processes in place, produce capital adequacy statements and conduct stress tests. In addition, they prepare forward‑looking, multi-year capital plans that include baseline and adverse scenarios under the normative internal ICAAP perspective. Under this perspective, banks assess their ability to fulfil regulatory capital requirements and to cope with other external financial constraints on an ongoing basis over the medium term.
The ECB finalised its conclusions without reference to a particular operating environment and before the COVID-19 pandemic hit Europe. It believes that good ICAAP practices are as relevant in times of severe stress as they are in normal times. The ECB therefore strongly encourages banks to embrace the report’s findings and conclusions and to enhance their ICAAP practices. Good ICAAPs are key to effective risk management, sustainable financial soundness and – ultimately – long-term prosperity. That is why the implementation of sound ICAAP practices in Europe will continue to be one of the ECB’s top supervisory priorities.