Internal Capital Adequacy Assessment Process Research Articles

Designing Stress Tests for UK Fast-Growing Firms and Fintech

This paper captures advances in prudential regulation and supervision for challenger banks and fintech in the UK. It presents a critical analysis of the prudential supervisory approaches towards fintech. The focus is placed on fast-growing firms (FGFs), building on the review performed by the Prudential Regulation Authority (PRA) of the Bank of England (BoE) in 2019. Specifically, it comprises a critical examination of the underlying regulatory framework in relation to the robustness of stress testing practices, as part of the review of FGF risk management practices and the weakness identified in the Internal Capital Adequacy Assessment Process (ICAAP). The economic analysis of law comprises the underlying methodology, using economic theory to analyse regulation and its effectiveness regarding fintech regulation and supervision. Recommendations for enhancements towards supervisory practices about the prudential governance and management of FGFs and fintech are included, with advances to the underlying regulatory framework in the UK. Overall, this critical legal research examines the supervisory practices of FGFs and fintech in the UK, under the lens of prudential regulation and risk management approaches, focusing on the design, development and implementation of the stress testing tool and scenario practices.

Stressing of migration matrixes for International Financial Reporting Standard 9 and Internal Capital Adequacy Assessment Process calculations

Stressing of migration matrixes for International Financial Reporting Standard 9 and Internal Capital Adequacy Assessment Process calculations

Kingdom of Lesotho

This mission, a follow up to the earlier mission from IMF AFRITAC South (AFS) conducted in March 2017 (STX Mr. Bernie Egan), was designed to further help the authorities in the implementation of Basel II and select elements of Basel III. The main objectives of the mission were to help the CBL finalize the Draft Guidelines to banks on Pillar 1; assist in the implementation of Pillar 2, with attention paid to the Supervisory Review and Evaluation Process (SREP) and the banks´ Internal Capital Adequacy Assessment Process (ICAAP); and evaluate current disclosure requirements in view of the recent revision of Pillar 3 by the Basel Committee on Banking Supervision (BCBS). The adoption of select elements of Basel III especially those related to definition of capital was discussed.

Modelling Corporate Probability of Default – A Possible Supervisory Benchmark Model

In recent years, supervisory bodies around the world have lost some of their confidence in the estimations of credit risk parameters at banks applying the internal ratings-based methodology. Supervisory experience shows that differences in risk metrics and ultimately in regulatory capital requirement levels stem primarily from inconsistencies in the modelling techniques applied and the various methodological approaches, rather than from any actual differences between the inherent risks of bank portfolios. To avoid this unwanted effect, in its supervisory review of banks’ internal capital adequacy assessment process, the Central Bank of Hungary (Magyar Nemzeti Bank, MNB) aims at specifying the necessary capital requirements by developing and applying harmonised benchmark models. This study shows how it is possible to estimate a probability of default (PD) for corporate portfolios, which is based on large banks’ corporate default rate data series and available corporate financial data, uses a harmonised methodology that factors in differences between the credit quality ratings of various customers, and is suitable for the supervisor’s calculation of the capital requirement for any given bank. Nonetheless, there may also be other factors in addition to individual financial data (e.g. qualitative expert elements, sector information) that may affect credit quality; identifying these may be one of the objectives of benchmark model development.

Australia

This Detailed Assessment of Observance report specifies Base Core Principles (BCP) for effective banking supervision in Australia. An assessment of the effectiveness of banking supervision requires a review of the legal framework, and a detailed examination of the policies and practices of the institution(s) responsible for banking regulation and supervision. In line with the BCP methodology, the assessment focused on banking supervision and regulation in Australia and did not cover the specificities of regulation and supervision of other financial institutions. The assessment has made use of five categories to determine compliance: compliant; largely compliant, materially noncompliant, noncompliant, and non-applicable. The report insists that Australian Prudential Regulation Authority (APRA) should put more focus on assessing the various components of firms’ Internal Capital Adequacy Assessment Process and other firm-wide stress testing practices. A periodic more comprehensive assessment of banks’ risk management and governance frameworks will further enhance APRA’s supervisory approach.

