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Developing an effective ICAAP

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1 Developing an effective ICAAP
Developing an effective ICAAP Chris Matten 31 May 2011

2 Agenda ICAAP components Challenges in implementing the ICAAP Roles of IA and risk management Ongoing maintenance

3 Pillar 2, Principle 1 – The ICAAP
“Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels” Board and senior management oversight Sound capital assessment Policies and procedures … to measure … all material risks Process to relate capital to level of risk Comprehensive assessment of all risks Monitoring and reporting Internal control review

4 ICAAP Principles - CEBS
Every institution must have a process for assessing its capital adequacy relative to its risk profile (an ICAAP) The ICAAP is the responsibility of the institution. The ICAAP’s design should be fully specified, the institution’s capital policy should be fully documented, and the management body should take responsibility for the ICAAP The ICAAP should form an integral part of the management process and decision-making culture of the institution The ICAAP should be reviewed regularly The ICAAP should be risk-based The ICAAP should be comprehensive The ICAAP should be forward-looking The ICAAP should be based on adequate measurement and assessment processes The ICAAP should produce a reasonable outcome

5 ICAAP components Description of risk governance
Statement of risk appetite Link to risk limits Link to strategy Comparison with risk-bearing capacity Assessment of material risks Comprehensive risk capital model (economic capital?) Capital forecasts and stress tests, showing: Regulatory capital Risk or economic capital Physical capital Available vs required capital Capital allocation process and policies Use test - embedded in business processes

6 Statement of risk appetite
Board-level document Quantifies the desired level of risk that an institution is willing to take. Typically be expressed in terms of risk limits, but under an ICAAP should also quantify those risk limits in terms of capital Usually refreshed at least annually. May be expressed in terms of earnings volatility (earnings perspective), either in addition to or instead of the solvency perspective. Where an institution only uses an earnings perspective, meeting Pillar 2 ICAAP requirements may be challenging

7 Statement of risk appetite - example

8 Statement of risk-bearing capacity
Board-level document Quantifies the ability of the institution to absorb risks Typically expressed in terms of capital (solvency perspective) but may also be expressed in an earnings perspective. The statement of risk-bearing capacity and statement of risk appetite are usually companion documents

9 In organisational terms
The quantum of risk the firm is willing to accept within its overall capacity Risk Appetite The maximum risk the firm can bear, which is linked to capital, liquid assets, borrowing limits etc Risk-bearing capacity Allocated risk limits Target Risk Profile Utilisation of limits Actual Risk Profile Credit Risk Market Risk Op.s Risk Int. rate Risk Liquidity Risk Etc. Individual risk measures

10 Assessment of material risks
Banks need to assess all material risks Should be fully documented Risks that are deemed not to be material still need to be documented (+ reasons) Should explain how risks are: Measured (where relevant) Managed Mitigated Develop a risk map to cover all risks Can be based on different approaches Regulatory capital Economic capital models Stress tests/scenario analysis Single-point estimates

11 Capital forecasts As the ICAAP must be forward-looking, it needs to incorporate planned capital levels. A fully-integrated capital forecast would be linked to the planning and budgeting process, providing forecasts for: Available physical (book) capital – essentially a function of profits, dividends and other capital management activities An adjustment of the available physical capital to reconcile to available economic capital and regulatory capital Required economic capital – essentially a function of forecast credit exposures, market risk limits etc. Required regulatory capital – essentially a function of forecast risk- weighted assets. Forecast requirements should be compared with forecast availability.

12 Capital stress tests Pillar 1 stress tests “tail” test
Sensitivity analysis Pillar 2 stress tests Capital stress test Additional scenarios for pillar 2 risks Level of severity? – look to regulatory guidance Purpose: to demonstrate that the bank can survive a reasonably severe crisis without breaching minimum capital levels

13 Capital stress tests illustrated (1)
Capital ratios Base case forecast “Net” stress test “Gross” stress test Bank will need to show how it intends to ensure that this gap is eliminated, usually by adding this amount to the initial ICA as a buffer or by raising additional capital in the plan Minimum Time horizon of forecast and stress test

14 Capital stress tests illustrated (2)
Capital ratios Base case forecast “Net” stress test “Gross” stress test Minimum Additional capital raised Time horizon of forecast and stress test

15 Agenda ICAAP components Challenges in implementing the ICAAP Roles of IA and risk management Ongoing maintenance

16 Challenges in implementation
Making it relevant for the business (and meeting the use test) Defining risk appetite is not easy! Assessment of material risks Comprehensiveness Appropriateness of approach Capital forecasting How robust is the planning/budgeting process? Time horizon? Capital stress testing Is the stress scenario appropriate? Are mitigating actions credible?

