Asset and Liability Management – A Supervisory Perspective - Ed Sibley, Director of Credit Institutions Supervision

Speaking at the Asset and Liability Management Association (ALMA) – International Summer Conference

Good afternoon ladies and gentlemen.  I am delighted to be here today and I thank ALMA for the invitation.

I can see from the Conference agenda that you are covering a range of interesting and important topics, including Brexit, stress testing, IFRS9 and, for obvious reasons, matters associated with asset and liability management.  I plan to touch on some of these same areas in my remarks, but given the theme of the conference, I will focus primarily on various aspects of asset and liability management.  

In some respects, the recent public focus on this area has been less than other risks and issues in banking.  This is arguably reflective of four factors:

• firstly, the level of central bank intervention in recent years;
• secondly, the strengthening of the regulatory framework;
• thirdly, the work done by banks themselves to improve risk management and control in this area; and
• fourthly, the lack of awareness and understanding of the fundamental importance of ALM to the safety and soundness of banks.

I will touch on all four of these factors in my remarks this afternoon.  I will cover at a high-level balance sheet developments in the banks operating in Ireland over the last decade, discuss regulatory developments, describe what we are seeing through our supervisory engagements with banks and outline risk areas and priorities for further work.  I will conclude by contending that while much has been done to improve asset and liability management across the banks operating in Ireland, risks are to the downside and more work is required to ensure that they are appropriately mitigated.  

Banking Sector in Ireland

I will start with a few facts and figures to emphasise the level of change that the banking sector in Ireland has undergone in the last decade.  The aggregate balance sheet size of the Irish banking sector at the end of 2007 was €1.35trn.  Since then, the number of licensed banks operating in Ireland has halved, and the overall size of the banking sector in Ireland has reduced to about one third of the size at €455bn.²

Moreover, the asset and liability mixes of these balance sheets is also materially different.  Capital ratios and the quality of capital have significantly improved. The importance of customer deposits has grown and reliance on wholesale funding has lessened. Resident private sector deposits importance increased from 24% of total liabilities to 46%³ from end 2007 to end 2016 across the sector.  This trend is even more evident in the Irish headquartered retail banks - where reliance on the more volatile wholesale markets has reduced to less than 10% of balance sheets⁴, compared to more than 40% in 2007. 

In other words, banks’ funding mix is typically more stable and longer dated than pre crisis.   Balance sheets are, consequently, undoubtedly more resilient.

These changes are important for lots of reasons and also demonstrate that the asset and liability management challenges and risks have changed significantly over this time – although perhaps the principles regarding sound management are not so different today.

Structural risks have definitively reduced. However, we should not be complacent.  There will, at some future point, be an unwinding of the extraordinary international central bank support measures, which will have implications on both sides of the balance sheet.  Greater volatility of liquid asset pricing may be coming, accounting rule changes may impact, increased supervisory focus on modelling and treatment of level 2 and level 3 assets is also relevant.  The need to increase MREL⁵ will also be a challenge.

Moreover, while soothsaying is a risky pastime, I think it is safe to say that the decline in the size and complexity of the banks operating in Ireland is coming to an end.  Domestic lending, having shrunk for many years, is starting to recover.  Much stronger, inorganic growth is expected in the internationally active banks – to some extent driven by Brexit impacts.  ALM discipline will be critical to ensure: that this balance sheet growth is delivered in a sustainable and robust fashion; that both sides of your balance sheets are capable of surviving severe but plausible stresses; and that risk appetites are appropriately prudent and informed by reverse stress testing.

The regulatory approach is also continuing to have to evolve and change as the overall risk profile of the sector changes.   To the extent possible, we are also taking a forward-looking view on the potential changes to the structure and make-up of the banking sector and the financial services sector more broadly. 

Regulatory developments

So with this level of change in mind, let me now turn to regulatory developments. 

It is inevitable, necessary and ultimately desirable that there are ongoing discussions and debates about financial services regulation – about its effectiveness and its impact. 

Post 2008, there was a recognition of the failings of the ‘light touch’ regulatory regime that pervaded much of the thinking on the approach to regulation internationally and domestically.  A swathe of sizeable, complex and far-reaching regulatory reforms have taken place since that time, transforming the regulatory and supervisory landscape across financial services, and seeking to ensure that the root causes of the financial crisis cannot recur.  It was with this ‘never again’ mind-set that increasing regulation and supervisory oversight was accepted by industry – albeit at times through gritted teeth. 

Given the level of change that has occurred, it would be arrogant in the extreme for the regulatory community to contend that all changes were perfectly calibrated in both execution and outcome.  This is why further developments are required – be it at Basel, in the CRD, BRRD, MiFiDII, etc.. I am sure that these developments, and those relating to Capital Markets Union, are being watched with keen interest by many of you in this room. 

