COVID-19 pandemic represents the biggest test of financial stability to the financial services sector. Pandemic constitutes unprecedented local as well as global macro-economic stress leading to slowed down economic conditions. Financial system in the country faces the dual challenge to sustain the flow of credit amidst declining growth and to manage the increased risks resulting due to changes in the economic landscape.
The depth and severity of financial shocks are often amplified by inadequate and low-quality capital in the financial services sector. On the other hand, many risks were not appropriately covered by a commensurate amount of capital, owing to weaknesses in banks’ risk identification and assessment. It is therefore of paramount importance to raise the resilience of individual credit institutions in periods of stress by seeking improvements in their forward-looking internal capital adequacy assessment processes (ICAAPs), including comprehensive stress testing and capital planning.
To help banks to navigate these ambiguities, we have thoroughly analyzed the ICAAP practices of the financial services sector in Sri Lanka combined with our own experience in ICAAP reviews and implementations.
The analysis will help banks to understand current practice and serves as a guide to the widespread adoption of leading practices to assist them to grapple with ICAAP:
Most banks can benefit substantially from a greater connection between internal risk and capital models combined with a transparent management process. To enable this banks could consider close involvement of leadership in the formulation of the risk strategy, consider the use of dashboarding of critical metrics to enable the banks to translate risk appetite into operational risk limits.
Achieve closer alignment of capital planning and corporate strategy to ensure the banks achieve the best possible use of their capital.
Enhance stress testing and scenario analysis and regularly revisit the approach to modelling pillar 1 and pillar 2 risk types.
In the local context, the biggest challenge, we have seen is the formulation of the risk appetite statement comprising of qualitative and quantitative elements inclusive of financial and non-financial risk. Banks could consider different approaches when formulating their risk appetite statements.
They could use more sophisticated and refined systems to create a joint perspective on capital, funding and risk and return by including Return on Equity (ROE), Return on Risk-Adjusted Capital (RORAC), Risk-Adjusted Return on Capital (RAROC).
Many of these metrics could play an important role when allowing banks to understand the interdependencies to aid them in formulating risk appetite limits.
Then reconciliation of capital planning and strategic planning is essential to ensure consistency between risk and business strategies. Capital is a scarce resource and banks must consider, as they never have done before, the cost of capital, while still pursuing growth and profits.
The best practice for banks would be to consider a reasonable alignment of their annual planning process, to ensure the growth of business adequately deliberate and compliment the capital planning process to maximize the profitability of the institution.
To deliberate, this topic further, join us for the discussion with Sanath Fernando & Rajith Perera “ A Likely Story?” a quick guide to the practical application of ICAAP and stress testing organized by the Financial Accounting Advisory Services (FAAS) Academy of training of Ernst & Young, Sri Lanka, on 30th September 2020 from 9.00 am to 12.00 noon, at JAIC Hilton Colombo. For registrations please contact Thilini Perera on [email protected] or 0115578859.
