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 tests 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.
Under ICAAP requirements a bank needs to have in place internal procedures and processes to ensure that it possesses adequate capital resources in the long term to cover all of its material risks. These processes and procedures together are known as the Internal Capital Adequacy and Assessment Process or ICAAP for short.
We first review the historical back ground behind the development of Basel II of which ICAAP is a part:
Requirements of the ICAAP process
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.
- Process Requirements: Purpose, Pre-requisites, Board of Director Responsibilities and Documentation
- Assessment Requirements: Approach, Nature , Comparative View to MCR and Review Process
Internal Capital Adequacy and Assessment Process (ICAAP): Report – main elements
- Sample ICAAP report format and table of content
Under 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).
Measuring credit risk & stress testing
In order to quantify credit risk for the internal ratings based approach of the Internal Capital Adequacy and Assessment Process 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.
One forward looking aspect of the Internal Capital Adequacy and Assessment Process 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.
i. Credit Risk Stress Tests
- Non – Performing Loan (NPL) Stress Test
- Simple Sensitivity Analysis – Increase & Shift in NPL
- Simple Sensitivity Analysis – Fall in Forced Sale Value (FSV) of mortgaged collateral
- How to construct a Transition Matrix
- How to Determine Expected Classification Rates
- Profitability Analysis of a bank’s loan portfolio
- Transition Matrix Stress Test
- Profitability Analysis Stress Test
ii. Market & Liquidity Risk Stress Tests
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.