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This task of the Banco de Espaa is generally known by the acronym SREP
(supervisory review and evaluation process) although in these Guidelines it is
referred to by the literal translation (capital review process) of the term used in the
Spanish version (proceso de revisin de capital, PRC).
The aim of the capital review process (PRC) is to ensure that the risk profile of
credit institutions is commensurate with the own funds held by them. To this end the
so-called Pillar 2 of the revised solvency framework known as Basel II establishes
the following four principles:
Principle 1: Credit institutions should have a process for assessing their overall
capital adequacy in relation to their risk profile and a strategy for maintaining their
capital levels.
It follows from the first of these principles that institutions should have in place
an internal capital adequacy assessment process which is appropriate for their size
and complexity. This principle is laid down in Article 6.4 of Law 13/1985 and
implemented in Article 68 of Royal Decree 216/2008. In order to facilitate
compliance with this obligation, on 25 June 2008 the Banco de Espaa published
the Guidelines on the internal capital adequacy assessment process (ICAAP) at
credit institutions, aimed at helping institutions to carry out this process.
Under the second principle set out above, the Banco de Espaa is responsible for
reviewing the aforementioned internal capital adequacy assessment process and
evaluating whether institutions corporate governance, risk management, control
procedures and own funds level ensure the adequate management and coverage of
the risks to which they are exposed. As stated above, this review and evaluation
process is referred to here as the capital review process (PRC).
This task which the regulation of own funds under Basel II has recently imposed
on supervisors is not, however, new, but rather the explicit and formal expression of
an obligation which has always existed. The Banco de Espaa, in its risk-based
supervisory model (SABER), has already established specific procedures for
assessing institutions risks and capital adecuacy, and this supervisory activity is a
fundamental part of the risk-based supervision of credit institutions performed by
the Banco de Espaa.
Accordingly, the capital review process forms part of the Banco de Espaas
general supervisory process, and receives as inputs the results or conclusions
obtained during the course of all supervisory activities [1] , particularly those
stemming from the assessment of institutions risks and solvency. For this reason
the PRC is included in this activity.
The capital review process is carried out by the Banco de Espaa once it knows
the degree of credit institutions compliance with the rules they have to follow
(particularly with the accounting rules) and after analysing institutions economic
and financial situation. Without such prior knowledge, a review of institutions
capital within the meaning of Article 10.bis of Law 13/1985 cannot be carried out.
The internal capital adequacy assessment process draws on the idea that the
minimum regulatory capital requirements (the so-called Pillar 1 capital) covers
credit, market and operational risk on the basis of uniform rules and constitute a
minimum; and that no set of uniform rules can capture all aspects of every risk or
cover all the risks to which each particular credit institution is exposed.
Therefore, forming a judgement on the risks assumed and on whether the capital
is adequate to support those risks calls for more than a simple assessment of
compliance with minimum regulatory capital requirements according to the rules set
in Pillar 1 of Basel II. But the capital review process cannot consist in setting
automatic increases in capital needs (Pillar 2 add-ons) for the risks not covered in
Pillar 1. It is not just a matter of simply aggregating the risks not considered under
Pillar 1 and determining the capital add-ons needed to cover them, since there may
be good reasons to accept that the total amount of capital required may be less than
the sum of the capital needed to cover the individual risks, as a result of the
well-known diversification effect. [2] In short, it is necessary to carry out an overall
assessment of the institutions risk profile and of the capital needs derived from that
risk profile.
The capital review process ends with a forward-looking assessment which results
from analysing and evaluating the financial strength of each institution to face any
adverse future events which may arise. To this end the institutions capital plan and,
within that capital plan, the envisaged stress scenarios are reviewed and evaluated.
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[1] The supervisory process of the Banco de Espaa consists of four separate
supervisory activities: accounting review, including valuation of assets and
liabilities, economic and financial analysis of institutions, review of regulatory
compliance, and analysis of risks and solvency.
[2] However, due to the difficulty in accurately evaluating the effect of risk
diversification, the Banco de Espaa is particularly prudent in evaluating the
benefit of diversification.