Internal capital adequacy process: A framework for participating banks from east and west African countries

Orientation: Basel III makes provision for banks to assess their internal capital adequacy by means of risk-based approaches, stress tests and a leverage ratio. However, the Basel regulations do not prescribe to banks or to bank supervisors which method should be used or how it should be used. Research purpose: The research problem was whether a framework could be formulated for the implementation of an internal capital adequacy assessment process in accordance with the Basel III accord. Motivation for the study: East and west African banks and bank supervisors (BS) aspire to become fully compliant with Basel regulations and requested research regarding an internal capital adequacy assessment process (ICAAP) framework for the implementation of Basel III. Research approach/design and method: A participatory action research (PAR) approach was used because PAR contributes to both knowledge creation and improving professional practice. The PAR comprised a survey and interest groups attended by bank supervisors and senior officers of banks. Main findings: As a result, an actionable framework for the performance of internal capital adequacy assessment is proposed. Practical/managerial implications: Capital adequacy, applied appropriately, safeguards a bank’s own economic sustainability and the stability of the financial sector in general. Contribution/value-add: The proposed capital adequacy framework assists bank supervisors and risk managers to apply a more consistent approach for the implementation of the capital adequacy requirements of Basel III.

Evaluating the Relationship between the Banking System Stability and the Internal Capital Adequacy Assessment Process: Evidence from the Egyptian Banking Sector

In the repercussions of the latest financial crisis that have occurred on the years 2008-2009, to fortify the stability of the banking systems, policy makers, and the Basel Committee on Banking Supervision—BCBS, together with national regulators have built up a few safety measures, and structures to guarantee that banks establishments keep up adequate capital levels through using risk management tools, in specific the Internal Capital Adequacy Assessment Processes (ICAAP). They all have called for thorough evaluations and assessments for the structure and components of risk management frameworks, tools, and practices whether by banks, regulators, analysts and risk management experts consistently, to ascertain the adequacy of the banking systems, policies, arrangements and techniques for overseeing risks, and guaranteeing the sufficiency of holding appropriate capital levels for confronting normal, as well as adverse and unexpected situations or emergencies. The main objectives of this research study are to shed the light on the ICAAP as one of the main keys of risk management programs, a process by which banks can use to ensure that they operate with an appropriate level of capital, forward looking processes for capital planning covering a broad range of risks across banks, activities beyond simple capital management, and bring together risk and capital management activities in a form that can be used to support business decisions. The research study shall evaluate the significant relationship between the Banking System Stability (dependent variable) and the Internal Capital Adequacy Assessment Process (ICAAP—independent variable) with evidence from the Egyptian Banking Sector.

Resolving the disconnect between risk appetites, tolerances, exposures and monitoring measurements

The asset management industry’s approach to risk management is continually evolving. A concentrated focus has been invested to develop risk appetite statements (RAS) and internal capital adequacy assessment process (ICAAP) reports. Guidance documentation and surveys often state that there are disconnects between the RAS, ICAAP, other risk processes and decision-making activities across firms. Resolving these disconnects enhances the integrated business profile reports submitted to committees, which ultimately drives how senior management decides to allocate resources. Not resolving these disconnects hinders a firm’s ability to grow and meeting strategic objectives. Risk management consists of multiple estimates — whether day-to-day or once-in-a-lifetime risk exposure assessments — and, as with all estimates, there are multiple ways to obtain a reasonable result based on relevant data and assumptions, but not without a certain level of subjectivity. It is therefore important to note that this paper provides one possible solution for resolving disconnects in risk processes, but its success is dependent on robust governance and proper business planning. The risk processes referred to in this paper relate to the risks facing the asset management business and not the risks contractually borne by its clients.

