The stark reality of business’ bottom line was undoubtedly unearthed as a result of the COVID-19 pandemic and the demand it created to hasten the response to transformational needs. Stress Testing in the Internal Capital Adequacy Assessment Processes (ICAAP) is no longer an option today. It is how financial institutions can ensure sufficient capital is maintained.
The COVID19’s reality test showed how important this analysis is which highlights the gravity of what institutions were undertaking in the past, way beyond.
For financial service institutions of all sizes the new normal brought significant stress on capital positions. The depth and severity of financial shocks may intensify if inadequate and low-quality capital exist in the financial services sector. On the other hand, risks intensified as a result of the pandemic may not be appropriately covered by an equally matching amount of capital volume because of the consideration of conventional risk identification and assessment. It is why raising the resilience of individual institutions in periods of stress is critical. It will help improve the forward-looking Internal Capital Adequacy Assessment Processes (ICAAPs).
A high-profile deliberation on this crucial theme conducted by Rajith Perera, Partner, Financial Accounting Advisory Services of Ernst and Young titled “Testing Times”– A Quick Guide to Practical Application of Integrated Stress Testing will be held on 29 March 2020 in Colombo.
Even though the larger exposure to stress on capital is due to Pillar 1 risks (minimum regulatory capital for credit and market and operational risk) financial institutions cannot underestimate the effects of the Pillar 2 risks (such as Liquidity Risk, Reputational Risk, Cyber Risk & etc) which could intensify due to the adverse impacts of the Pandemic. As a result, banks may not be able to rely on traditional stress testing and risk measurement techniques (locally and globally) resulting from economic slowdowns and pressures.
Internal Capital Adequacy Assessment Process (ICAAP) ensures financial institutions hold capital volumes matching the risks in Pillar I and Pillar II. Therefore, risk identification and assessment and applying appropriate magnitude of shocks are important than ever. Common weaknesses seen in current practices of financial services include stressing risks in isolation, limiting stress testing to sensitivity analysis, not considering the impact of macro-economic variables, lack of rationale for application of stress testing methodologies.
To help banks to navigate these ambiguities, EY teams have thoroughly analyzed the ICAAP practices of the financial services sector in Sri Lanka combined with the EY organization own experience in ICAAP reviews and implementations. The analysis will also help banks to understand the current practices and serves as a guide to the widespread adoption of leading practices to assist banks implement ICAAP especially during these most challenged times for financial stability in the financial services sector.
Financial Institutions can make ICAAP more meaningful by integrating unprecedented conditions resulting from Corvid19 pandemic scenario into Stress Testing. Key criteria in implementing a stress testing mechanism requires to look at the impact on to all forms of risks faced by the financial institutions covering Pillar 1 and Pillar 2 Risks. Modeling methodologies adopted by Banks should capture behavior of macroeconomic variables along with hypothetical scenario definition and selection of macroeconomic factors based on balance sheet structure and risk profile of a bank.
Also stress testing should be dynamic and forward looking – i.e. factor-in business growth plans, structural shifts in funding profile, and capital strategies. Integrated stress testing provides a framework to assess vulnerabilities in the balance sheet that impacts more than one area of risk.
Risk management best practices are at the heart of Pillar 2. Quantification of risks has become a more significant aspect of Pillar 2 especially during the post pandemic. Banks must undertake an ICAAP that looks at all risks to which the bank is exposed. Senior management should understand the nature and materiality of Pillar II risks inherent in the Bank’s activities. Regulatory provisions issued by Central bank on ICAAP requires stronger alignment between risk and capital. This is to ensure there is solvency under normal and stress conditions such as epidemic, global financial recession etc. is intact.
Considering current context of rapid digitalization, working from home arrangements, and increased usage of online platforms for day-today activities, it’s prudent to have tools and methodologies to assess different forms of Pillar 2 Risks.
Economists, banking and financial service professionals and others decision makers interested are invited to join for further deliberations on this crucial theme with Rajith Perera, Partner, Financial Accounting Advisory Services of Ernst and Young, Sri Lanka in “Testing Times – A Quick Guide to Practical Application of Integrated Stress Testing” session organized by the Financial Accounting Advisory Services (FAAS) division, on 29 March 2021 from 9.00am to 01.00pm, at JAIC Hilton Colombo. For Registrations contact Thilini Perera on Thilini.firstname.lastname@example.org or Tel. 0115578859.
Photo – Rajith Perera, Partner, Financial Accounting Advisory Services of Ernst and Young, Sri Lanka