The individual credit institutions in the group, regardless of the degree of control
exercised over them by the parent, should have the capacity to turn to the markets to
finance their activity and arrange individually the appropriate risk coverage.
Intra-group transactions should always be at market prices and not be subsidised in
either direction. The best way of achieving this is for the different institutions in a
banking group to operate directly with the market, since this improves transparency
and enables effective knowledge and rating not only of the group, but also of each
of its components.
- The host supervisor exercises the individual prudential supervision of all the
subsidiaries authorised in his country. Where existing, it is also responsible for
supervising the sub-consolidated group in his country, formed by the subsidiaries
established in its jurisdiction and the subsidiaries of these.
Neither the new Basel capital framework (Basel II) nor the new capital
requirements directive (CRD) has altered this legal sharing of responsibilities.
Hence, under Pillar 2 the home supervisor carries out the PRC at group and parent
level and the host supervisor carries out the PRC of the subsidiaries in his
jurisdiction (and of the sub-consolidated group, if any, in his country).
- The supervisory review process of the Banco de Espaa will take into
consideration the degree of integration of the banking group and its internal
organisation. Banking groups may have centralised certain activities such as their
risk management functions and, consequently, there may be a need to develop a
more integrated and coordinated approach to supervision. In such cases the
coordinating role of the home supervisor should be more important to ensure an
efficient supervisory review.
The PRC analyses the solvency of credit institutions in the broad sense of the
term, i.e. it analyses not only capital adequacy at a given time, but also foreseeable
capital needs and availability. It also analyses the quality of the own funds held, its
distribution in consonance with risk allocation within a banking group, the existence
of unrealised gains and other items which may be used to absorb unexpected losses,
etc. And clearly the PRC considers the ability to generate future profits which can
strengthen an institutions solvency if necessary, since an institutions first line of
defence against possible future losses is a sound profit and loss account based on
recurring earnings.
The main sources of information used by the PRC are the periodical institutions
own funds return to Banco de Espaa and its internal capital adequacy assessment
report (ICAAR). However, the Banco de Espaa uses other relevant information
available to it, most notably all that derived from its supervisory activities.
The supervisory process of the Banco de Espaa is established such that the
multiple tasks comprising the process enable to update as often as necessary, and at
least yearly, each institutions supervisory risk profile and, where applicable, the
Banco de Espaas supervisory strategy and supervisory plan for the institution [3] .
The PRC forms an integral part of the Banco de Espaas risk-based supervisory
process and receives input from all supervisory activities which affect the solvency
of institutions in one way or another. The Banco de Espaa assesses institutions
risk profiles by means of its different supervisory activities, i.e. through off-site
monitoring and analysis, inspection visits and continuous on-site monitoring.
The PRC is based on all the relevant information available to the Banco de
Espaa about an institution, and, specifically, that resulting from all its supervisory
activities. Notwithstanding this, the PRC basically consists of two activities:
- Review and evaluation of the periodical own funds return to the Banco de
Espaa.
The PRC consists firstly of checking that institutions comply with the regulatory
minimum solvency requirements, and analysing and evaluating such compliance
through review of the own funds returns submitted periodically by institutions to the
Banco de Espaa.
This review and evaluation is conducted basically off-site, [4] but also
periodically in inspection visits in accordance with the supervisory plans. Both
reviews, i.e. off-site and in inspection visits, are carried out by the operating groups.
The off-site review analyses the consistency of the information received, while
inspection visits also check the accuracy of the information sent to the Banco de
Espaa. The review of the own funds return puts particular emphasis on the past
history of the institutions solvency ratios and on comparing these solvency ratios,
in terms of both volume and quality (i.e. percentage of tier 1 capital on total capital
held), with those of peer institutions.
As stated below (in Section 6.1.2 on the capital plan), this review includes the
analysis of possible increases in own funds requirements at times of unfavourable
economic circumstances (known as the analysis of capital procyclicality), and also
the analysis of the ability of institutions to develop their strategic business plans
while complying with their regulatory capital requirements at any time in the future.
