DNB Liquidity Pillar 2 Supervision. Seminar Das neue SREP Konzept der Aufsicht Clemens Bonner (c.bonner@dnb.nl)

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1 DNB Liquidity Pillar 2 Supervision Seminar Das neue SREP Konzept der Aufsicht Clemens Bonner (c.bonner@dnb.nl)

2 Legal framework Act on Financial Supervision (Wft) Decree on Prudential Rules pursuant to the Wft 2011 Liquidity regulation pursuant to the Wft LCR like monthly reporting since 2003 (adjusted as of May 1st 2011) 2011 Liquidity policy rule pursuant to the Wft Introduction of the ILAAP requirement as of July 1st

3 Overview- ILAAP & Pillar 2 Timeline September 2008: Publication of the BCBS Principles for Sound Liquidity Risk Management and Supervision June 2011: Introduction of Dutch Internal Liquidity Adequacy Assessment Process (ILAAP) From November 2011: quarterly data submissions by banks allowing DNB to carry out a quantitative Pillar 2 assessment and annual submissions of banks qualitative and quantitative risk management information 2012: Formal implementation of funding assessment framework 2013: Formal implementation of top-down liquidity stress test Main purpose of Liquidity Pillar 2 Encourage firms to develop and use better risk management techniques in monitoring and managing their risks Ensure that firms hold internal capital and liquidity buffers that are consistent with their risk profiles and strategies

4 ILAAP and ICAAP Joint but different Risk profile based on FOCUS assessment Qualitative assessment of the controls (EBA principles) ILAAP received from Bank Quantitative assessment ICAAP received from Bank SREP assessment of capital and liquidity buffers Stresstesting

5 The Liquidity SREP process Identification of themes Identification of Themes Banks prepare ILAAP and data submissions Assessment and benchmark sessions DNB Panel and decision making Communication to banks Identification of themes: points of attention which can be specific (i.e. asset encumbrance) but also more general (i.e. funding risks) Assessment and benchmark sessions: Initially split in qualitative and quantitative workstreams, which later come to a joint assessment per bank (includes several meetings with the banks). In the benchmark sessions, outcomes for the individual banks are compared and discussed to ensure a level playing field. DNB Panel and decision making: Panel members are managers of Supervision, Supervision Policy and Financial Stability divisions (to cover both micro and macro). In the panel session, proposed feedback to the bank is discussed and formally approved. Communication to banks: Each SREP round ends with a formal letter communicating the results of the assessment as well as potential measures

6 Main elements of an ILAAP package Sign off by (a member of) the board of directors Readers manual Overview of the group structure including intra-group (or intra-company for branches) cash flows Documents along the lines of the BCBS Sound Principles, such as: Stress testing Funds Transfer Pricing Risk tolerance and strategy, etc. Completed ILAAP self-assessment template Completed ILAAP Data Template: Balance sheet in 3 major currencies, behavioural and contractual maturity calendar, breakdown of liquidity buffer, funding plan, asset encumbrance, stress testing Explanatory note with details on interpretations made regarding the data template or with details when instructions were not followed as well as explanation on the scope (group / solo) of the report; An ILAAP-process description, including the governance of the ILAAP; An overview of relevant findings by the Internal Audit Department;

7 Building blocks and assessment Short-term liquidity risk Pillar 1 requirement LCR and NSFR Liquidity Stress Testing Long-term funding risk Concentration of funding Asset encumbrance Long term maturity mismatch Currency mismatch Market access External factors Assessment of liquidity and funding risk Mitigating actions required from the bank Strength of governance Risk management Quality of risk management Self assessment Audit

8 Building blocks and assessment Short-term liquidity risk Pillar 1 requirement LCR and NSFR Liquidity Stress Testing Concentration of funding Long-term funding risk Asset encumbrance Long term maturity mismatch Currency mismatch Market access External factors Assessment of liquidity and funding risk Mitigating actions required from the bank Strength of governance Risk management Quality of risk management Self assessment Audit

9 Short-term liquidity risk Dutch Pillar 1 liquidity requirement Compares expected outflows under severe stress with possibilities to generate liquidity Similar to Basel III LCR; more strict on outflow assumptions, more lenient on collateral recognition 1 week & 1 month requirement LCR and NSFR Although not a formal requirement yet, important part of assessment Especially banks migration plans receive attention Stress test Top-down and bottom-up with stress horizons up to 5 years Top-down is used to challenge and benchmark banks internal stress test results Idiosyncratic, marktet-wide as well as combinations Takes into account banks capital and funding position as well as quality of risk management Compliance with Pillar 1 requirement during stress is tested Functions as binding component

10 Building blocks and assessment Short-term liquidity risk Pillar 1 requirement LCR and NSFR Liquidity Stress Testing Long-term funding risk Concentration of funding Asset encumbrance Long term maturity mismatch Currency mismatch Market access External factors Assessment of liquidity and funding risk Mitigating actions required from the bank Strength of governance Risk management Quality of risk management Self assessment Audit

