The new version puts the standards and criteria to be applied during the supervisory assessment process on a completely new foundation. The following article explains the background and gives an outline of the main changes.

Changes to supervisory structures and practice

Supervisory structures and practices have changed significantly since the end of 2011, when the previous guidelines on bank-internal capital adequacy concepts were published. These changes demanded a fundamental review of the national standards and criteria to be applied during the supervisory assessment of internal capital adequacy concepts, and their adaptation to the new framework.

The most crucial changes are the introduction of the Single Supervisory Mechanism (SSM) and the resulting new tasks and powers for the European Central Bank (ECB), which were also flanked by greater harmonisation of the supervisory metrics to be applied for the assessment of ICAAP in banks. In addition, the European Banking Authority (EBA) published Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP) in 2014. These, too, aim to better harmonise the approaches to ICAAP taken by the supervisory authorities and to better align supervisory review and assessment processes.

The ECB’s expectations

In January 2016, the ECB formulated its expectations as to how ICAAP should be designed within the SSM, although this was initially limited to significant institutions (SIs). As a result this topic gained in importance once more. In the meantime, the ECB has developed draft guidelines on this basis and discussed these with the banking industry. The final version is expected to be released in late summer and the guidelines will enter into force for SIs in the SSM on 1 January 2019.

It is not yet clear whether the ECB will develop separate ICAAP expectations for less significant institutions (LSIs) or whether it will apply the guidelines for the SIs proportionately to the LSIs. But, without doubt, the guidelines have created a basic ICAAP structure that also significantly affects the standards and criteria applied by national supervisors when reviewing and assessing ICAAP at LSIs.

Scope of the new guidelines

The principles, standards and criteria set out by German supervisors in the new internal capital adequacy guidelines expressly apply only to credit institutions that are directly supervised by German banking supervisors. They therefore do not apply to significant institutions that are supervised by the ECB. This is also due to the fact that the basic structure of the assessment standards formulated by the ECB for SIs served as a blueprint for the new guidelines, and therefore correspond to them. This approach also ensures that the national standards and criteria are aligned with the perspectives on assessment adopted within the SSM.

During development, supervisors faced the question of how they should deal with existing approaches, and in particular with the going concern approaches used to date. These are in widespread use and an integral part of corporate management. The supervisors decided to adopt a pragmatic policy: institutions are permitted to continue using their previous going concern approaches until further notice. Specific assessment criteria from the new ICAAP regime – namely those relating to the “normative” and “economic” perspectives – do not apply to them. The assessment standards and criteria for the going concern approaches used to date are set out in a separate annex to the internal capital adequacy guidelines.

Principles underlying ICAAP

In the new guidelines, supervisors clarify the scope of the term “ICAAP”, which has not been legally defined, and explain it in the context of the terminology used in the German Banking Act (Kreditwesengesetz – KWG - only available in German) and the Minimum Requirements for Risk Management by Banks (MaRisk - only available in German). According to this, ICAAP is the equivalent of the internal process used to safeguard internal capital adequacy required by section 25a (1) sentence 3 no. 2 of the KWG. In turn, this is primarily characterized by an internal capital adequacy concept comprising an internal capital adequacy calculation, capital planning and supplementary stress tests. Another equally important feature of ICAAP is that it is linked to the development of business und risk strategies on the one hand, and risk management and control processes on the other. This is designed to ensure its integration into processes of integrated performance and risk management.

However, the new guidelines also make clear that no matter what methodology is used or how it is implemented in concrete cases, ICAAP’s goal is to ensure the long-term sustainability of the enterprise concerned, based on its own assets and earnings power. This leads to two conclusions. Firstly, payments expected from third parties that are earmarked to offset the cost of risks that materialise must not be included in the risk coverage potential, since this would be contradictory to the goal stated above. And secondly, approaches that focus exclusively on creditor protection are insufficient, in particular since they do not adequately reflect the need to comply with supervisory ratios, a precondition for continuing an enterprise as a going concern in the long term. This also means that assets that can only be used to cover risks in cases of insolvency or resolution cannot be included in ICAAP.

