Themed Examination Feedback: Internal Capital Adequacy Assessment Process

Themed Examination Programme 2019:

ICAAP Review

Issued: 12 March 2020

1   Introduction

The Jersey Financial Services Commission (JFSC) regularly undertakes thematic examinations to assess the extent to which the regulatory framework is being complied with. The thematic examinations provide direct feedback to those within scope and a public feedback document which summarises the key findings.

Over recent years, our review of the Internal Capital Adequacy Assessment Process (ICAAP) for Jersey Incorporated Banks (JIBs) has been desk-based. In 2019 we performed onsite examinations as part of these Supervisory Review and Evaluation Process (SREP) assessments. It is important to note that the original requirement for the ICAAP to cover an assessment in respect of capital has been expanded in the Jersey regime, and now includes also a liquidity adequacy assessment, and the recovery plan.

The supervisory expectations for the content, production and use of the ICAAP are set out in the Pillar 2 Guidance Note (Pillar 2 in Jersey), and these are underpinned by the requirements of the Deposit-taking Business Code of Practice, in particular principle 3 (risk management) and principle 5 (financial resources).

2   Scope and methodology

The thematic examinations were conducted by the banking supervision team and were performed throughout 2019. This review consisted of onsite visits to the four major JIBs. The scope of the thematic examination focused on the following three areas, in relation to the content, production and use of the ICAAP:

1. Governance

2. Operational Risk and

3. Recovery Planning.

Our review of ICAAP governance has given insights into the functioning of the Board generally, the role of non-executives, organisational culture, and sign-off procedures more widely.

We explored how the banks assess their operational risk exposures, how these are reported, and the extent to which mitigants are put in place. There is a growing school of thought that the next crisis may stem from the crystallisation of an operational risk. This wide area can include financial crime risk, regulatory risk, fraud, cyber, and a range of other risk types.

Recovery planning was introduced in the Pillar 2 Guidance Note in 2017. Therefore, we wanted to see how well embedded recovery planning is becoming, and how it is being used to complement stress testing and reverse stress testing.

Where appropriate, other risks relevant to an individual bank’s business model was also explored and assessed during the examination. In addition to the core focus areas set out above, we identified common findings in relation to stress testing and reverse stress testing. The SREP assessments were completed desk-based; capital minima and Liquidity Coverage Ratio (LCR) adjustments were agreed with banks individually; and individual examination reports were issued setting out findings.

The JFSC takes this opportunity to thank the JIBs involved for their courtesy and the assistance shown during the examination process.

3   Key findings

3.1   Governance

Good practice We found that in all cases the relevant Board could demonstrate clear ownership of the ICAAP, and the process for its formal review and approval.

Some ICAAPs were particularly readable and were presented in a way that allowed the reader to understand how the different sections interrelated. However, in some cases, the ICAAP did not cover all of the areas expected. One bank had not prepared a recovery plan; one bank had not conducted a reverse stress test; and one had omitted an assessment of the continued appropriateness of the proposed LCR adjustments.

Good practice One JIB ICAAP included a section which detailed the various stages of review that the document had gone through, including listing the challenges received at each stage, and the response to those challenges. It also listed prior year feedback from the JFSC and how those comments had been addressed.

All Boards had received some training on the subjects covered by the ICAAPs and in one case this was provided by an external party. However, in some cases this was becoming historic, and in one case the training was not being driven by the Board’s assessment of its needs.

Good practice One JIB used an external third party to perform a benchmarking exercise, comparing the ICAAP to industry best practice, and making recommendations for improvements.

We observed that JIBs appeared to struggle to coordinate the approval cycles of the various parts of the ICAAP (capital assessment, liquidity assessment, recovery plan). In some cases this meant that the resulting combined assessment was not fully joined up and in one case we felt that the non-executive directors did not have the opportunity to input early enough in the process.

One bank did not formally consider the potential need to update its ICAAP following a material change to its business model.

While many JIBs rely on a small number of people for the production of the ICAAP, one bank in particular had critical key person risk that was a concern to us.

