• Daniel O’Neill, Head of Capital and Liquidity Management Models at Nordea


• 02.08.2018 11:13 am

Ahead of the 22nd Annual Bank Capital Management Conference , we spoke with Daniel O’Neill, Head of Capital and Liquidity Management Models at Nordea about Pillar 2 capital and the key changes as a result of ICAAP.

To view the Conference Agenda, click HERE!

What are some of the key findings from the recent stress tests? What is the impact of this on capital management?

From a pure quantitative results perspective, the economic recovery since pre 2010 has seen the resilience of the banking sector generically improving. CCAR, PRA, EBA and European local stress tests have generically shown increased financial robustness and greater sector stability. Individual banks facing specific risks, often related to market and conduct risks, naturally continue to face particular scrutiny from regulators and enhanced public disclosures has led to greater market scrutiny alongside this. 

More importantly, regulators, markets and firms, are now typically shifting their focus from analysis of the stress testing quantitative results only to include a focus on understanding why the stress has the impact it does, and what actions are available to the firm to provide mitigation. A couple of examples include the removal of the pass/failure rate in the EBA stress and a focus on qualitative plans for CCAR. 

This change in emphasis has seen regulators and markets alike being able to focus on the behaviours that might take place in stress, while allowing the banks management bodies to become comfortable with the fact that assessments of capital sufficiency are grounded in the behaviour of the bank and its clients, rather than relying on the robustness of the models used to generate the results. 

In doing so, stress testing allows firms to calibrate risk appetite and strategy, and provide insights into business planning. With an emphasis on understanding the drivers of the P&L under any market condition, tied business planning and stress testing is allowing firms to not only have greater clarity on the timing and magnitude of capital demand, but also to understand the indicators and drivers of how this may change in future. As such, one of the key trends in stress testing is the insight generated for the management body and ongoing management practices rather than the quantitative outputs. 

Can you please explain what goes into Pillar 2 capital?

Pillar 2 is a long established concept under Basel II. Pillar 2 is intended to capture a firms own view of risks, focused mainly on those that are not already captured under Pillar 1.

Specifically, Pillar 2 can be thought of in two parts:
1. Risks that are not appropriately captured in Pillar 1. Although many firms use internal models to capture risk, they may still not represent a true internal view of risk. For example, the IRB formula for calculating credit risk, applies fixed portfolio correlation values that may be inappropriate for a given firm. Similarly, regulatorily imposed floors on risk weights, may suit regulatory objectives, but may distort internal decision making.

2. Risks that are not captured at all in Pillar 1. Such risks vary by firm and typically require a well thought out risk taxonomy. Many risks do not require capital and are managed in other ways, but at the same time there are many risks that do.
As always, the objective of capital measurement is not only to calculate a minimum own funds requirement. Part of the objective, is to ensure, that ongoing transactional decision making and strategic decision making incorporate the full suite of risks faced by the bank. Pillar 2 can be thought of as the mechanism by which the firm internally gains comfort that its risks are understood, quantified, and incorporated into decision making without relying solely on external regulatory or other market requirements. Pillar 2 therefore, in conjunction with Pillar 1, is a vital tool for allowing senior management to feel comfortable that their decisions are based on a solid risk foundation. 

Can you please expand on the key changes as a result of ICAAP and its impact on capital allocation across the business mix?

In many ways, banks have increasingly focused on understanding the behaviours that are encouraged by their capital mix. As a result, the ICAAP process is increasingly focused on ensuring that capital allocation supports both strategy and transactional decision making, in highlighting those products where banks can achieve sustainable earnings. Such knowledge helps steer the business mix, by both helping to define the boundaries of the portfolio (as per the risk appetite), and provide direct and objective criteria over which to select individual transactions. 

What is the potential impact of fragmentation on how banks design and implement stress testing methodologies?

Fragmentation of banks, and the potential data issues that this often creates, can have a large impact on the meaningfulness of results. This can be partially offset by ensuring a strong management actions process, a strong review, and challenge process. 
Many banks however, have made substantial progress in minimising the fragmentation through enhanced data, more advanced scenario generation processes, and introducing common data collection and analysis templates. Such tools can therefore assist in minimising the impact on fragmentation due to organisational structure. A focus for the future on the other hand, is how to meaningfully integrate the various risk types into one coherent firm wide stress.

What would you like to achieve by attending the 22nd Annual Bank Capital Management Conference?

As with most people, I personally see the requirements around regulation as being more about ensuring the risk is understood and that it influences decision making throughout the organisation. Since there is unlikely to be one perfect solution to achieving this, as an industry, we can learn a lot from the knowledge and experience of our peers. I would personally hope to gain insight into some of those approaches to capital management that have been tried and failed, as well as those that have worked well.