Understanding Internal Capital Adequacy Assessment Process (ICAAP)

Checklist Description
This checklist outlines the role, functions, and requirements of the Internal Capital Adequacy Assessment Process (ICAAP).

Definition
Under Basel II, ICAAP is a new requirement for financial institutions, requiring the following assessments: Pillar I minimum capital requirements; the extent of total stockholder funds required to meet a firms strategy and maintain minimum capital requirements; ensuring that material risks of the firm are understood by its board, and that there is sufficient and appropriate risk management.

Four crucial elements in any ICAAP are: 1. 2. 3. 4. assessment (identification and measurement) of the risks a bank is, or may be, exposed to; application of mitigation techniques that may help to lower capital requirements; stress-testing techniques; role of the board of directors and management.

Pillar II requires that risks are presented to, and discussed by, the board to ensure its acceptance and understanding. Pillar II also requires a bank to maintain capital ratios and convince the regulator. Risk models and capital are only part of this. A financial institution must also consider any other internal risks that the firm may face which may result in losses such as fraud, rogue trading, or strategy failure. The preparation of a capital plan should incorporate all risks, and requires the cooperation of, and collaboration with, the finance, treasury, business, and risk departments. Capital plans are usually based on a firms forecasts for growth, given the maintenance of a capital ratio. The ICAAP should be customized for each firm, taking into account the particular risks and information available. The process usually consists of the following stages: 1. 2. 3. 4. Identifying risksList all material risks, interview staff in relevant departments, and assess the probability of risks occurring. Assessing capitalHow much capital would a risk require? Forward capital planningAssess how the capital calculated from the capital assessment might be altered by its business plan, i.e. perform stress and scenario analyses. ConclusionWhat are the ranges of capital identified, and how much internal capital should a firm hold?

Managers should also consider the following risks: credit risk; market risk; operational risk; liquidity risk; insurance risk; concentration risk; residual risk; securitization risk; business risk; interest rate risk; pension obligation risk;
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Understanding Internal Capital Adequacy Assessment Process (ICAAP)

any other risks identified.

The ICAAP typically has the following structure: 1. 2. 3. 4. 5. 6. 7. 8. executive summary; background of the ICAAP process; statement of firms attitude to risk; business strategy; risk assessment; capital planning; stress and scenario testing; adoption of the ICAAP.

Banks tend to calculate the capital buffer they hold by simply extrapolating figures from previous events, instead of using a forecast risk profile. The ICAAP should clearly distinguish between a companys regulatory capital, its actual capital, and the capital it needs to hold for business purposes. Using a newly developed ICAAP should provide firms with the best capital buffer required, and the best level of funds from stockholders. Risks are often considered by a bank, yet are not always reflected in strategic options and capital planning. ICAAP requires stress and scenario analysis to demonstrate risks at an enterprise level. Firm managers must show that ICAAP is an integral part of its processes and demonstrate that senior management both supports and is engaged in the ICAAP. In addition, companies need to explain in detail how they will use the ICAAP as they move forward and how key risk indicators and economic capital indicators/assumptions can be updated and presented to the board of directors when required. ICAAP is still in its early stagescompanies are being encouraged to embrace the process for the sake of their business rather than for purposes of regulation. Management should understand the positive benefits and strive, through ICAAP, to make the business more efficient and less risky.

More Info
Report:
Financial Services Authority. ICAAP submissionsuggested format. November 22, 2007. Online at: www.fsa.gov.uk/pages/About/What/International/pdf/ICAAP_sub.pdf.

See Also
Best Practice Why Organizations Need to be RegulatedLessons from History Checklists Basel IIIts Development and Aims Comparative and International Financial Regulation The EU Regulatory Regime Principles of Financial Services Regulation

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Understanding Internal Capital Adequacy Assessment Process (ICAAP)

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