Any prospective bank going through the authorisation process will need to deliver three core documents, the Regulatory Business Plan (RBP), the Internal Capital Adequacy Assessment Process (ICAAP) and the Internal Liquidity Adequacy Assessment Process (ILAAP). The key elements of the ICAAP and ILAAP are presented in the RBP, and while the ICAAP and ILAAP serve different purposes, the regulator will expect to see consistent underlying messages across all three documents.
Liquidity is the lifeblood of a bank and the margin between loans and deposits defines how a traditional bank makes money. It is therefore essential that this element is adequately addressed and presented to the PRA in a way that gives it confidence that the applicant firm understands its liquidity and funding risk profile.
Providing inadequate detail on deposits and liquidity risks is one of the reasons that applicant banks sometimes face delays in the process. A robust ILAAP is not a supplement to an application for authorisation, but a core component of it.
What is an ILAAP?
The main purpose of the ILAAP is to demonstrate “overall liquidity adequacy”, meaning that the applicant has sufficient liquidity to function in business as usual, survive liquidity stresses and that it can manage the liquidity risks it faces. Most central to this is ensuring that it can face a liquidity stress and avoid failure through having insufficient funds available to meet its liabilities as they fall due. The ILAAP should describe the type of liquidity risks the bank will face, the board’s liquidity risk appetite and lay out its strategy for implementing it e.g. the type deposits the applicant will accept, the expected inflows and outflows of liquidity and the liquidity buffer that it expects to hold to counterbalance net outflows.
The ILAAP must be closely aligned to the business plan because the type and duration of deposits it accepts form a core part of the applicant’s plan and identity as a business. It should also be an accurate interpretation of the Board’s liquidity risk appetite.
Liquidity Risk Appetite (LRA)
Every firm needs to have a clearly articulated risk appetite defining the duration and type of stress or stresses that the firm aims to survive. This risk appetite should be cascaded throughout the firm in the form of appropriate limits on funding sources, the liquidity buffer and the firm’s structural liquidity position. The PRA also expects firms to articulate for themselves the amount of risk they are willing to take across different business lines to achieve their strategic objectives.
Supporting the overarching risk appetite should be a carefully configured set of metrics which will demonstrate whether the firm remains within its risk appetite and also to provide early warning if it is at risk of falling outside of it. The metrics will themselves need to be built upon accurate and timely reporting and MI.
The risk appetite and management of liquidity risks should be implemented through its liquidity management strategy. For example, this should describe in detail the type of deposits the bank will target and their duration. Liquidity risk is usually lowered by having more “stickier” products, such as fixed-term and notice deposit products, or within tax wrappers, such as ISAs. High interest, internet-only, instant access savings accounts are less sticky, especially where there is no other relationship with the client. This is naturally a challenge for new banks, because most need to grow their deposits rapidly and high interest rate internet accounts are generally the easiest way to do so.
The LRA should also show the appetite for having retail deposits in excess of the FSCS limit, and for non-retail deposits.
Liquidity Risk Drivers
The PRA expects firms to describe and analyse the following liquidity risk drivers:
The type of deposits are directly linked to the expected outflows in a stress – less sticky deposits, would indicate higher levels of outflows, both in the normal run of business and in a stress. Other stressed outflows will include off balance sheet liabilities, such as the loan pipeline undrawn credit card balances, as well as cash to cover stressed intraday liquidity requirements. The ILAAP should show a good understanding of the behaviour of customers both under normal and stressed conditions.
The risk appetite and outflow assumptions will drive the calculation of the liquidity buffer that the applicant will hold and can be drawn down in times of stress. The PRA expects to see that it is driven by the firm’s own risk appetite and assesses what surplus the bank feels it needs to survive a stress and the time it can survive for without needing additional funds.
A robust liquidity stress test will help the applicant test its risk appetite and adjust it according to the results. It should test the vulnerabilities and key risk drivers for the firm. The PRA will expect to see that the firm can survive a severe but plausible stress, utilising management actions as appropriate. The Liquidity Contingency Plan (LCP) should provide additional reassurance of the applicant’s ability to cope with a stress, describing clear actions and sources of liquidity that the bank could employ in a stress scenario. The actions might include launching new products, securitising assets or accessing Bank of England facilities. This is important from the regulator’s perspective, as it shows that the applicant understands that things can go wrong and has developed realistic and actionable steps to mitigate any crystallised risks.
The PRA would not expect a firm to only rely upon the regulatory measures of liquidity risk management, such as the LCR – these are regulatory measures designed to provide regulators with a common view across banks, but banks should not use them as their only measure of setting risk appetite or measuring liquidity – ILAAPs that do are likely to be subject to additional challenge and delay the application.
A Typical ILAAP Development Process
Developing an ILAAP from scratch without an established business model is challenging, but below are the typical steps in the development of an ILAAP:
Only when the RBP, ICAAP and ILAAP are of sufficient quality will the regulator approve a banking application. As a result, it is important to ensure that all of the documents are robust and where relevant consistent.
It is essential that any plan for a new bank put to the regulators has a well-developed and consistent ILAAP that fully assesses funding risks that apply to the business model.