Presentation on theme: "Developing an effective ICAAP"— Presentation transcript:
1 Developing an effective ICAAP Developing an effective ICAAPChris Matten31 May 2011
2 AgendaICAAP 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 oversightSound capital assessmentPolicies and procedures … to measure … all material risksProcess to relate capital to level of riskComprehensive assessment of all risksMonitoring and reportingInternal 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 ICAAPThe ICAAP should form an integral part of the management process and decision-making culture of the institutionThe ICAAP should be reviewed regularlyThe ICAAP should be risk-basedThe ICAAP should be comprehensiveThe ICAAP should be forward-lookingThe ICAAP should be based on adequate measurement and assessment processesThe ICAAP should produce a reasonable outcome
5 ICAAP components Description of risk governance Statement of risk appetiteLink to risk limitsLink to strategyComparison with risk-bearing capacityAssessment of material risksComprehensive risk capital model (economic capital?)Capital forecasts and stress tests, showing:Regulatory capitalRisk or economic capitalPhysical capitalAvailable vs required capitalCapital allocation process and policiesUse test - embedded in business processes
6 Statement of risk appetite Board-level documentQuantifies 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 capitalUsually 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
8 Statement of risk-bearing capacity Board-level documentQuantifies the ability of the institution to absorb risksTypically 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 capacityRiskAppetiteThe maximum risk the firm can bear, which is linked to capital, liquid assets, borrowing limits etcRisk-bearing capacityAllocated risk limitsTarget Risk ProfileUtilisation of limitsActual Risk ProfileCreditRiskMarketRiskOp.sRiskInt. rateRiskLiquidityRiskEtc.Individual risk measures
10 Assessment of material risks Banks need to assess all material risksShould be fully documentedRisks that are deemed not to be material still need to be documented (+ reasons)Should explain how risks are:Measured (where relevant)ManagedMitigatedDevelop a risk map to cover all risksCan be based on different approachesRegulatory capitalEconomic capital modelsStress tests/scenario analysisSingle-point estimates
11 Capital forecastsAs 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 activitiesAn adjustment of the available physical capital to reconcile to available economic capital and regulatory capitalRequired 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 analysisPillar 2 stress testsCapital stress testAdditional scenarios for pillar 2 risksLevel of severity? – look to regulatory guidancePurpose: to demonstrate that the bank can survive a reasonably severe crisis without breaching minimum capital levels
13 Capital stress tests illustrated (1) Capital ratiosBase case forecast“Net” stress test“Gross” stress testBank 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 planMinimumTime horizon of forecast and stress test
14 Capital stress tests illustrated (2) Capital ratiosBase case forecast“Net” stress test“Gross” stress testMinimumAdditional capital raisedTime horizon of forecast and stress test
15 AgendaICAAP 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 risksComprehensivenessAppropriateness of approachCapital forecastingHow robust is the planning/budgeting process?Time horizon?Capital stress testingIs 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 strategyEnables understanding of capital requirements under different economic scenarios and “stress” scenariosBuilds 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 flexibilityStrengthens 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 AgendaICAAP components Challenges in implementing the ICAAP Roles of IA and risk management Ongoing maintenance
19 Typical roles and responsibilities FunctionRoleRisk ownersRisk mapsRisk managementAssessment of individual risksRisk appetiteInput into capital stress testingFinanceInitial ICACapital planningCapital stress testingInternal AuditReview and challengeSenior managementReview, challenge and approveBoard
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?StrategyEconomicsBusiness headsRiskFinanceIs it consistent with regulatory expectations?Are management mitigating actions credible?Arithmetic accuracy?
24 Challenges: Use testHow effectively is the ICAAP embedded into day-to-day management processes?Capital allocationCapital budgeting and rationingPerformance measurementPricingCompensationInvestor communicationsRisk 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 AgendaICAAP 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 disposalsSignificant changes in corporate structureMaterial changes in regulatory requirements (e.g. Basel III)Crisis occursIf 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 relevancyCapital planning and stress testing updatedProper review, challenge and approval
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