11 Long-term Funding risk 1. The bank s funding sources are well diversified 2. The characteristics of assets and liabilities match 3. No excessive asset encumbrance 4. The bank is active in important funding markets 5. The bank s liquidity buffers are sufficient to withstand prolonged periods of stress 6. The bank s reputation is not at stake (external drivers) Overall assessment of sustainability of funding model Assessment of structural soundness of banks funding models Longer horizon than LCR and stress tests View on market access during times of stress Limits set during ILAAP evaluation but not a minimum requirement Higher risk of unsustainable funding model leads to increased liquidity or capital requirements

12 Building blocks and assessment Short-term liquidity risk Pillar 1 requirement LCR and NSFR Liquidity Stress Testing Long-term funding risk Concentration of funding Asset encumbrance Long term maturity mismatch Currency mismatch Market access External factors Assessment of liquidity and funding risk Mitigating actions required from the bank Strength of governance Risk management Quality of risk management Self assessment Audit

13 Quality of risk management General Liquidity risk management: General Principles Governance Public disclosure Liquidity focused Liquidity risk tolerance and risk appetite Identification and measurement Contingency Funding Plan (CFP) Intraday liquidity risk management Internal stress testing frameworks Collateral management Funding focused Intra-group relationship and currency risks Funding Strategy and market access Fund Transfer Pricing

14 Quality of risk management Contingency Funding Plan (CFP) Internal stress testing frameworks

15 Stress testing Many banks see stress tests as academic exercises to fulfil supervisory expectations However, they should be based on realistic assessments of what can go wrong Important types: Idiosyncratic Market-wide Combined Reverse stress testing Periods: 3 to 12 months Documentation is very important: the regulator should be able to replicate the stress test and understand underlying assumptions

16 Stress testing Scenario assumptions: Complete dry-up of unsecured interbank markets Secured funding is more stable but maturities will shorten Especially complex products will suffer very high haircuts Retail deposits also entail liquidity risk (especially in idiosyncratic stress) Margin calls associated with derivatives increase in the volatility of the underlying asset. Legal impediments on the transfer of liquidity can cause major issues It is difficult to stop lending (roll-over) to retail and corporates Some run-off rates for idiosyncratic stress: Retail: 10% to 15% Unsecured: 100% Corporate: 40% to 60% Committed facilities to SME/corporates (20%) and to banks (100%) Haircuts (depending on rating) Government bonds (5% to 25%) Covered bonds (15% to 70%) ABS (20% to 70%) Equities (25% to 60%)

17 Contingency Funding Plans If liquidity suddenly evaporates, managers have a very limited amount of time on their hands to act. A plan helps in such a situation Some key questions: Which assets can be more easily sold? What is the estimated price of these sales? Which emergency funding sources may be available? At which cost? What should be done first? Who are the key contacts? Key elements: Roles and responsibilities (procedures, responsibilities and lines of authority to be activated) Early warning indicators (definition of liquidity events and triggers for applying contingency funding plans) Measures (escalation levels and action plans to enhance liquidity management) Communication (procedures for enhancing internal and external communications) Reviews and tests Important: CFP should be practicable with a clear link to liquidity stress tests

18 Other points of attention Funding Strategy Funds Transfer Pricing Intraday liquidity risk management Data quality

19 ILAAP: linking the principles Bank Business Model Basic Questions: Does the risk appetite correspond with the business model? Has the risk appetite statement been implemented in the risk appetite framework? Are there limits in place that correspond to the risk tolerance? Have stress tests been used to establish limits and buffers? Is the CFP a good fit and are there clear triggers and actions? (linked to stress test)

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21 How to determine adequacy? Green / 1 = all principles fulfilled Yellow / 2 = Improvement Requirement Orange / 3 = Non Compliance Red / 4 = Non compliance, and risk requires Immediate intervention Overall Assessment 2 Qualitative Criteria Risk Appetite Management Fund pricing Measurement Data integrity Trend analysis Balance sheet Maturity calendar Consolidatie Funding Intraday Collateral Limits Buffer Stress test Forecasts Stress test Contingency plan Liquid assets Publication Assessment of Liquidity Adequacy 2 Quality of ILAAP package 1 Quantitative Criteria Risk Control Risk Position

22 Potential Supervisory Measures Outcome of SREP can refer to both qualitative and quantitative deficiencies In case of deficiencies in risk management, quantitative measures are used as short-term measures and incentives Potential quantitative measures: Higher buffer requirement (increased liquidity requirement) Minimum excess liquidity buffer on top of 100% requirement Limits on concentration of less liquid assets in the buffer Limit on maturity mismatches, foreign currency funding, asset encumbrance Potential qualitative measures: Revision of specific parts of ILAAP (i.e. connect CFP to stress testing results) Broader changes to the banks governance structure

23 Thank You