ILAAP, Stress testing & Pillar 2

ILAAP

A key purpose of the Internal Liquidity Adequacy Assessment Process (ILAAP) is to document and demonstrate overall liquidity adequacy. The document informs the bank’s Board and regulators of the ongoing assessment and quantification of the bank's liquidity and funding risks, how the bank intends to mitigate those risks and how much current and future liquidity is required. In addition to the analysis of liquidity risk, the ILAAP should also include a detailed analysis of the bank's funding profile and evaluation of risks to the stability of the funding profile.

The ILAAP document demonstrates and explains the bank’s internal liquidity adequacy assessment process. The ILAAP should be easily understood and contains all of the relevant information necessary for both the board and the regulators to take an informed decision as to the appropriate amount of liquidity the bank should hold and to form a view on the bank’s liquidity risk management process and methodologies. 

The ILAAP is the exercise by which the Board and management of the bank oversees and regularly assesses:-

• the bank’s liquidity related processes, strategies and systems;

• the major sources of liquidity risk to the bank’s ability to meet its obligations as and when they fall due;

• the results of internal stress testing of these liquidity risks; and

• the quantity and quality of High Quality Liquid Asset (HQLA) buffer, and whether or not these are adequate to cover the nature and level of liquidity risks to which the bank is exposed to currently and potentially in the future.

The ILAAP document sets out the framework for the bank’s internal governance, and the operation of liquidity risk management arrangements. In particular, the document sets out:

• the internal governance structure and assurance framework;

• the liquidity and funding risk management framework;

• the key liquidity and funding risk areas that are relevant to the bank;

• the adequacy of HQLA resource and the type of HQLA buffer resources in relation to the liquidity risk profile and hence the bank’s overall ability to meet its liabilities as they fall due;

• the bank's contingency funding plan; and

• the way in which the ILAAP is used in the business.

The ILAAP document has to be produced on a proportionate basis, taking into account the size, nature and complexity of the bank’s activities. It should set out the approach taken by the bank to identifying liquidity risk drivers, the impact of such risks and the overall impact on liquidity adequacy. The ILAAP document is one of the key inputs used by the regulators in the Liquidity-Supervisory Review and Evaluation Process (L-SREP).

The Prudential Regulation Authority (PRA) in the latest Supervisory Statement (SS24/15 - The PRA's approach to supervising liquidity and funding risks - updated September 2020) has outlined the regulators expectation of banks undertaking an ILAAP exercise. The PRA expects banks to consider the overarching principle set out in the overall liquidity adequacy rule (OLAR) on overall strategies, processes and systems. Banks merely attempting to calculate the High Quality Liquid Assets (HQLA) requirement alone, will not be carrying out its own assessment in accordance with the ILAA rules. 

The ILAAP should also provide details of the bank’s funds transfer mechanism and the liquidity contingency plan.

Stress testing

In PRA's Supervisory Statement SS24/15, provides clear guidelines on the ILAAP stress testing. The stress tests should include assumptions for the following risk drivers :-

1. The run-off of retail funding;

2. The reduction of secured and unsecured wholesale funding;

3. The correlation and concentration of funding;

4. Additional contingent off-balance sheet exposures;

5. Funding tenors;

6. The impact of a deterioration in the firm’s credit rating;

7. Foreign exchange convertibility and access to foreign exchange markets;

8. The ability to transfer liquidity across entities, sectors and countries;

9. Estimates of future balance sheet growth;

10. The impact on a firm’s reputation or franchise;

11. Marketable asset risk;

12. Non-marketable asset risk;

13. Internalisation risk; and

14. Intra-day risk

Pillar 2

The elements of liquidity risks are not fully covered by the Pillar 1 Liquidity Coverage Ratio (LCR) based HQLA analysis. There are elements (e.g. intra-day liquidity) that could also be addressed by holding a buffer of high quality liquid assets. Hence, over and above the HQLA calculated in Pillar 1 LCR, we suggest banks to consider additional Pillar 2 add-on HQLA based on the following elements:-

1. Intra-day liquidity risk;

2. The lowest point over a 3 month severe and plausible stress test analysis [e.g. if the lowest point was £10 million, and the LCR HQLA requirement is £6 million, we suggest a Pillar 2 add-on of £4 million); and

3. The PRA110 based LCR granular 30 day horizon [similar to (2) above, but over a 30 day period].