Unfortunately, internationally and domestically, the tone of the debate regarding regulation has started to shift.   At a time when the legacies of the financial crisis are still being addressed, there is increasing talk of regulation being overly burdensome, or in the case of Ireland, the Central Bank not being accommodating enough to potential new entrants. 

It strikes me that the loudest proponents of this thinking are those with the shortest memories regarding the lessons from the failures leading up to 2008.  Regulators and supervisors are typically tasked with the orderly function of the market place, mitigating the risks and externalities of failing firms and protecting market participations – especially those that are the most vulnerable. 

Banks, like other financial services firms, are built on the premise of taking risk.  Banks can, have and will in the future overestimate potential profits and upsides, and underestimate downside risks.  But economic growth and stability is dependent on the sound functioning of the banking system. Moreover, there are wider societal dependencies on the financial system and the services it provides.  It is therefore critically important that the financial system works well over the long term. There is an inherent tension here and the risks associated with this inherent tension are manifest.  It is less than a decade since we saw these risks crystallise to devasting effects.

Regulation should, therefore, be based on solid foundations, and should not be pro-cyclical or tidal – sweeping in too late post a serious crisis, and ebbing away as the memories of that crisis fade. The lessons from the global financial crisis remain fresh in the minds of the European regulatory community. For these financial stability reasons, the importance of a robust approach to prudential supervision is a widely held view and is certainly one held by the Central Bank.  

Across all sectors, the Central Bank aims to be pragmatically operating in line with European regulatory and supervisory norms, and to be effective in influencing these norms. I am satisfied that this approach is both correct, and proving worthwhile in delivering our mandate. 

And there are unquestionably wider, system-wide benefits to this approach - as my fellow member of the Single Supervisory Mechanism (SSM) Supervisory Board, Pentti Hakkarainen contended in his speech in Dublin last week⁶

“a robust prudential environment…... can allow the well-known advantages of competition to be achieved in the banking sector, such as value-adding innovation, a wide range of competitively priced products, and resources shifting over time to the most efficient providers.”

To touch momentarily on Brexit, the Central Bank has been to the fore in the discussions on the regulatory and supervisory approach to Brexit across all three European Supervisory Authorities (ESAs) and the work of the SSM.

The aim of this approach is to mitigate against the risk of regulatory and supervisory arbitrage and to ensure that regardless of where a firm relocates activities to, it can expect a consistent application of the applicable EU regulatory standards and intrusive ongoing supervision of its activities.  The post-Brexit evolution of the European financial system cannot involve any dilution in the capacity of supervisors to ensure effective regulation of international financial services firms, in relation both to firm-specific and systemic risk.

Supervisory Perspectives

Having first-hand experience of one of the worst banking crises on record, the Central Bank is acutely aware of how risks interrelate and how a problem in one risk area may lead to contagion into another.  

Effective asset and liability management is a key part of understanding these interdependencies and promoting strong risk awareness and management within banks, both domestically and internationally focused.

As I have touched on already, it is clear that there has been significant progress in improving the balance sheet structures and funding models of banks operating in Ireland as well as in associated governance and risk management practices. It is crucial that we maintain the momentum, as it is also clear that there is more work to be done.

Starting at the top, the Central Bank’s Corporate Governance Code is very clear that the licenced entity board is responsible for setting and overseeing the business strategy. Yet, insight from our supervisory and inspections work has shown that there is not always sufficient and robust discussion at the board regarding strategic initiatives – including those developed at group level but conducted from Dublin.

This increases the risk of Irish entities’ businesses running ahead of control and risk management arrangements. We expect boards to provide effective challenge to proposed strategies and to ensure that local governance, risk management and control arrangements are commensurate with the scale, complexity and risk of the business being undertaken.  This includes ensuring that risks on both sides of the balance sheet are understood and mitigated effectively.

Therefore, it is with concern that we are seeing material issues in our liquidity risk work.  Some key themes coming out of recent liquidity risk inspections include:

• lack of understanding and / or embedding of liquidity risk appetites;
• poor awareness of the differences between the assumptions underlying internal stress tests and those of the regulatory requirements – i.e., whether the internal or regulatory metrics are the bank’s binding constraint and how this may change in different scenarios;
• inadequately resourced and experienced compliance and risk functions, resulting in a lack of oversight and challenge of the treasury management functions;
• insufficient understanding of the liquidity coverage ratio (LCR) rules resulting in mis-reporting, transactions being incorrectly represented or operational control of the liquidity buffer not being evidenced;
• absence of forecasting of regulatory metrics e.g. LCR projections;
• poor understanding and control of the risk of using foreign exchange swaps to fund foreign currency assets;
• inadequate Funds Transfer Pricing methodologies where the full costs and benefits of funding are not attributed;
• a lack of challenge to the appropriateness of using group policies and procedures for subsidiaries based in Ireland e.g., relating to Contingency Funding Plans; and
• issues with availability, reliability and accuracy of data being used internally and / or reported to the Central Bank.

