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The ICAAP (Internal Capital Adequacy), Stress Testing and Credit Risk Road Map

The ICAAP (Internal Capital Adequacy Assessment) Roadmap post reviews the core topics in a crash course format for Internal Capital Adequacy Assessment. The hope is that armed with the relevant context, historical background and tools we would be able to do a better job of informing our boards of expected as well as unexpected capital shortfalls.

We start off with Interest Rate Simulations, followed by a laundry list of topics related to ICAAP, followed by a review of collateral risk management (you would have never thought that a foray in ICAAP would land you on this particular road). Without further ado…

Interest Rate Simulation Crash Course

Whether its mark to market pricing of treasury investments, calculation of interest rate shocks for stress testing, configuring a probability of default model, a conditional transition matrix or valuation of collateral, you ultimately have to turn towards interest rate modeling if you are serious about ICAAP analysis. Interest rate models are defined by state variables and their processes. Think of these are the primary drivers or factors behind a given phenomenon. Just like pressing the accelerator changes and impact speed of a vehicle, tweaking a model parameter or model variable changes the value being simulated.

The values taken by the state variables that constitute an interest model give the position or state of the item being model. The processes determine how the state variables change over time. Interest rate processes or changes in state variables are usually stochastic processes, i.e. they incorporate an element of randomness. These processes can usually be divided into a non-random deterministic component, called drift and a random, noise term called volatility.

Interest Rate Simulation: Introduction

Model processes may depend on the evolution of a single factor such as the short rate, as in the case of the CIR one factor equilibrium model. We start with the simplest of interest rate models, the Cox Ingersoll Ross interest rate simulator and review the model as well as the steps required in its calibration.

Interest Rate Simulation: Using CIR (Cox Ingersoll Ross) Model: Introduction
Interest Rate Simulation: Using CIR (Cox Ingersoll Ross) Model: Estimating Parameters & Calibrating the CIR Model
Interest Rate Simulation: Using CIR (Cox Ingersoll Ross) Model: Simulating the term structure of interest rates

A slightly different application is used to illustrate the construction and calibration of the one factor no arbitrage Black, Derman and Toy (BDT) model

Interest Rate Simulation Models: Building BDT in Excel: Introduction
Interest Rate Simulation Models: Black, Derman and Toy (BDT) model in Excel: Define Input Cells
Interest Rate Simulation Models: Black, Derman and Toy (BDT) in Excel: Define Output Cells
Interest Rate Simulation Models: Black, Derman and Toy (BDT) model in Excel: Define Calculation Cells: Construct short rate binomial tree
Interest Rate Simulation Models: (BDT) model in Excel: Define Calculation Cells: Construct State Price Lattices
Interest Rate Simulation Models: (BDT) model in Excel: Calculate Prices from Lattice
Interest Rate Simulation Models: (BDT) model in Excel: Calculate Yields & Yield volatility from Lattice
Interest Rate Simulation Models: (BDT) model in Excel: Define & Set Solver Function & Results
Interest Rate Simulation Models: (BDT) model in Excel: How to utilize the results of a BDT interest rate model: Derivation of Short Rates
Interest Rate Simulation Models: The results of a BDT interest rate model: Pricing Bonds
Interest Rate Simulation Models: The results of a BDT interest rate model: Pricing Options

We then move towards more complicated Interest rate models that use multiple factors and require estimates as well as configuration of drift, volatility for multiple factors, as in the case of the Heath, Jarrow, Merton (HJM) no arbitrage model.

Interest Rate Simulation Models: HJM (Heath Jarrow Merton) Model: Define input cells
Interest Rate Simulation Models: HJM (Heath Jarrow Merton) Model: Interest Rate Model in Excel – Define calculation cells
Interest Rate Simulation Modeling: HJM (Heath Jarrow Merton) Model: Interest Rate Model in Excel – Determine Prices

In order to determine a workable number of components / factors for the Heath, Jarrow, Merton (HJM) model, a principal component analysis (PCA) needs to be performed.

Interest Rate Forecasting: Principal Component Analysis (PCA): Overview
Interest Rate Forecasting: Principal Component Analysis (PCA): Data
Interest Rate Forecasting: Principal Component Analysis (PCA) : Principal Component Analysis in Excel: Covariance Matrix
Interest Rate Forecasting: Principal Component Analysis (PCA): Eigenvectors
Interest Rate Forecasting: Principal Component Analysis (PCA): Diagonal Matrix
Interest Rate Forecasting: Principal Component Analysis (PCA): Solver Setup & Results

Internal Capital Adequacy Assessment Process (ICAAP) – Overview and Core concepts

Capital Adequacy was the principal message of the Basel II framework.  However a static regulator driven capital adequacy measure was deemed insufficient to manage the risk profile and capital requirements of an active bank in today’s risk environment creating the need for an internal and invasive assessment of the capital profile of a bank.  Ideally such a measure would allocate and attribute risk capital to all significant sources of risk, stress test the results and keep the board informed of any expected or projected capital shortfall.

Under Pillar 2 of the Basel II Accord, Internal Capital Adequacy and Assessment Process (ICAAP for short) was introduced with exactly the same objectives.

We first review the historical back ground behind the development of Basel II of which ICAAP is a part:

Internal Capital Adequacy and Assessment Process (ICAAP): Basel II – Background: Great Depression, Regulation Q, Basel I
Internal Capital Adequacy and Assessment Process (ICAAP): Basel II

One forward looking aspect of the Internal Capital Adequacy and Assessment Process (ICAAP) is stress testing of all risk factors in order to arrive at the capital requirements for the worst case scenario. Stress testing also allows the bank to plan and prepare for unexpected situations that may arise in the future. We look at some of the stress tests that can be applied to credit, market and liquidity risk.

