The following guidance provides a description of the methodology used for assessing the capital adequacy of banks as part of the Supervisory Review and Evaluation Process (SREP).

1 Introduction

Capital adequacy is defined as a bank’s ability to maintain adequate levels of capital over time from both the normative and the economic perspective. It is assessed by means of a quantitative assessment (risk level) and an ICAAP^[1] assessment (risk control), which looks at the effectiveness of the bank’s capital management strategies, methodologies and processes.

Figure 1

The capital adequacy assessment consists of a quantitative assessment and an ICAAP assessment

Capital adequacy is a fundamental prerequisite for a banks’ viability. Consequently, the quantitative assessment is a core assessment, meaning that it is mandatory in every SREP cycle. JSTs also assess some aspects of the ICAAP, such as the quality of banks’ baseline and adverse capital planning scenarios and projections, every year in parallel.

The ICAAP assessment is subject to the SREP multi-year assessment. A peculiarity of capital adequacy assessments is that there is no phase 1 or 2 in either the quantitative part or the ICAAP assessment. Accordingly, the assessment methodology does not foresee a sub-structure along the three phases required for other SREP assessments.

The capital adequacy assessment and score under SREP element 3 is a combination of the quantitative assessment and the ICAAP assessment, applying supervisory judgement.

The ICAAP (ICAAP packages, bank-internal risk reports, etc.) is a key information source regarding banks’ current and forward-looking capital adequacy, analysed both from the normative and the economic perspective.

JSTs assess the reliability of the ICAAP figures as part of the ICAAP assessment. There is a feedback loop between the quantitative assessment and the qualitative assessment of the ICAAP. Material weaknesses in the capital management framework identified in the ICAAP assessment − and in particular in the assessment of management actions, stress testing, risk quantification methodologies, internal capital definition and data quality − inform the quantitative assessment of the bank’s capital adequacy.

Such qualitative weaknesses in banks’ risk management increase the level of uncertainty around the available risk and capital figures. JSTs form a view on this level of uncertainty when performing the quantitative capital adequacy assessment.

2 Risk level – quantitative assessment

2.1 Assessment overview

The quantitative assessment of a bank’s capital adequacy involves assessing its ability to comply with all the relevant regulatory capital requirements, guidance and other capital needs. The JST assesses the extent to which the bank’s capital position raises doubts about its ability to sustainably follow its business model. When doing so, they consider the normative and the economic perspectives both in the current situation and over the medium term, in normal and stressed conditions.

The principle of proportionality is applicable, allowing the JST to focus on the aspects most relevant to the nature, scale and complexity of the bank’s activities. Banks with tight projected capital headroom or high uncertainty around their capital projections are scrutinised more closely; conversely, a lighter assessment is possible for banks with sound capital management frameworks that can evidence large projected capital headrooms under baseline and severe adverse scenarios. The objective of the quantitative capital adequacy assessment is to assess the bank’s capital position and projections, conservatively taking into account uncertainties and deficiencies revealed in the assessment.

The JST determines the main drivers of the quantity and quality of the bank’s capital and how these are likely to evolve over time. In addition to the bank’s individual situation, the JST also takes into account market expectations and the bank’s situation compared with its peers.

Capital headrooms to be considered in the assessment cover the whole range of capital metrics. This includes all relevant tiers of risk-based capital ratios, in excess of the regulatory and supervisory requirements and guidance, the leverage ratio, MREL/TLAC requirements and the relation between capital availability and capital needs in the normative and the economic perspective of the ICAAP.

2.2 Current and forward-looking capital situation

Quantitative capital adequacy assessments start with the current capital and MREL situation, including a short analysis of changes in the capital position since the previous assessment. The current capital adequacy is determined explicitly by combining the supervisory assessment of the regulatory and the economic capital positions. It also includes an assessment of the quality of available capital, reflecting the composition of CET1 components such as the amount of deferred tax assets, the volatility of other comprehensive income, the share of minority interests and the relevance of unrealised losses.

In the case of banking groups, the assessment of the current capital situation also encompasses the capital allocation across the group.

After assessing the current capital position, the JST assesses the extent to which the bank’s capital and MREL projections accurately capture the potential impact of material risks to capital and other relevant impacts (e.g. dividend payments, profitability). The forward-looking assessment horizon covers at least three years, under both baseline and adverse conditions. At the same time, potentially material impacts on capital adequacy beyond that horizon are also considered. This includes factors like the potential increase in macroprudential capital buffers, the implementation of the Basel III final package and the management of climate and nature-related risks.