The Banco de Espaa reviews and evaluates the internal capital adequacy
assessment process (ICAAP) performed by institutions by means of the review of
the ICAAR and the dialogue with the institution. The dialogue between the
institution and the Banco de Espaa is an essential part of the capital review process
and includes the Banco de Espaa informing the institution of its evaluation of the
ICAAP. The ICAAR is the basic document for this dialogue between the institution
and the Banco de Espaa, whose intensity and depth should be proportionate to the
complexity and systemic importance of the institution.
This dialogue encompasses all the risks held by the institution, which can be
grouped in four categories:
- Risks not fully covered under Pillar 1 (for example, residual risk in credit risk
mitigation, and securitisation risk).
- Pillar 2 risks (interest rate risk in the banking book, concentration risk, liquidity
risk, reputation risk, strategic risk, etc.).
- External factors, where not already considered in the previous points, including
the impact of economic cycles.
Regarding the capital held to meet capital needs, although the internal capital
adequacy assessment processes of institutions refer to internal capital (as explained
in the ICAAP guidelines), this concept of capital differs from own funds in both
meaning and composition. Accordingly, for greater clarity, in the dialogue which
compares and contrasts the ICAAP and the PRC, the Banco de Espaa bases this
dialogue in terms of own funds.
Although the review of the ICAAR is ongoing and lies within the general
supervisory process, it has two distinct landmarks: a yearly off-site review, to check
that the ICAAR is complete and is reasonable, and the performance of specific
reviews of greater depth and wider scope, during inspection visits [5] . Both reviews
are subject to the principle of proportionality, whereby the intensity of the review is
commensurate with the importance and complexity of what is being reviewed.
The yearly off-site review of the ICAAR does not aim to check the information
submitted by the institution, but rather to draw the conclusions which reasonably
derive from that information. However, if major inconsistencies are observed, or if
the institution makes statements clearly contrary to the Banco de Espaas
knowledge of that institution, the pertinent clarifications will be requested. In
extreme cases, the institution will be asked to correct the report and re-submit it to
the Board of Directors for approval.
The yearly review of the ICAAR consists of examining its content to check that
it is complete and reasonable, and of making a first assessment of the report. To this
end, the following two tasks are previously carried out:
- The summary ICAAP return [6] is reconciled to the correspondent own funds
return and any inconsistencies are identified.
The review of the ICAAR is also included in the yearly on-site inspection plan.
The scope of the review is defined before the inspection visit is commenced. This
scope may encompass the full ICAAR or specific aspects of it. It is considered
advisable to carry out the review of the ICAAR together with the review of the
corresponding own funds return because they are closely related to each other.
A major aim of this review is to check that the information in the ICAAR is
adequate and accurate. Another aim is to review and evaluate the methodological
aspects of the ICAAP incorporated into the ICAAR and identify possible
deficiencies and weaknesses affecting the outcome of the ICAAP.
This review includes a review of institutions internal capital models if they are
used to prepare the ICAAP.
Notwithstanding what has been said in the preceding two sections, the
supervisory operating groups which engage in on-site continuous monitoring may
review the ICAAR by using the teams located at the institution and the methodology
normally employed in the day-to-day conduct of their supervisory activity.
For this purpose, each year a programme will be drawn up to facilitate the review
of the ICAAR by coordinating the tasks of the various teams which will review each
section of the ICAAR. This programme will set the scope, which will normally be
full.
Given that the monitoring of the different risks addressed in the ICAAR, of
corporate governance and of the controls in place is of a permanent nature, the
information gathered in this monitoring will be used to keep each institutions
supervisory risk profile up to date, independently of whether the yearly review of
the ICAAR has been formally completed.
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[4] In the larger banking groups, in which a continuous on-site monitoring system
has been established, this review is conducted basically through this continuous
on-site monitoring procedure.
[5] In the larger banking groups, in which a continuous on-site monitoring system
has been established, this review is conducted basically through this continuous
on-site monitoring procedure.
The supervisory process of the Banco de Espaa is established so that all of the
multiple tasks comprising it are updated and reviewed each year. This enables
supervisory teams to keep up-to-date each institutions risk profile and, when
applicable, the Banco de Espaas supervisory strategy and supervisory plan for the
institution.
