Essential Risk Components of ICAAP
This comment piece looks at the Internal Capital Adequacy Assessment Process (ICAAP).
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The Internal Capital Adequacy Assessment Process (ICAAP) is an internal assessment of capital that a bank can conduct in order to cover the material risks to which it is exposed. The purpose of the ICAAP is to formalise a bank‟s approach to understanding its risk profile and the processes and systems it needs to have in place to assess, quantify, and monitor risks. It is aimed to achieve transparency and improved risk management in institutions, and thereby increased stability in the financial system.
Guiding principles of ICAAP
Under Pillar II of the Basel II accord, the ICAAP should be guided by the following principles:
- Risk-based: ICAAP should be based on risk-management approaches.
- Capital adequacy: Every institution must have a process for assessing its capital adequacy relative to its risk profile; ICAAP design should specify the institution‟s capital policy.
- Principle of proportionality: The ICAAP's design should be proportional to a bank‟s size, risk level, and complexity;
- Forward looking: It should consider existing risks and possible future risks facing the bank;
- An ongoing exercise: The ICAAP is a dynamic and continuous process to ensure sufficient internal capital as business and market conditions change;
- Have an evolving-nature: The ICAAP should be continuously monitored and improved as needed for evolving business conditions and institutional complexity and experience.
ICAAP & Basel III
In the aftermath of the 2008 global financial crisis, to reinforce the stability of the financial system, policy makers and the Basel Committee have developed proposals to ensure that financial institutions maintain sufficient capital buffers. The December, 2009 proposal by the Basel Committee outlines fundamental changes and is already being called “Basel III” by the practitioners.
It includes a more restrictive definition of Tier one capital, use of leverage ratios, restrictions on discretionary distributions of earnings, and a “bottom-of-the-cycle” calibration for the Pillar I regulatory capital requirements.
While the jury is still out on "Basel III" many have argued that these additional measures imply redundancies and likely to result in income and profit destruction per unit of capital base. Addressing the capital buffer problem within the Pillar II Internal Capital Adequacy Assessment Process (ICAAP) framework supplemented by conditional and forward looking stress testing and reverse stress testing simulations is a more flexible and preferred approach for banking risk managers.
Essential risk components of ICAAP
ICAAP is dealing with all different types of financial and operational risks.
- Credit risk (including counterparty credit risk, concentration risk, equity risk in the banking book, securitisation risk, country and transfer risk, residual risk from CRM strategies)
- Market risk (interest rate risk, equity risk, commodities risk, foreign exchange risk)
- Operational risk
- Interest rate risk in the banking book
- Liquidity risk
- Other risks (including strategic risk, reputation risk, business risk, legal and compliance risk and more)