Economic Capital for Market Risk

The interaction of capital and risk for trading and treasury units is of primary interest in the corporate governance of banks as it links operational profitability and strategic risk management. During the financial crisis, several banks’ trading units suffered significantly higher losses than their risk capital charged based on value-at-risk constraints. There is a structural inconsistency between strategic risk management with a one-year internal capital adequacy assessment process and operating risk management with a ten-day risk horizon for trading units.A new risk budgeting scheme aligns bank risk appetite on an annual basis with operating short-term risk limits. A bank assigns an annual risk budget to its market risk managers. The annual risk budget equals the probability of an annual loss that is higher than a predefined capital-at-risk. Managers’ risk consumption equals the probability of a year-to-date loss in excess of the capital-at-risk at the 10-day risk horizon. As soon as the risk manager has completely consumed his annual risk budget, he immediately has to hedge his positions. The more risk a manager takes and consumes today, the more likely he will be restricted in the future. This relation forces the risk taker to run market risk in a conscious and far-sighted manner.

Managing differences in economic and regulatory capital: An examination of return of equity (ROE) maximising strategies

As per their internal capital adequacy assessment process (ICAAP) and own risk and solvency assessment (ORSA) frameworks, financial institutions (FIs) are subject to both regulatory capital (RC) and economic capital (EC) requirements, the maximum of which becomes the binding constraint, determining the minimum amount of available capital the FI needs to hold. This paper examines alternative strategies and dynamics of the relative RC and EC relationship as FIs seek to maximise return on equity (ROE). The paper shows that EC remains relevant even in cases where RC requirements are higher on aggregate. Under such circumstances FIs are incentivised to ‘dial up’ economic risk by expanding businesses that consume more EC than RC or by divesting businesses consuming more RC than EC in order to enhance ROE. It is explicitly shown that dialling up economic risk lifts up return on EC, boosting ROE. As these opportunities are arbitraged away, EC and RC requirements will tend to converge over time. These strategies, while improving ROE, come at an economic cost. While improving ROE in the short run, low return on EC business may need to be acquired or high return on EC business may need to be divested. The higher the RC relative to EC on aggregate, the higher the potential economic cost. Both the FIs and regulators should prefer EC being the binding constraint on aggregate, supported by strong ICAAP and ORSA frameworks.

Regulation of Capital Adequacy in Western European Banking through the Internal Capital Adequacy Assessment Process (Icaap) & the Supervisory Review & Evaluation Process (Srep)

Regulation of Capital Adequacy in Western European Banking through the Internal Capital Adequacy Assessment Process (Icaap) & the Supervisory Review & Evaluation Process (Srep)

Banks’ internal controls and risk management: Value-added functions in Italian credit cooperative banks

A critical component of safe and sound bank management is constituted by an effective and efficient system of internal controls, which help to ensure that the goals and objectives of a bank will be met, that long-term profitability targets will be achieved, and maintain reliable financial and managerial reporting. Such a system can also ensure that the bank will comply with laws and regulations as well as policies, plans, internal rules and procedures, and decrease the risk of unexpected losses or damage to the bank’s reputation. The paper describes the essential elements of a sound internal control system and through a qualitative approach, it shows how is tied to the rules attaining capital requirements and, above all, to the purpose of the Internal Capital Adequacy Assessment Process (ICAAP) which aims at determining the adequate capitalisation of a bank given the risks endured as well as future risks arising from growth, and new business lines. After the recent financial crisis ICAAP is becoming more and more relevant and a central component of an effective strategy for managing risk and creating value. All principles and considerations are referred to Italian Credit Cooperative Banks particular both for dimension and for governance and risk management. They have been contacted though local federations and the results confirm the existing of weakness in internal controls.