ICAAP Submission: Credit Risk: Stress Test: Non – Performing Loan (NPL) Stress Test
ICAAP Compliance: Credit Risk: Stress Test: Simple Sensitivity Analysis – Increase & Shift in NPL
ICAAP Compliance: Credit Risk: Stress Test: Simple Sensitivity Analysis – Fall in Forced Sale Value (FSV) of mortgaged collateral
ICAAP: Credit Risk: Stress Test: How to construct a Transition Matrix
ICAAP: Credit Risk: Stress Test: How to Determine Expected Classification Rates
ICAAP: Credit Risk: Stress Test: Profitability Analysis of a bank’s loan portfolio
ICAAP: Credit Risk: Stress Test: Transition Matrix Stress Test
ICAAP: Credit Risk: Stress Test: Profitability Analysis Stress Test
ICAAP: Stress Test: Market Risk
ICAAP: Stress Test: Liquidity Risk

We then review some of the requirements of the ICAAP process and consider the main sections of an ICAAP report. We also present an extract from a sample ICAAP report showing the Executive Summary and the Approaches used to quantify and aggregate risks.

ICAAP: Process Requirements: Purpose, Pre-requisites, Board of Director Responsibilities and Documentation
ICAAP: Assessment Requirements: Approach, Nature , Comparative View to MCR and Review Process
Internal Capital Adequacy and Assessment Process (ICAAP): Report – main elements

ICAAP: Internal Capital Adequacy Assessment – Sample ICAAP report format and table of content

Under the Internal Capital Adequacy and Assessment Process (ICAAP) the bank will make use of internal models to assess, quantify and stress test risk drivers and factors and the amount of capital required to support them. We consider some of the building blocks in a modeling construction process and the risks involved in model building as well as ways to avoid those risks. This discussion is based on the paper “Model Risk” by Emanuel Derman (Goldman Sachs Quantitative Strategies Research Notes – April 1996).

Internal Capital Adequacy and Assessment Process (ICAAP): Modeling Building Process
Internal Capital Adequacy and Assessment Process (ICAAP): Model Risks
Internal Capital Adequacy and Assessment Process (ICAAP): Prevention and Limitation of Model Risks

In order to quantify credit risk for the internal ratings based approach of the Internal Capital Adequacy and Assessment Process (ICAAP) the bank would need to be able to calculate the probability of default (PD). We discuss one methodology of calculating PD which is based on historical behavioral data.

ICAAP Submissions: Probability of Default (PD) Calculation

Collateral Valuation in Credit Risk Management

Stress testing, forced sale value modeling and credit risk mitigations are the three pillars that connect collateral valuation to ICAAP Analysis and modeling. Without incorporation of a sound collateral management, tracking and valuation model, there is a reasonable chance that your ICAAP numbers are completely disconnected from reality.

Estimation of collateral value is an important part of the process of quantifying Credit Risk. Valuations having a greater level of accuracy and reliability translate to Loss Given Default (LGD) estimates that are more in line with what is expected to be recovered. Inaccurate valuations would mean that more capital than anticipated will be used up as recoveries from the liquidation of collateral are lower and slower than expected so that losses and costs of recovery are higher.

In the Collateral Valuation course we first define collateral and list the various types available. We consider the desirable characteristics that are sought for in collateral and a number of performance measures for evaluating its effectiveness. We review how collateral can help in enhancing the financial intermediation process and the impediments and restrictions that exist when there is insufficient collateral or when law pertaining to collateral is un-reformed or ineffective:

Collateral Valuation: Credit Risk: Definition and Types
Collateral Valuation: Credit Risk: Extent of collateral & Performance indicators for collateral
Collateral Valuation: Credit Risk: Role of collateral in Financial Intermediation
Collateral Valuation: Credit Risk: Collateral and Collateral Law

Next, we discuss the importance of collateral valuation to credit risk management. We consider some general principals of valuing collateral and then look at specific methodologies for valuing real estate, such as the sales comparison approach, income capitalization approach and cost approach. We also briefly review the estimation approaches used for other assets pledged as collateral:

Collateral Valuation: Credit Risk: Importance of collateral valuation to credit risk management
Collateral Valuation: Credit Risk: General principles
Collateral Valuation: Credit Risk: Real Estate Valuation Approaches
Collateral Valuation: Credit Risk: Sales Comparison Approach for real estate
Collateral Valuation: Credit Risk: Income Capitalization Approach for real estate
Collateral Valuation: Credit Risk: Cost Approach for real estate
Collateral Valuation: Credit Risk: Approaches for other assets

After this we look into the process that is followed for ensuring that a lender is able to claim the collateral in the event of a default or breach of contract/ agreement. This process includes the creation, perfection and enforcement of security interest in collateral. We will also look at different elements of collateral management and how after full repayment security interest is terminated.

Collateral Valuation: Credit Risk: Security Interest – creation and perfection
Collateral Valuation: Credit Risk: Collateral Management of Security Interest
Collateral Valuation: Credit Risk: Enforcement of Security Interest
Collateral Valuation: Credit Risk: Termination or the extinguishing of Security Interest

If you would like to buy this complete course as a PDF file or a Sample ICAAP report as a PDF file or the sample credit risk EXCEL sheet, please see the ICAAP section at our online finance training course store. The online finance training course store includes easy-to-read-and-work-with downloadable PDF files, excel templates and ready-to-work with models that are shared to illustrate usage and speed up learning and pick-up for advanced financial modeling, forecasting and simulation topics including interest rate forecasting and simulation, value at risk analysis, collateral valuation, asset liability management, ICAAP and other related middle office and risk topics.

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