By Rajith Perera, Partner/Principal, Financial Accounting Advisory Services, Ernst & Young, Sri Lanka

COVID-19 pandemic represents the biggest test of the 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 grapple with ICAAP:

• Most banks can benefit substantially from 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 formulation of the risk strategy, consider the use of dashboarding of critical metrics to enable the banks to translate risk appetite in to 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 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 growth of business adequately deliberate and compliment the capital planning process with the intention of maximizing profitability of the institution.

Further a well designed and implemented stress testing can add value to a bank in a multitude of ways. Below are some emerging trends we believe that banks should embrace:

• Strategic Planning:

A combination of stress testing and sensitivity analysis can be used to measure interaction between balance sheet functions and exogenous factors such as macro-economic factors. This information will be powerful in guiding the bank’s strategic objective, product strategy and investment strategy.

• Funding Strategy and Contingency planning: Funding strategy and contingency liquidity plans will be better informed and sharper by stress testing the relationship between capital, funding cost and liquidity
• Feedback response: In the event of breach of any of the risk limits (i.e- capital adequacy ratio, leverage ratio) banks take action through asset sale, raising capital, cutting down lending and etc. These balance sheet changes could be captured iteratively in stress testing.

In order to deliberate this topic further, join us for the discussion with Sanath Fernando & Rajith Perera    “ A Likely Story?” a quick guide to practical application of ICAAP and stress testing organized by the  Financial Accounting Advisory Services (FAAS) Academy of training of Ernst & Young, Sri Lanka, on  30^th   September 2020 from 9.00am to 12.00 noon,  at Jaic Hilton Colombo. For Registrations Please contact Thilini Perera on [email protected] or 0115578859

Photo Caption

1. Sanath Fernando – Partner, Assurance, EY Sri Lanka
2. Rajith Perera- Partner/Principal, Financial Accounting Advisory Services, EY Sri Lanka