17 ICAAP: Business benefits
Enhances ability to understand how much capital flexibility exists to support risk appetite and acquisition strategy Enables understanding of capital requirements under different economic scenarios and “stress” scenarios Builds and supports linkage between risk and capital – and ties performance to both; Positions Bank to optimize the outcome of supervisor’s review of capital requirements, freeing up the maximum amount of capital to support strategic flexibility Strengthens position to respond to increasing focus on capital management by both rating agencies and analysts. As regulators and banks gain experience with Basel II framework, objective would be to have the “regulatory” capital requirement move closer to the Bank’s view of required capital (including support for target rating) – blurring of Pillar 1 & Pillar 2 components

18 Agenda ICAAP components Challenges in implementing the ICAAP Roles of IA and risk management Ongoing maintenance

19 Typical roles and responsibilities
Function Role Risk owners Risk maps Risk management Assessment of individual risks Risk appetite Input into capital stress testing Finance Initial ICA Capital planning Capital stress testing Internal Audit Review and challenge Senior management Review, challenge and approve Board

20 Challenges: Risk appetite and risk-bearing capacity
Level of senior management/board involvement? Is it consistent with past experience? Is it consistent with strategic and business plans? Proper level of review and challenge at Board level?

21 Challenges: Assessment of material risks
Was there full involvement of risk owners and risk management? Risk maps fully documented? Is it complete based on past experience? Has all relevant date been incorporated into the assessment? Is the modelling approach appropriate for the type of risk? Has ‘material’ been clearly and properly defined? Proper level of review and challenge at senior management and Board level? Arithmetic accuracy of Internal Capital Assessment?

22 Challenges: Capital planning
Robustness of underlying budgeting/planning process? Appropriate time horizon (3-5 years)? Sufficient granularity of detail? Components of available capital? Proper treatment of dividends etc? Different assets classes? Different RWA classes? Consistent with past experience? Arithmetic accuracy? Proper challenge, review and sign-off?

23 Challenges: Capital stress testing
Is the severity of the stress scenario(s) appropriate? Are the results consistent with the scenario(s) adopted? Has there been proper involvement of all relevant departments? Strategy Economics Business heads Risk Finance Is it consistent with regulatory expectations? Are management mitigating actions credible? Arithmetic accuracy?

24 Challenges: Use test How effectively is the ICAAP embedded into day-to-day management processes? Capital allocation Capital budgeting and rationing Performance measurement Pricing Compensation Investor communications Risk management (limits etc)

25 Challenges: Overall ICAAP governance
Was there a single ‘owner’ of the ICAAP to drive a consistent, comprehensive approach? Was there the right level of involvement of other stakeholders? BUs, Risk, Finance, Strategy, Economics, etc? Has senior management/the Board been actively involved in review and challenge? Was there a formal sign-off process? Any involvement of external parties to develop/review the ICAAP? Skills and qualifications? Any issues raised by them not addressed?

26 Agenda ICAAP components Challenges in implementing the ICAAP Roles of IA and risk management Ongoing maintenance

27 Ongoing maintenance ICAAP should be refreshed at least annually
More frequently if: Significant M&A or disposals Significant changes in corporate structure Material changes in regulatory requirements (e.g. Basel III) Crisis occurs If no major changes, it is a ‘refresh’, not a ‘re-do’ IA needs to review the process to ensure that: All elements have been reviewed to ensure relevancy Capital planning and stress testing updated Proper review, challenge and approval

28 Thank you This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, [insert legal name of the PwC firm], its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2011 PricewaterhouseCoopers Limited. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Limited which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.


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