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:

1. Management bodies are responsible for ICAAP & ILAAP. Management boards, senior managers and risk committees need to take full ownership of the processes and also the capital adequacy statement and liquidity adequacy statement, respectively.
2. The ICAAP & ILAAP are integral to risk management frameworks. The processes should be aligned with group risk appetite and look not just at the current situation, but also at least three years ahead.
3. The ICAAP & ILAAP aim to ensure the institution’s short and medium-term viability. Institutions need to make their assessments from two different perspectives, which are intended to be mutually informative.
   1. The normative perspective is based on the ability to fulfil supervisory requirements. For capital this includes key ratios such as CET 1, Tier 1, and leverage; for liquidity it includes the LCR. The normative view should consider the short term position but also look forward three years or more, including a baseline scenario and at least two adverse scenarios.
   2. The economic perspective is based on the bank’s economic or net present value. As such, it should consider the wide range of possible risks that a potential shareholder might consider. This includes taking ‘hidden’ or off-balance sheet liabilities into account.
4. The ICAAP and ILAAP should identify and consider all material risks. Institutions are expected to address any potential threats to their capital or liquidity positions, according to their business model.
5. Capital and liquidity need to be clearly defined, and of high quality. In the case of capital, common equity is expected to play a major role. Liquidity buffers should be marketable and well diversified.
6. Assumptions and methodologies need to be proportionate, consistent and thoroughly validated. Each bank’s approach to ICAAP and ILAAP should be appropriate for its business model and risk appetite. Assumptions should be conservative, independently validated and consistent across the whole group.
7. Regular stress tests should ensure viability under adverse market conditions. Internal stress tests should be conducted at least once a year, based on in-depth review of potential vulnerabilities.
   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.

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.