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ICAAP Strategic Risk – Estimating ICAAP Capital reserve for Strategic Risk

ICAAP Strategic Risk Capital Charge Estimation

Estimating the ICAAP (Internal Capital Adequacy Assessment Process) capital charge for Strategic Risk has been possibly the most under covered topic since ICAAP submissions became a regulatory requirement under Pillar II disclosures. The only other topic also required for ICAAP submissions to receive similar disservice is capital integration across multiple risk categories (market, credit, op, liquidity, interest rate mismatch, strategic and other residual risks). Like Strategic Risk, Capital Integration deserves a separate post which will follow later.

Why is modeling strategic risk for ICAAP so difficult? Perhaps one reason is that unlike Value at Risk (VaR) or Credit Risk, there is no agreed upon, accepted, unified framework or tool to measure, report or track the capital required to recover from a strategic misstep. What further complicates the capital estimation exercise is the fact that strategic initiatives and resulting challenges at each bank are different. Somewhat like how our immune systems react differently to the H1N1 swine flu virus or how quickly the virus mutates when confronted with a trial vaccine, ICAAP strategic risk estimation varies similarly from one bank to the next. Modeling Strategic Risk for ICAAP is a complicated exercise that needs to follow a process customized for each client.

Let me elaborate with two examples and instances of estimation of capital for this risk type.

Here are the results from two recently finished ICAAP exercises for two different client banks. The table below presents some of the strategic initiatives that were identified during our strategic initiative audit. A strategic initiative audit is an exercise that reviews all initiatives linked to the top line vision professed by the senior management team.

ICAAP Strategic Risk Audit template

Strategic Audit ItemsBank One – A regional power houseBank Two – A local joint venture between two non-local partners
Fresh Capital Injection from Public and private sourcesYes – Rights issue fully subscribed – Now need to fully deploy capital to avoid erosion in Return on Equity due to the higher capital base.Yes – Initial approvals in place – need to hire an advisor for the book building and public offering exercise.
New Product LaunchesRetail Mortgage ProductRetail Liability Product
Human resourcesLocalization drive for integration of local origin employees. Salary freezes in place for existing talent pool.Hiring an effective retail team in a bank unrecognized for its retail prowess.
Technology infrastructureDeployment of new core banking platform complete.Parallel run of new core banking system to start in the next three months.
Items with long range financial impact – oneRestructured product pricing and incentive compensation plan for sales team.Restructured trading desk booking unrealized losses and revamping bonus structure
Items with long range financial impact – twoNew transfer pricing mechanism in place resulting in a redistribution of cost base.Successful launch of retail liability product.
Strategic visionTo be the largest local bank. Currently within the top 5To be the most efficient corporate bank with the largest capital and liquidity base.
ChallengesEconomic EnvironmentAbility to raise and retain retail deposits
VehiclesOrganic growthAcquisitions
Business environmentSupportive regulatory framework and teamRegulator now concerned about pace of implementations and control process around non-performing loans
Out reach30 new branches rolled out this yearRetail customer distribution and collection centers
Primary Economic Factor that can derail new initiativesOil pricesInterest rates

The Strategic Initiative Audit is the first step in completion of a successful ICAAP strategic risk assessment exercise since it lays the foundation for the next steps. While the above list is not as large or detailed as we would prefer it provides a good starting point to begin our work. Ideally the output from the strategic audit should be a list of activities or initiatives planned for the short as well as long term that can impact and change the strategic and competitive positioning of the bank in its operating environment.

The next step is to assess if the impact of strategic items identified above can be quantified and translated into a capital charge. Depending on the list the answer to this question may be yes, no or maybe. The challenge here is across two dimensions

  1. The first is to determine an already accepted methodology or tool that has established usage within the industry and with regulators.
  2. The second is to create a framework around that tool that incorporate the probability of a misstep as well as expected loss.

This is not that different from already existing frameworks we use for credit and operational risk: A frequency distribution to determine probability of a loss event, a loss distribution to determine the size of loss.

ICAAP Strategic Risk Audit – Capital Estimation and Quantification

Strategic Audit ItemsBank One – Numerical Quantification of strategic capital for ICAAPBank Two – Numerical Quantification of strategic capital for ICAAP
Fresh Capital Injection from Public and private sourcesYes – ROE basedYes – Liquidity and funding cost based
New Product LaunchesYes – NII basedYes – ALM based
Human resourcesNoYes – Top and bottom line contribution ased
Technology infrastructurePartially – linked to cost savings of new system roll out.Partially – linked to cost savings and ROI of new system rollout
Items with long range financial impact – onePartially – product revenue linked.Yes – based on historical loss.
Items with long range financial impact – twoPartially – profitability and gross revenue based.Yes – ALM based
Strategic visionMaybeMaybe
ChallengesPartially top-line basedPartially – ALM based
Business environmentNoNo
Out reachYes deposit basedYes deposit based
Primary Economic Factor that can derail new initiativesMaybe – Value at Risk basedMaybe – Value at Risk based

The next step is to apply the framework to estimate initial probabilities and expected as well as worst case losses. Two questions that now need to be answered are correlation across multiple strategic events (with the strategic risk category) and the integration of strategic risk capital with other major risk types and categories. The simplest approach for a first time filing of ICAAP submission is based on an enumeration of zero correlation, perfect correlation and a combination creating scenarios for a single strategic misstep, multiple missteps as well as what is popularly now known as the end of the world scenario (everything that can go wrong will go wrong).

While no one believes in the dooms day scenario you would be surprised by how badly things go wrong when they start to go wrong.

Also see: An alternate approach for calculating Economic Capital using accounting data rather than the BIS guidelines using the difference between Expected and Unexpected Loss. 

About the Author

Jawwad Farid is a Columbia Business School Alumni, a Fellow Society of Actuaries and the Founder CEO of Alchemy Technologies. Jawwad has been teaching and working with the banking industry on ICAAP frameworks and submissions from early 2007 when the Basel II framework was rolled out in the region. For more detailed material on ICAAP prepared by the same team, please see  Sample ICAAP report templates, ICAAP Excel worksheets and a primer on ICAAP.

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