Managing capital buffers in the Pillar II framework: designing an effective ICAAP/ORSA to manage procyclicality and to reconcile short-term and long-term views of capital

We discuss the validation and management of the capital buffers within a Pillar II framework. This issue can only be meaningfully discussed from within the all-encompassing Pillar II framework, where both required risk capital and available capital are examined. As the recent "Basel III" proposals are limited to the Basel II Pillar I framework, they are unable to function as intended. We discuss the design of an effective internal capital adequacy assessment process (ICAAP, which corresponds to the own risk and solvency assessment in Solvency II) for managing capital buffers with respect to credit cycles, stress conditions and strategic objectives. We discuss two solutions in Pillar II for the procyclicality issue. The first solution ties the confidence level to the target debt rating more accurately and, by doing so, it retains the benefits of forward-looking risk information while dampening the procyclicality of capital. The second solution decomposes capital into its conditional and unconditional elements to obtain both shorter and longer views of capital adequacy. Decomposition also enables an "apples-withapples" comparison of capital adequacy among financial institutions, which is not possible when only examining Tier 1 capital ratios.

Risk‐return optimization with different risk‐aggregation strategies

PurposeNew methods of integrated risk modeling play an important role in determining the efficiency of bank portfolio management. The purpose of this paper is to suggest a systematic approach for risk strategies formulation based on risk‐return optimized portfolios, which applies different methodologies of risk measurement in the context of actual regulatory requirements.Design/methodology/approachOptimization problems to illustrate different levels of integrated bank portfolio management has been set up. It constrains economic capital allocation using different risk aggregation methodologies. Novel methods of financial engineering to relate actual bank capital regulations to recently developed methods of risk measurement value‐at‐risk (VaR) and conditional value‐at‐risk (CVaR) deviation are applied. Optimization problems with the portfolio safeguard package by American Optimal Decision (web site: www.AOrDA.com) are run.FindingsThis paper finds evidence that risk aggregation in Internal Capital Adequacy Assessment Process (ICAAP) should be based on risk‐adjusted aggregation approaches, resulting in an efficient use of economic capital. By using different values of confidence level α in VaR and CVaR, deviation, it is possible to obtain optimal portfolios with similar properties. Before deciding to insert constraints on VaR or CVaR, one should analyze properties of the dataset on which computation are based, with particular focus on the model for the tails of the distribution, as none of them is “better” than the other.Research limitations/implicationsThis study should further be extended by an inclusion of simulation‐based scenarios and copula approaches for integrated risk measurements.Originality/valueThe suggested optimization models support a systematic generation of risk‐return efficient target portfolios under the ICAAP. However, issues of practical implementation in risk aggregation and capital allocation still remain unsolved and require heuristic implementations.

Can Basel III Work? Examining the New Capital Stability Rules by the Basel Committee: A Theoretical and Empirical Study of Capital Buffers

In the aftermath of the financial crisis, to reinforce the stability of the financial system, policy makers and the Basel Committee have developed proposals to ensure that financial institutions maintain sufficient capital buffers. The December proposal by the Basel Committee outlines fundamental changes and is already being called “Basel III” by the practitioners. It includes a more restrictive definition of Tier 1 Capital, use of leverage ratios, restrictions on discretionary distributions of earnings, and a “bottom-of-the-cycle” calibration for the Pillar I regulatory capital requirements. In this paper we study these proposals first from a theoretical standpoint and then conduct a quantitative impact study. Recent studies and observations support increasing the quality of capital, although a recalibration of minimum Tier 1 ratio will be required. Leverage ratios appear redundant and implementation of them would further complicate the risk optimization problem faced by financial institutions (FIs). Constraining the discretionary distributions of earnings can keep agency costs under control but needs be carefully thought through to make sure that value transfer simply does not take another form and it does not overly interfere with the FI’s dividend policies. The “bottom-of-the-cycle” calibration does not look defendable. Among other problems, it could adversely affect the FI’s profitability, decelerating the capital built up by reducing the income generation per unit of capital base. Addressing the capital buffer problem within the Pillar II Internal Capital Adequacy Assessment Process (ICAAP) framework supplemented by conditional and forward looking stress testing is clearly the preferred approach.