Under this supervisory framework, the regular, at least yearly, execution of the
PRC [7] seeks to provide the conclusions needed to better update the institutions
risk profile. To enable this, the ICAARs received from institutions are reviewed and
evaluated and, based on this review and on the other supervisory activities
performed during the year, possible deficiencies are identified, the pertinent
conclusions are drawn and, where applicable, the necessary prudential measures are
taken.
1. Capital target. The capital target set by the institution is specified and
assessed. To do so, the institutions specific situation and the targets set by peer
institutions are considered.
2. Capital plan. The capital plan, including stress scenarios and contingency
plans, is analysed to determine its reasonableness. The discrepancies between the
current reality and what was envisaged in the capital planning of prior years are
stated, if significant.
The Banco de Espaa ICAAP guidelines define the capital target as the amount
of capital in excess of the regulatory minimum which the institution considers
necessary to hold both currently and in the future period projected in its capital
planning and which is in accordance with:
- The real possibility of obtaining further own funds in the future, if needed.
The ICAAR must justify the institutions capital target to the satisfaction of the
Banco de Espaa. In assessing the capital target the Banco de Espaa considers:
- The Banco de Espaa view, reflected in the risk matrix ratings and the
supervisory risk profile given to the institution.
The Banco de Espaa, in assessing an institutions capital target, will take into
account particularly that this target should be commensurate with the institutions
risk profile. Hence institutions with a risk profile considered high by the Banco de
Espaa should have a higher capital target than institutions with a "medium-high"
risk profile; institutions with a "medium-high" risk profile should have a higher
capital target than institutions with a "medium-low risk profile; and finally,
institutions with a medium-low risk profile should have a higher capital target
than institutions with a "low" risk profile.
The capital plan, in conjunction with the institutions capital target, should allow
the growth envisaged in the strategic business plan and, furthermore, the compliance
with the mnimum capital requirements under Pillar 1 in the event of a severe
recession or of clearly unfavourable business circumstances.
For this purpose, institutions should carry out stress tests and the Banco de
Espaa should evaluate them, since these stress tests should be sufficiently severe
(for example, considering situations occurring once in the last 20-30 years). To
determine the impact in terms of the actual losses arising with a certain probability,
institutions may use (when possible and appropriate) advanced regulatory methods
for calculating own funds and, on the basis of these methods, estimate the losses
which may arise with a certain periodicity (which may be set previously by the
Banco de Espaa).
To review these stress tests, the Banco de Espaa will follow the principles and
recommendations established in this respect by international supervisory bodies [9] ,
and will apply these recommendations to check that the degree of severity of the
stress scenarios used by the various institutions is comparable. The Banco de
Espaa will assist institutions in order for them to establish scenarios of comparable
severity. For this purpose, the Banco de Espaa may provide direct inputs to
institutions for certain stress tests, such as, for example, specific falls in GDP,
certain rises in the unemployment rate, house price falls, increases in doubtful loans
ratios, etc. and may also define specific reverse stress scenarios [10] to be
considered by institutions.
Capital buffers over and above the regulatory minimum are held by institutions
largely so that regulatory capital requirements continue to be met even in situations
of stress, in which extraordinary losses appear. For this reason, if such extraordinary
losses materialise, it does not make sense to require institutions to restore
immediately their capital to its former level, since in such a case this excess capital
lacks utility [11] . In the case those losses occur, the institution should consider a
realistic and prudent plan for returning to its capital target.
Based on the assessments set out in the ICAAR, institutions should also
summarise the main deficiencies and weaknesses found and, if significant, draw up
an action plan to remedy them. This action plan may include the following
measures, among others:
- Modificate (raise up) the capital target, stating the related adaptation period, if
appropriate.
The Banco de Espaa will analyse and assess, as often as necessary and at least
yearly, the degree of fulfilment of these programmes of future measures which, as
explained in the ICAAP guidelines, constitute a voluntary commitment of the
institution.
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[7] The yearly conclusion drawn from the PRC aims to comply with the obligation
of yearly updating referred to in the last subparagraph of paragraph 1 of Article
10.bis of Law 13/1985.