The assessment takes into account the relevant sources of uncertainty and deficiencies around the projections identified in the ICAAP assessment, considering the following four elements:

• Capital plan information
• Design of capital planning scenarios
• Translation of scenarios into capital projections
• Plausibility of capital projections

2.3 Assessment outcome

The JST performs a comprehensive assessment of the bank’s current and forward-looking capital adequacy, from both a normative and an economic perspective. To do so, it builds on the reviews conducted mainly in the ICAAP assessment regarding the comprehensiveness and reliability of information submitted by the bank, the assumptions and methodologies used for producing the capital projections and the plausibility of the projected figures.

In conclusion, the JST forms a view on the current and, in particular, the future capital head-rooms (adjusted where relevant) in both the baseline and the adverse scenarios, considering the normative and the economic perspective and after conservatively taking into account uncertainties.

The JST formalises its assessment in a narrative and a score. Scores are used as a means of summarising supervisors’ views and facilitating high-level, cross-sector comparisons and communication. The JST judges all elements assessed from a holistic perspective (including the results of internal and supervisory stress testing) and assigns the score that best reflects the capital adequacy situation overall.

The JSTs use qualifiers^[2] which allow for better differentiation between banks’ capital adequacy situations.

3 Risk control – ICAAP assessment^[3]

3.1 Assessment overview

A good ICAAP gives supervisors an increased level of confidence in the bank’s ability to continue operating by maintaining adequate capitalisation and by managing its risks effectively. This requires the bank, in a forward-looking manner, to ensure that all material risks are identified, effectively managed (using an appropriate combination of quantification and controls) and covered by a sufficient amount of high-quality capital. The ICAAP quality assessment includes an assessment of the methodologies and processes the bank uses for determining risk and capital figures of the ICAAP. The outcome of the assessment is an overall judgement on whether the ICAAP quality allows the institution to ensure its continuity from a capital perspective by effectively assessing and managing its risks and capital position, and maintaining them at adequate levels.

3.2 Modular structure

The ICAAP assessment consists of four modules (see figure below). The assessment for each module broadly entails examining the following:

• Module 1 “ICAAP integration”: The extent to which the ICAAP is integrated in the management framework. This includes the involvement of the management body and senior management and the extent to which the ICAAP is protected by a rigorous control environment, including regular internal reviews and comprehensive and up-to-date documentation.
• Module 2 “Capital management”: The soundness of the bank’s capital adequacy management framework from the normative and the economic perspective. This includes the robustness of capital planning and stress testing frameworks, the effectiveness of capital management instruments and processes and – in the economic perspective – the adequacy of internal capital definition.
• Module 3 “Risk controls”: The strength of the risk identification, measurement and aggregation methodologies and processes applied to produce the quantitative ICAAP outcomes for all material risks to capital. This includes the adequate identification, quantification and aggregation of all risks and considering the appropriateness of the methodologies, the prudency of the assumptions and the nature, scale and complexity of the bank’s activities.
• Module 4 “Data quality and IT infrastructure”: The robustness of risk data and IT infrastructures, ensuring effective risk assessment and management.

Figure 2

The ICAAP assessment pyramid

Together, the assessment modules provide a holistic view of all aspects needed to judge the effectiveness of a bank’s ability to manage its risks to capital and capital adequacy. To avoid duplications with other SREP assessments, some of these aspects are assessed in other parts of the SREP structure and, rather than being repeated for the ICAAP assessment, are directly integrated into the ICAAP assessment (with their respective scores).

The assessment of the ICAAP and/or different parts of it follows a general process in line with the modular structure:

• Given its concise and holistic nature and the direct accountability of the management body, the capital adequacy statement (CAS)^[4] forms the starting point for the ICAAP assessment by the JST. The JST also navigates through other documents available, including in the ICAAP packages, to gain a more comprehensive understanding of the ICAAP and fill any still existing information or assessment gaps.
• The JST completes the assessment for the modules according to the priorities set for the multi-year assessment (e.g. which modules are being reviewed) and documents the underlying analysis, assessment outcomes, supporting narratives and assigned scores.
• The JST then forms its global view on the extent to which the ICAAP allows the institution to effectively manage its capital adequacy and completes the overall ICAAP assessment, assigns a score (using the usual SREP scale from 1 to 4 plus qualifiers) and formulates a comprehensive narrative pointing out the key ICAAP strengths and weaknesses.
• If the ICAAP risk figures are considered reliable, they should inform risks-to-capital assessments.