The following changes were made to the European regulators’ approach to Recovery Planning requirements:

• Firms should consider options available to raise liquidity by encumbering assets in each stress scenario, noting the impact of such asset encumbrance on Recovery Planning as a whole; and

Whilst these are relatively minor changes, they require new thinking from firms around what scenario testing should include, and what the impacts of asset encumbrance are on Recovery Planning. Furthermore, the impact and response to the COVID-19 pandemic should bring out practical adjustments and enhancements to a firm’s Recovery Plan, especially in an environment where operational changes (such as working remotely or an increase in collections activity) is running alongside this. 

What should Internal Audit be doing?

The European regulators have previously published requirements for Internal Capital Adequacy Assessment Processes (ICAAPs) for climate-related risks and prescribed climate related scenarios but this exercise was paused due to the COVID-19 pandemic and has been restarted with an updated position for 2021.

The key requirements for scenario analysis for assessing climate related financial risks are:

Three scenarios:

• Early action: orderly transition to achieve a net zero CO2 emissions economy within ambitious timescales;
• Late action: disorderly action to achieve net zero CO2 emissions economy which is unanticipated/sudden and disruptive; and
• No additional action: minimal action results in a ‘hot house world’ which leads to global warming and an increasingly significant impact from physical risks (see below).

Two key risks:

• Transition Risk: risks associated with the implementation of significant policy and economical changes required to achieve net zero emissions; and
• Physical risk: risks associated with the impact from higher global temperatures such as extreme weather events, both currently and expected resultant impacts from taking no further policy action.

Internal Audit should continue to focus on key topical areas such as COVID-19 related impacts and climate change. These two key themes should feature in the following key areas of audit focus:

Scenario generation capabilities:

Scenario generation capabilities:
Strong capabilities for projecting outcomes should include a robust base case plan which can be updated in a timely manner to respond to changes in the external environment such as a stress event/scenario. As such, stress testing of base case plans should be commonplace and should include a range of relevant scenarios that can be utilised effectively to consider any required Management response. These capabilities should be developed for new and growing Banks and should be widened to incorporate climate-related risks. Internal Audit should determine the adequacy of the base case plan and the corresponding capacity of the business to respond to stress events/scenarios.

Horizon scanning:
Horizon scanning practices and associated analyses should be performed to understand the impacts given the many recent and expected changes to guidance as a result of Brexit, CRD V, CRR2, Basel 3.1, COVID-19 and climate related risks. Internal Audit should review the adequacy of the horizon scanning framework to ensure it effectively responds to identifiable future events and scenarios.

Risk appetite:
As the regulatory environment changes, and new insights are gained from stress testing analysis, firms need to ensure they are updating and regularly monitoring their risk appetites to ensure adherence to regulatory minima. Internal Audit should review the approach to this updating process and ensure robust monitoring controls are in place.

Models and data:
Internal Audit should continue to review the adequacy of the governance frameworks and processes around data and models that are heavily used to inform day to day planning and stress testing. There should be a focus on the approach to model updates as result of recent regulatory changes that will impact upon stress testing activities, such as the Pillar 2B assessment as part of the ICAAP.