10. Case study on the assessment of capital adequacy

Alessandro Nardi, Slavka Eley, EBA, Supervisory Convergence Unit

21-22 April 2016 | EBA Seminar on SREP Guidelines

In the previous section we have learnt the main concepts and characteristics of the capital

adequacy assessment introduced by the SREP guidelines. We are now going to implement all

these in practice through a simple case study which should help fixing them in our minds.

The case study is based on a hypothetical bank with a simplified balance sheet. You will be

provided with fundamental information coming from the supervisory risk assessment and with

estimates of capital needs from the ICAAP and supervisory benchmarks.

What you’ll be asked to do is filling the table 2 of the Annex 4 of the ITS on Joint decisions on

institution specific prudential requirements based on the information provided in order to

calculate the TSCR and OCR, which will require very little computational effort.

Once initial capital requirements are determined, the next step will be analysing the outcome of

supervisory stress test and the determination of any additional measure to the requirements set

at the previous step.

The final step will the scoring of capital adequacy, which is mainly qualitative

Introduction (no to be projected but recorded as Audio)

2

The case study will help you better understanding

- The relationship between risk assessment and capital adequacy

- The use of supervisory benchmarks for determining additional capital requirements

- The application of the principles behind the determination of capital add-ons (Risk by risk

assessment, Pillar 1+ approach, treatment of inter-risk diversification)

- Interaction between micro and macro prudential requirements

- TSCR articulation

- The use of stress test in SREP

- The scoring of capital adequacy

Objective

3

Euro Bank: overview

Euro Bank

Country A

Branch 1

Country B

Branch 2

Country C

Branch 3

Country D

- Retail bank, mainly focused on mortgages and financing to local SMEs active in the real estate and import/export businesses (through foreign branches)

- Trading activity limited to treasury and driven by customer needs

- Offer of investment and insurance products to customers also through external

- Funding relying on customer deposits

Business model

4

Non-significant

Country A - 2 year recession - Rise in default rates

and credit spreads - Drop of real estate

market Country B, C, D Stable and strong economies not showing deterioration

Economic environment

Systemic Importance SREP category 1; O-SII

Solvency ratios CET 1: 9.37% ; TCR: 14.73%

Combined buffer Capital conservation buffer: 1% O-SII: 1% SRB:1%

Supervisory info

Assets Liabilities

Interbank loans 15

Loans to customers 55

of which: Central Bank 5

retail mortgages 25 Interbank loans 11

consumer revolving loans 5 Other debt instruments 13

other retail loans 3 Tier 1 eligible debt 4

corporate loans 22

Cash 10

Other assets 10

Total 100 100

Banking Book

Government bonds 10 Deposits from customers 60

Equity 7

Trading Book

Simplified Balance sheet

5

Concentration on Real Estate sector

Low coverage ratio 30% of NPL Material credit and operational losses

High Cost\Income Optimistic P&L forecast

Includes real estate

developers

Credit Quality

Total loans 70

Non Performing (gross) 10

Non Performing (net) 7

Current year

NIM 5

Fees 1

Costs -3.5

Credit losses -1.5

Op losses -0.5

EBT 0.5

Net profits 0.25

P&L

Forecast

NIM 8

Fees 1

Costs -4

Credit losses -1.5

Op losses -0.5

EBT 3

Net profits 1.5

P&L

Risk assessment

Business model analysis: business focused on lending to retail customers, which are now being hit by the

economic slowdown. Future strategy aimed at increasing exposure towards highly rated SMEs exporting to

stronger economies (sector with high competition) and towards local consumer revolving loans (highly

risky). Cost /income ratio above peers. Score 4

Internal governance: generally robust internal governance with regular reporting and involving of the

Board in all strategic decisions. Adequate control system, but struggling with embedding risk appetite (in

particular operational risk) in business decisions. Score 3

Credit risk: The bank’s book has experienced a material deterioration of credit quality due to prolonged recession

which led to a material increase of the NPL ratio (to 13% of total loans to customers). The coverage ratio (30%) is

lower than peers in Country A (45% on average).

High exposure concentration to real estate sector (retail mortgages and real estate developers) which

counts for 50% of the loans. Material concentration on some single names. Observed increase of exposure

to risky consumer revolving loans. Score 4

Operational risk: operational risk losses are on the rise due to litigation costs and redressing of customers’ losses

for wrong advisory on investments (+300% YoY). The number of outstanding customer complaints has increased.