While the liquidity positions of the banks operating in Ireland is more robust, there is clearly much more to be done with regard to liquidity management.  The issues also demonstrate the need for more work to meet the requirement for banks to have a robust and embedded Internal Liquidity Adequacy Assessment Processes (ILAAPs). While the ILAAP will inform our supervisory risk assessment and minimum regulatory liquidity requirements, it is an internal process that remains the responsibility of each bank to implement. ILAAP reporting should be consistent with the guidelines issued by the SSM⁷ and EBA⁸.

I will also take the opportunity to highlight a few other issues:

Interest Rate Risk in the Banking Book (IRRBB)

It is clear from our engagement with the banks operating in Ireland that IRRBB management needs to improve.  In particular:

1. data quality and availability is typically poor, with difficulties evident in measuring, monitoring and stress testing (recognising that data quality issues are much more pervasive than for IRRBB management);
2. modelling risk – there is a prevalence of reliance on recent data (e.g. last five years) to use in the modelling of IRRBB; this unprecedented period of ultra-low interest rates is not reflective of plausible future stresses.

Recovery Planning

As I have already outlined, effective ALM has a critically important role in the safety and soundness of banks’ strategies, business models and balance sheets. This is thrown into sharp relief when we consider recovery planning.  While much has been done to develop recovery plans across all banks operating in Ireland, material weaknesses still exist.  For example, from an ALM perspective, identified weaknesses include:

1. failures to align and embed recovery planning with risk appetite, capital planning, liquidity planning, and contingency funding plans – all clearly also linked to ALM;
2. weaknesses in or absence of key risk indicators and key recovery indicators relating to funding and solvency;
3. an absence of rigour in assessing recovery capacity (both in terms of capital and liquidity) and achievability of recovery actions under various stress scenarios.
4. Moreover, I think ALM discipline, viewed through the lens of recovery planning, can and should have a more explicit and demonstrable role in strategic planning, particularly in light of a growing banking sector.      

MREL

Resolution planning remains a work in progress.  Much work has been done, and in recent weeks, we have seen the first resolution actions under the Single Resolution Mechanism.  However, further work is necessary to be confident of resolving banks without taxpayer support – a key tenet of the new supervisory and resolution arrangements in the Eurozone. 

Banks face a number of challenges in meeting MREL requirements. While MREL setting has yet to occur, banks should prudently incorporate an element of MREL planning within their financial plans, particularly as this may impact on profitability, and require some structural balance sheet changes, as well consideration regarding issuances on multi-year basis.

I will finish here. 

The Central Bank has long recognised the importance of effective asset and liability management and has had a dedicated treasury risk team operating in banking supervision for the best part of a decade for this reason.  ALM will continue to be subject to sharp supervisory scrutiny.  Remediation of existing issues needs to be prioritised, including through the embedding of ILAAP and of strong risk oversight and management at local regulated entity level. There will also be a focus on banks’ responses to new regulatory requirements, including NSFR and IRRBB⁹.

Extraordinary central bank support will end at some point, the relatively benign liquidity environment will not last forever, and even in this environment, we have very recently seen idiosyncratic liquidity issues crystallise to devastating effect for individual banks.

I will leave you with two questions.  Have you taken sufficient advantage of the sunshine? Is your roof fixed and strong enough for the storms that will come?  My own view is that the evidence is mixed and that more needs to be done.  

Thank you for your attention.

1. I am grateful to Garrett Poynton, Geraldine Hannon, Cormac Grogan, Colm Brady, Trevor Fitzpatrick, Enda Nolan, Catherine Byrne, Oban Breathnach and David Nolan for their assistance in preparing these remarks
2. Based on data submitted through prudential regulatory reports (does not include EU branches) December 2007 and December 2016.
3. Sourced from the published Statistics bulletin Table A.4.1 Domestic Market Group.
4. Based on AIB, BOI and PTSB, end 2007 reporting vs end 2016
5. Minimum Requirement for own funds and Eligible Liabilities (MREL)
6. “Enhancing the environment for banking competition” – address by Pentti Hakkarainen, Member of the Supervisory Board of the ECB, at the FIBI International Banking Conference 2017, Dublin, 22 June 2017 (see )
7. Supervisory expectations on ICAAP and ILAAP and harmonised information collection on ICAAP and ILAAP – Letter issued to Significant Institutions, 8 January 2016
8. EBA GL on ICAAP and ILAAP (GL10, 2016) 
9. The Basel Committee on Banking Supervision’s Standard on Interest Rate Risk in the Banking Book (2016) and Basel III: The Net Stable Funding Ratio (2014) are due to be transposed into EU requirements in 2018.