The fundamental issue
From a technical perspective, the exercise of capital planning under different scenarios forces institutions to manage several processes that are each complex individually and that have a compounding effect on one another: regulatory capital calculations, projections over multiple years, and scenario modeling (whether baseline or adverse). The complexity of scenario modeling is unavoidable; the future is unknown to us all, even if some of us do a better job figuring it out than others. The complexity involved in regulatory calculations and projecting over multiple years is more a matter of computing, and therefore more easily solved with technology.
At least they should be. These two intricate processes, historically, have been managed by different departments within banks, and by different people. Experts on regulatory requirements have resided in, or close to, the reporting departments, under finance. Specialists in making projections have tended to work in the Asset and Liability Management (ALM) or risk department. The result is that people performing different functions may be using different software solutions: regulatory experts using regulatory reporting solutions, and risk or ALM experts using their own solutions with more or less developed scenario capabilities.
An obvious solution is to create a software suite that combines the capabilities that both types of experts rely on: for regulatory calculations, and for risk and ALM projections and scenario modeling. But until recently this has been easier said than done because available solutions lacked the requisite speed or flexibility, or both. That has changed with technological developments such as in- memory computing, with its increased calculation speed, as well as the migration to the cloud, which allows businesses to increase or decrease computing resources as needed.
Together these enhancements are making high-volume, complex calculations more accessible. For financial institutions, software solutions have become available that combine precise regulatory calculations (as used in regulatory reporting) with scenario and projection management (for ALM and risk). With the regulatory calculation and projection issues largely resolved, bankers can focus on the thorny challenge of modeling the future.
The opportunities that Basel IV presents
As banks implement Basel IV, they will address all major blocks of the software solution chain, replacing some components, significantly adjusting others. It is an ideal opportunity to evaluate all Basel IV components against the ICAAP and Internal Liquidity Adequacy Assessment Process (ILAAP) requirements, in particular capital planning, and make any necessary changes. Indeed, Basel IV will be in effect for the next 15 years, and supervisory requirements will not be curtailed, so if you want your Basel IV implementation to succeed, then you need to ensure that your solution will meet capital planning and ICAAP/ILAAP requirements.
That means there is more at stake as banks address capital planning to satisfy ECB mandates – and perhaps similar ones imposed by supervisors elsewhere. But there is more to gain for institutions that manage the task effectively. They will be able to address other key ICAAP and ILAAP elements, as well as stress testing and analyses related to the internal economic view. The timing is right, too. With firms already working on their broad Basel IV implementation projects, the additional burden of undertaking capital planning work can be reduced.
Getting it right the first time
The ECB has issued a challenge to banks to ensure the longer-term reliability of their capital planning models under multiple scenarios. It is a challenge that they will need to meet, and one that they should want to meet to make their businesses run better. Fortunately, technology has advanced to the point that solutions are available that combine the disparate capabilities that are required, covering regulatory calculations, risk scenarios and ALM projections, within a single, consistent environment. By incorporating such a solution into an ongoing Basel IV implementation project, an institution will be able to meet its capital planning objectives the first time it tries, and for a long time after.
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1. https://www.bankingsupervision.europa.eu/about/thessm/html/index.en.html
2. https://www.bankingsupervision.europa.eu/banking/srep/2021/html/ssm.srepaggregateresults2021.en.html#toc8