[8] For further details on the risk matrix ratings, see the document The Banco de
Espaa supervisory model at Banco de Espaa website.
[9] The BCBS published guidelines on Principles for sound stress testing practices
and supervision in May 2009. The CEBS published guidelines on Technical
aspects of stress testing under the supervisory review process in December 2006.
In December 2009 has published, for consultation, a revised version.
[11] Nevertheless, it should be kept in mind that the capital able to absorb losses in
these situations consists solely of the capital that can be used to absorb losses in a
going-concern situation (which is only the highest-quality capital). It must be
realised that if core capital is consumed to absorb losses this will affect the
subsequent eligibility of the lower-quality capital which is leveraged to it. For
example, an institution can (theoretically) have a solvency ratio of 12% with core
capital of 3%, but the other 9% only counts if that 3% exists. If, due to
extraordinary losses, 2% of the core capital is lost, then 6% of the lower-quality
capital automatically ceases to count and the institution would have a solvency
ratio of 4% from that time.
Taking into account all the supervisory activities performed in the year and the
result of the review of the ICAAR, decisions considered appropriate are taken.
These decisions may be of internal scope or may have practical implications for the
institution:
- Decisions of internal scope:
- Changes to risk matrix ratings and to the institutions supervisory risk profile.
- Changes to the supervisory plan for the institution and, where appropriate,
performance of extraordinary supervisory activities.
- Urge the institution to make changes in its ICAAP or in its ICAAR, in its
capital target, in its capital plan or in its programme of future measures.
Principle 2: The PRC should apply to all authorised institutions. The scope
of application of the PRC will be determined by reference to the CRD.
Principle 3: The PRC should cover all the activities of an institution. All
significant business units of the institution, whether operating domestically or
abroad, will be considered in the review and evaluation process.
Principle 4: The PRC should cover all material risks and internal
governance. The supervisory authority will evaluate the institutions risks and
internal governance (including risk controls, compliance, and internal audit). The
evaluation will focus on identifying each institution's risk profile and assessing the
quality of the institution's risk management system. The evaluation of controls
should include, at a minimum, an assessment of the quality of internal governance,
management body, organisational structure, the risk management and control
environment and internal audit and compliance functions. The evaluation should be
forward-looking in the sense that it should consider, based on information known at
the time, whether the risk profile of the institution is likely to change over the
forthcoming period. The supervisor can use stress tests to help determine the need
for early intervention.
Principle 5: The PRC will assess and review the institution's ICAAP. The
supervisor will assess the institution's ICAAP as part of its PRC. This should
include a consideration of the assumptions, components, methodology, coverage
and outcome of the institution's ICAAP.
Principle 6: The PRC will assess and review the institution's compliance
with the requirements laid down in the CRD. As part of the PRC, the supervisor
must also evaluate the institution's compliance with the minimum requirements
under the CRD.
Principle 7: The PRC should identify existing or potential problems and key
risks faced by the institution and deficiencies in its control and risk
management frameworks and it should assess the degree of reliance that can be
placed on the outputs of the institution's ICAAP. The PRC will enable the
supervisory authority to tailor its approach to the individual institution and provide
the foundation for the supervisors general approach to the institution and its
actions.
Principle 8: The PRC will inform supervisors about the need to apply
prudential measures. Once it has evaluated the adequacy of an institution's capital
in relation to its risk profile, the supervisor should identify any prudential measures
or other supervisory actions required. For example, where there is an imbalance
between business and risk controls, on the one hand, and the capital held, on the
other, the supervisor should consider the range of remedial supervisory actions that
may be needed to rectify a deficiency in controls or perceived shortfalls in capital.
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[12] The Spanish acronym Of SREP is used here, in order to be consistent with the
text of these Guidelines.
Annex 2. Guidelines relating to Pillar 2 prepared by the CEBS and the Basel
Committee on Banking Supervision.
- CEBS documents:
- Principles for the management and supervision of interest rate risk, July 2004.
- Principles for sound stress testing practices and supervision, May 2009