Internal Capital Adequacy Assessment Process (ICAAP): Basel II
Earlier we looked at some of the preceding regulations to Basel II. We first look at some of the loopholes in Basel I and how the introduction of Basel II addressed these issues. We also consider in more detail the 3 Pillars of Basel II.
The Basel I accord had a number of well-documented shortcomings. It ignored portfolio effects across a large well diversified banking book, it ignored relative credit worthiness between and across corporate and OECD borrowers, created a regulatory loop hole supporting 364 day revolving facilities with no capital charge, did not allow for netting or provide any incentives for credit risk mitigation. It employed a simplified flat risk charge based approach so that the methodology could be applied across the industry with the least resistance and complication. However this simplification meant that items carrying different risks were subjected to the same risk charge. These problems led to suggestions that the banking industry be allowed to develop their own internal model to calculate the minimum capital requirements. This would serve as the credit risk equivalent of the BIS 98 standard for market risk capital requirements and allow well-diversified banks to report numbers that were more reflective of the risks carried on their balance sheets. The Basel II Accord addressed some of these concerns, introduced the concept of operational risk capital and provided capital requirements for new products that were previously not handled in the original capital accord. It took what is now regarded as the third and final step towards capital requirements that were reflective of credit, market and operational risk.
In recent years, banking supervisory bodies have all issued their own frame works defining how Basel II is to be implemented in their respected domains. The Basel II accord itself is composed of three pillars:
- Minimum capital requirements
- Supervisory review
- Market discipline
a. Minimum Capital Requirements
This is the first pillar where banks would need to maintain a minimum regulatory capital amount that covers three main risks, i.e. credit, market and operational risks, which the banks face. The credit risk component can be calculated using either a standardized approach or a foundation internal ratings based approach or an advanced internal ratings based approach. In the standardized approach the risk weight are applied on the basis of the rating of the counterparty and the maturity profile of the exposure. In the internal ratings based approaches the values of probability of default, loss given default, exposure at default and maturity are used in the computation for capital charge. The values are estimated using historical data of the bank’s credit portfolio.
The market risk component relies on VaR approaches to compute the risk of the exposure. VaR shows that for a selected portfolio, how much you stand to lose, over a certain period and with a certain probability.
The operational risk component can be calculated using either a basic indicator approach or a standardized approach or an advanced measurement approach. In the basic indicator approach, the average of the positive annual gross income figures is used to calculate the charge. In the standardized approach the banks’ activities are divided into eight business lines and the capital for operational risk for each of these lines is computed as a percentage of the bank’s gross income from that particular line of business. In the advanced measurement approach the institutions employ their own empirical models to calculate the required capital for operational risk.
b. Supervisory Review
This is the second pillar and it deals with the regulatory response to the first pillar and provides a frame work for dealing with the residual risks such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk that are not covered in the minimum capital requirements. The supervisory review process ensures that the banks have considered all material risks in the business and encourages banks to develop and used better risk management techniques in monitoring and managing their risks.
All risks that are material to the bank need to be quantified and stress tested and the relevant procedures for carrying out this assessment, the results and additional or target capital requirements that are commensurate with the bank’s risk profile and control environment would need to be communicated through an ICAAP document firstly to the board of directors and then to the supervisor and the market.
Supervisors would evaluate the ICAAP report to see how well banks were assessing their capital needs in relation to their risks. They would expect banks to operate above and hold more than the minimum capital requirements. If there were deficiencies identified in the process/ capital, the supervisors would intervene and prompt, decisive action would be taken to reduce the risk or restore the capital.
c. Market Discipline
This is the third pillar and it details the obligations of the bank to disclose information to all stakeholders. The clients and shareholders should have sufficient understanding to comprehend how the bank manages its risks. The purpose is to allow more transparency and let the market have a better idea of the banks risk positions so that they can deal with the bank in a better way.
d. Thoughts going forward
In a world where capital is neither free nor abundant, the new paradigm is risk based pricing. For some of us here, this is a little outside of our comfort zone. With the implementation of Basel II and the removal of traditional barriers to doing business across geographic boundaries, we as bankers need to think more carefully about the capital impact of our choices. This cannot be done till we include and accept risk capital based resource allocation in our mindset, our pricing, our decision-making and our regulatory reporting processes. This will introduce a significant new cost component in our pricing – both in terms of contributed capital costs as well as in terms of investments in technology, infrastructure, process improvement and change management. Those of us who do well in accepting and implementing these new frameworks will succeed as institutions and bankers. Those of us who don’t will face many difficult challenges in the years to come.
We have reviewed the 3 Pillars that constitute the Basel II Accord. In the next post we will look more closely at the requirements of the internal capital adequacy process (ICAAP) as prescribed under Pillar 2 of this Accord.