Good practice We found one example where part of a contingency plan had been tried and tested routinely, meaning that staff and Directors were comfortable with triggers, and when and how to take action; the results were also more predictable, based on past experience.

3.2   Operational risk

The banks reviewed each used different methodologies in respect of assessing and quantifying their operational risk. While one bank reviewed could improve its assessment of operational risk through greater use of judgement in interpreting the historical data used, others placed too much reliance on judgement, with very little or no use of any data. We recognise that the quantification of operational risk can be challenging, and encourage JIBs to look widely for data and other inputs – be that historic data from within the bank, insights from the wider group, or evidence and examples from industry more generally.

One bank had not explicitly considered internal and external fraud risk, despite this being a relevant consideration for banks under the heading of operational risk, and specifically set out in international standards (https://www.bis.org/publ/bcbs96.pdf).

3.3   Recovery planning

The Pillar 2 Guidance Note was updated in March 2017 and included new guidance on recovery plans. This revised guidance was applicable to all ICAAPs dated 1 October 2017 or later. Therefore, it was disappointing that two of the four banks assessed had either not prepared a recovery plan, or only had one in draft. We noted that some JIBs were still adjusting their timetable to coordinate the production of their capital assessment, liquidity assessment and recovery plan.

Where recovery plans were in place, we noted that there was clear scope to improve the quality of the plan. In particular, the range and analysis of recovery options, and the range and calibration of early warning indicators (EWIs). For example, in one case there was a potential conflict between the execution of a recovery option as it depended on group resource; this potential conflict had not been acknowledged in the plan.  In some cases there were actions that could reasonably be taken now, to improve the viability of recovery options.

3.4   Stress testing and reverse stress testing

In the performance of their stress testing, two banks did not sufficiently consider their own business model and the concentrations and vulnerabilities that are specific to it.  In order to maximise the benefit and insights of stress testing, it must include stress scenarios that are appropriate for individual business models.

In general we found that reverse stress testing was not performed well. The JIBs reviewed seemed to find it too difficult to ‘stare into the abyss’ and to consider scenarios severe enough that the bank had failed. In one case a bank had not attempted to perform a reverse stress test. In one case the bank had not responded to previous feedback from the JFSC on improvements required in its reverse stress testing.

4 Conclusion

This thematic review has enabled the JFSC to perform a more in-depth assessment of certain aspects of the ICAAP. In each of our focus areas of governance, operational risk, and recovery planning, we identified findings in multiple entities. We also identified some areas of good practice, as highlighted above.

All JIBs involved in the examination have received direct feedback and where findings have been identified, they are (have been or will be) subject to a formal remediation plan submitted to and agreed with the JFSC, setting out actions to be taken and timescales to complete them.

It is expected that the Boards of all JIBs will review this paper and consider whether there are any further improvements that can be made to their ICAAPs. This will assist Boards in ensuring that their risk management is effective, that their financial resources are sufficient, and that their ability to recover from stress is robust.

5   Glossary of terms

Board	Board of Directors
EWI	Early Warning Indicator
ICAAP	Internal Capital Adequacy Assessment Process [note: the original requirement for the ICAAP to cover an assessment in respect of capital has been expanded in the Jersey regime, and now includes also a liquidity adequacy assessment, and the recovery plan]
JFSC	Jersey Financial Services Commission
JIB	Jersey Incorporated Bank
LCR	Liquidity Coverage Ratio
Pillar 2	One of the three Pillars established in Basel II, this covers a requirement for each JIB to assess and record the full range of its risks, the mitigation it applies, and any resultant financial resource requirements in addition to that generated under Pillar 1.
Pillar 2 Guidance Note	The JFSC’s guidance note ‘Pillar 2 in Jersey’ last revised in June 2018.
Recovery Plan	A plan which includes a range of recovery options to restore capital and liquidity adequacy or otherwise mitigate the impact of stresses on the JIB and its customers.
SREP	Supervisory Review and Evaluation Process