The bank has reviewed its product catalogue and is undertaking a massive review of customers’ profiles for a more

consistent offer starting from the next months. The bank is subject to Standardised Capital Requirement. Score 4

Market risk and IRRBB: these risks are present but not very significant. Trading mainly aimed at covering FX risk

arising from FX lending. IRRBB risk related to mismatch between long term funding and lending. Score 2

No other material risks identified.

6

ICAAP assessment (quantification only)

- The bank uses the standardised approach for P1

requirements. For ICAAP an IRB-Foundation-like

capital is adopted for performing exposures based

on ‘managerial PDs’ used for pricing and risk

monitoring

- Expected Losses > accounting provisions

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- The supervisory benchmark applies a multiplier

to P1 credit risk requirement, which takes into

account the concentration risk and the shortfall

(difference between EL and provisions)

Credit risk

ICAAP Sup Benchmarks

- The bank use IMM (internal model method) for

Pillar 1 (which entails the sum of stressed and

unstressed VaR). For Pillar 2, the max of unstressed

and stressed VaR is considered

- The bank uses the same IMM adopted for market

risk. The ICAAP covers prepayment and optionalities

and assumes a lower duration for sight deposits (2

year) compared to market convention (3.5years)

- Simplified model (duration gap) based on a 200

bps shock. Sight deposit duration equal to 3.5

years

- Judgmental capital buffer equal to 10% of P1

requirements

- Qualitative correction factor based on

Equity/Sovereign 5yCDS weighted by market/credit

exposures

- Standardised approach for P1. Scenario analysis for

ICAAP

- Peer analysis with other banks using AMA and

with similar operational risk profile

Market risk

Op Risk

IRRBB

Systemic risk

Diversification

- Systemic risk assessed in case of non-SII.

Benchmark = 1% of market share of deposit

NA

NA

Capital adequacy assessment

8

Risk quantification

• Risk by risk

• Add-ons

SREP Capital

• TSCR

• OCR

Capital Adequacy

through the cycle

• Supervisory Stress Testing

• Review of TSCR/Capital plan

- Are all risks considered? - Is the Pillar 1+ approach applied?

- Is the quality and composition of own

funds adequate?

- What measures should be adopted? - Capital plan? - Increase of TSCR?

Risk Quantification

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Pillar 1 capital

requirements,

where

applicable

(in mln EUR)

ICAAP estimate

(in mln EUR)

Supervisory

benchmark

A. Business Model 0 N.A. ?

B. Internal governance arrangements 0 N.A. ?C.

C.1 Credit and counterparty risk 4.80 4.00 6.00 ?C.3 Inter-concentration risk 0.00 0.00 ?C.4 Market risk 0.80 0.40 N.A. ?C.5 IRRBB 0.20 0.30 ?C.6 Operational risk 0.375 0.25 1.00 ?E. Systemic risk 0.50 0.00 ?F. Inter-risk diversification effects -0.60 0.00 ?

G. Capital planning / stress test buffer 2.00 ?

SREP elements

Overall SREP

capital

requirement/est

imate

(in mln EUR)

Risks to solvency

Determination of TSCR and OCR and of capital adequacy (first step)

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Pillar 1 capital

requirements,

where

applicable

(in mln EUR)

ICAAP estimate

(in mln EUR)

Supervisory

benchmark

Overall SREP

capital

requirement/est

imate

(in mln EUR)

Overall capital estimate - TSCR (in mln EUR0) 5.98 6.75 7.3 ?Capital adequacy assessment (capital is assessed as

adequate/inadequate)

TSCR ratio and composition ?

H.

SREP capital outcome (preliminary proposal for joint decision discussion)

Total own funds (mln EUR) at reference date 11.00

Tier 1 own funds (mln EUR) at reference date 4.00

Common Equity Tier 1 own funds (mln EUR) at reference date 7.00

Total risk weighted assets (TREA) (mln EUR) at reference date 74.69

The level of the capital conservation buffer that the institution is

required to maintain in accordance with Article 129 of Directive

2013/36/EU

1%

The level of the institution-specific countercyclical capital buffer

to be maintained by the institution in accordance with Article 130

of Directive 2013/36/EU

0

The level of any systemic risk buffer that the institution is

required to maintain in accordance with Article 133 of Directive

2013/36/EU

1%

The level of any G-SII buffer or O-SII buffer that the institution is

required to maintain in accordance with Article 128(3) and (4) of

Directive 2013/36/EU

1%

Memoranda items (values at reference date)

HP: Pillar 2 add-ons imposed only in form

of CET1 and AT1

Capital adequacy assessment (second step)

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NB: Current macro-economic conditions do not pose a threat of imminent risk of breaching TSCR

EUROPEAN BANKING AUTHORITY

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