Storm clouds ahead:
preparing your ICAAP in 2018
Preparing the ICAAP is always a challenge. The sheer level of input required from senior leaders from across the business is staggering, never mind the complexity of the financial and capital models that underlie the analysis. Those who take on the task of bringing the ICAAP together are modern day banking heroes.
2018 looks to be a year with several challenges, not least the impact of IFRS 9 and Brexit. A storm is brewing and failure to plan and address the potential issues now could signal a rocky road ahead.
In October 2017 the PRA issued a clarification for 2018 ICAAP stress testing and capital planning to address the issues caused by the implementation of IFRS 9. The clarification applies to any bank that reports under IFRS, FRS 101 or FRS 102 and have opted to use IFRS 9 for their financial instruments.
The clarification was expected, given that IFRS 9 is effective for annual periods beginning on or after 1 January 2018. The PRA expects the affected banks to prepare their ICAAPs based on accounts as at 31 December 2017 on an IFRS 9 basis. This means that the starting point for stress testing and capital planning should be the IFRS 9 balance sheet on 1 January 2018 (for banks with a 31 December year end), not the closing IAS 39 balance sheet they will have reported at 31 December 2017. ICAAP heroes should also note that equivalent IAS 39 data will need to be included in the ICAAP so that the PRA can understand day one changes.
Many banks have been working hard on their IFRS 9 transition projects and some will be in a position to report the impact of adopting IFRS 9 at 31 December 2017. Others, particularly the smaller banks, are less advanced. The first set of IFRS 9 numbers will not be required for external reporting until the first COREP returns are submitted in May 2018 – this may be too late for the ICAAP process. The ICAAP does not just require the point in time adjustment at 1 January 2018, banks will need to amend their financial and capital models to align them with IFRS 9 in order to run base and stress scenarios on this basis. Changes to capital models are not always straight forward and may produce unexpected results. For example, the impact of accounting for expected credit losses under IFRS 9 is likely to be highly sensitive to changes in economic conditions for some. Banks may find increased volatility in capital ratios in base and stress cases, which may in turn require Banks to reassess mitigating actions available to them or amend plans going forward.
An EBA survey conducted earlier in the year indicated that the average estimated impact of IFRS 9 on CET1 ratio is a 45 basis points (bps) decrease. In the same survey smaller banks (generally using the standardised approach to credit risk) reported an average decrease in CET 1 ratio of 78bps due to implementation of IFRS 9. These figures are before taking into account transitional provisions.
Modelling will also be complicated by the need to reflect any transitional arrangements in the calculations. The PRA made clear its support for the transitional provisions (as currently drafted) and has encouraged banks to use them from the first day of IFRS 9 application. Banks need to make a decision on this and inform the PRA of their intentions.
The PRA has promised to use the results after adjusting for the transitional provisions as the basis for its supervision. However ICAAP heroes should also note the PRA expects to see ‘fully loaded’ (i.e. excluding transitional adjustments) capital forecasts for the base and stress scenarios in the ICAAP so they can better assess the capital modelling undertaken.
Be warned, for banks unable to incorporate the impact of IFRS 9 in the ICAAP or unable to adequately assess the impact of a stress on the bank’s IFRS 9 capital position the PRA has not ruled out increasing the PRA buffer.
In addition to the IFRS 9 issue, the ICAAP preparer will have to grapple with the wider risks posed by Brexit and the lack of certainty over the UK’s future relationship with the EU. For some this will mean factoring in the impact and the costs of any planned restructuring, for others it will mean thinking carefully about any potential impact on the wider UK/EU economy and the knock-on effect this might have on future business. The general slowdown of the UK economy, rising consumer debt, faltering housing market as well as global macroeconomic and political uncertainties will also impact on business planning assumptions and financial forecasts in the 2018 ICAAP.
ICAAP heroes need to start planning now to prepare for the challenges ahead.