A key feature of future internal capital adequacy concepts under the new guidelines is the adoption of two perspectives, which adequately reflect the goal of continuing the bank’s operations on an ongoing basis on the one hand and the goal of protecting creditors from an economic perspective on the other: these are known as the normative and the economic perspective.

Normative perspective

In essence, the normative perspective aims to ensure that institutions can meet all regulatory and external restrictions and resulting internal requirements on an ongoing basis. Consequently, this perspective requires all relevant capital ratios –and in particular the Tier 1 capital requirement, the SREP overall capital requirement, the combined buffer requirement and the target equity ratio (“Pillar 2 Guidance” – P2G) – to be treated as performance indicators. Also relevant in this context are structural capital requirements such as the leverage ratio and large exposure limits.

The normative perspective comprises a one-year risk horizon and a capital planning horizon of at least three years. In turn, capital planning must include both a basic scenario and an adverse scenario. This is intended to ensure that the “hard” overall capital requirement (i.e. the SREP overall capital requirement) can be met on an ongoing basis, even under conditions that have a negative impact on an institution’s net assets and financial position.

Since the normative perspective treats supervisory capital requirements as performance indicators, counterparty credit risk, market risk and operational risk are initially calculated using the legal requirements of the Capital Requirements Regulation (CRR). In addition, all material risks resulting from the internal risk inventory are to be included in the normative perspective, to the extent that these can reasonably be limited by means of capital. The amounts are ultimately quantified as part of the economic perspective. It is therefore evident even at this stage that the two perspectives – normative and economic – are inseparably linked and that they can only have the desired management effect if viewed as a whole. The result of the supervisory SREP capital determination, the size of which determines the risk involved, is another input. All these indicators must be updated in a plausible manner during the capital planning process, both for the basic scenario and for the adverse scenario.

The available risk coverage potential comprises those components that have been approved as coverage for minimum capital and stress capital requirements. In essence, this means that, for example, the capital conservation buffer can be used to cover risks arising from adverse scenarios, where these are considered to be sufficiently severe, but not risks resulting from the basic scenario.

Economic perspective

Whereas the normative perspective primarily reflects the regulatory viewpoint, the economic perspective is designed to be independent of supervisory and accounting law conventions. Instead, it mainly focuses on fair values and similar valuation approaches. In other words, the economic perspective mainly serves to safeguard the institution’s economic substance for the long term.

Although the economic perspective ideally adopts the present value to derive risk and risk coverage potential, institutions can also use similar methods. For example, the risk coverage potential can be determined by taking the balance sheet items and then adjusting them for hidden liabilities and hidden reserves. A similar approach could also be taken with reference to risks. Supervisors have also provided an additional simplification option for very small institutions with relatively simple structures: these can use Pillar 1 figures¹ for counterparty credit risk, market risk and operational risk as a starting point and supplement these using present value-based amounts, particularly in the case of additional material risks that are not covered by Pillar 1.

Thus the economic perspective crucially complements the normative perspective and an internal capital adequacy concept hardly seems reasonable without it. In addition to providing a strictly economic perspective that goes beyond accounting and supervisory law, it serves to capture information that is required for the normative perspective. Risks that only become visible in a purely economic perspective must be analysed for their potential effect in the future on profit and loss, own funds and the total exposure amount. These effects are then to be included at the quantitative level in the normative perspective.

Effective date

No concrete deadlines for implementation have been set, since the supervisors have permitted institutions to continue using the going concern approaches in widespread use to date until further notice. This gives nationally supervised institutions sufficient leeway to prepare thoroughly for the new ICAAP regime in the SSM and to make concrete plans for how to integrate new internal capital adequacy concepts in their internal corporate management processes without being put under unnecessary time pressure. However, institutions should make use of this window of opportunity since German supervisors are basically assuming a relatively limited future for the old approaches, due to the efforts to achieve harmonisation within the SSM.

Institutions that previously used “gone concern” (or “liquidation”) approaches are already being called on to start transitioning to the new SSM regime. While migrating to an economic perspective should generally be relatively unproblematic, developing the concept for a normative perspective will undoubtedly demand some effort on the part of these institutions. However, this perspective is crucial since it aims to ensure that all relevant supervisory indicators can be met on an ongoing basis going forward, including in stress situations. This means that the institutions affected will have to progress quickly with implementation.

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