Developing an effective ICAAP

Chris Matten31 May 2011

www.pwc.com

PwC

Agenda

ICAAP components

Challenges in implementing the ICAAP

Roles of IA and risk management

Ongoing maintenance

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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

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ICAAP Principles - CEBS

I. Every institution must have a process for assessing its capital adequacy relative to its risk profile (an ICAAP)

II. The ICAAP is the responsibility of the institution. III. 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

IV. The ICAAP should form an integral part of the management process and decision-making culture of the institution

V. The ICAAP should be reviewed regularlyVI. The ICAAP should be risk-basedVII. The ICAAP should be comprehensiveVIII.The ICAAP should be forward-lookingIX. The ICAAP should be based on adequate measurement and

assessment processesX. The ICAAP should produce a reasonable outcome

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ICAAP components

1. Description of risk governance2. Statement of risk appetite

i. Link to risk limitsii. Link to strategy

3. Comparison with risk-bearing capacity4. Assessment of material risks5. Comprehensive risk capital model (economic capital?)6. Capital forecasts and stress tests, showing:

i. Regulatory capitalii. Risk or economic capitaliii. Physical capitaliv. Available vs required capital

7. Capital allocation process and policies8. Use test - embedded in business processes

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Statement of risk appetite

1. Board-level document 2. Quantifies the desired level of risk that an institution is

willing to take. 3. Typically be expressed in terms of risk limits, but under an

ICAAP should also quantify those risk limits in terms of capital

4. Usually refreshed at least annually. 5. May be expressed in terms of earnings volatility (earnings

perspective), either in addition to or instead of the solvency perspective.

6. Where an institution only uses an earnings perspective, meeting Pillar 2 ICAAP requirements may be challenging

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Statement of risk appetite - example

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Metric Indicators

Quantitative indicators

Earnings volatility No more than 5% chance of being unable to pay our forecast dividend. (i.e. we expect to

pay our dividend in 19 out of 20 years)

Do not deliver below market consensus earnings forecast (as at the beginning of the financial year) for the Group and each of its Divisions, by more than 20% (the consensus

market forecast for this year is PAT of £700m, but our budget envisages £750 m)

Return on equity Target return on equity is 12%

Target capital ratios Our Tier 1 capital ratio should not fall below 6% of RWAs and our total capital ratio

should not fall below 10%

Our economic capital utlisation should not exceed 85% of our available capital Note: our EC requirement is lower than our Basel I minimum capital requirement; once

Basel II comes into force on 1 Jan 2007, we expect our regulatory capital requirements to fall closer into line with our EC requirements

Credit rating AA- (equivalent to Probability of Default of 0.03% for one year – S&P).

AA is our target rating and our intention is to maintain it

Qualitative indicators

Unable to manage

growth effectively

Monitor indicators for early warnings of non-sustainability of growth (e.g. overconfidence

of management, process delays, system constraints)

Business activities Limit our business activities to: retail and corporate banking; expand our IB activities only

in those areas where we have proven competence; asset management. Limit overseas expansion to China and the US

Insufficient risk is

assumed

Track rationale for rejected (and accepted) business opportunities to ensure that risk

appetite is properly reflected

Zero tolerance risks

Regulatory risk In key regimes (UK and USA), have no instance of “flagrant breaches”, fines or headlines

No breach of delegated authorities

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Statement of risk-bearing capacity

1. Board-level document2. Quantifies the ability of the institution to absorb risks3. Typically expressed in terms of capital (solvency

perspective) but may also be expressed in an earnings perspective.

4. The statement of risk-bearing capacity and statement of risk appetite are usually companion documents

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In organisational terms

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Actual Risk Profile

Target Risk Profile

Risk-bearing capacity

RiskAppetite

The quantum of risk the firm is willing to accept within its overall capacity

The maximum risk the firm can bear, which is linked to capital, liquid assets, borrowing limits etc

Allocated risk limits

Utilisation of limits

CreditRisk

MarketRisk

Op.sRisk

Int. rateRisk

LiquidityRisk

Etc. Individual risk measures

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Assessment of material risks

1. Banks need to assess all material risks2. Should be fully documented3. Risks that are deemed not to be material still need to be

documented (+ reasons)4. Should explain how risks are:

a. Measured (where relevant)b. Managedc. Mitigated

5. Develop a risk map to cover all risks6. Can be based on different approaches

a. Regulatory capitalb. Economic capital modelsc. Stress tests/scenario analysisd. Single-point estimates

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Capital forecasts

1. As the ICAAP must be forward-looking, it needs to incorporate planned capital levels.

2. A fully-integrated capital forecast would be linked to the planning and budgeting process, providing forecasts for:

a. Available physical (book) capital – essentially a function of profits, dividends and other capital management activities

b. An adjustment of the available physical capital to reconcile to available economic capital and regulatory capital

c. Required economic capital – essentially a function of forecast credit exposures, market risk limits etc.

d. Required regulatory capital – essentially a function of forecast risk-weighted assets.

3. Forecast requirements should be compared with forecast availability.

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Capital stress tests

1. Pillar 1 stress testsa. “tail” testb. Sensitivity analysis

2. Pillar 2 stress testsa. Capital stress testb. Additional scenarios for pillar 2 risks

3. Level of severity? – look to regulatory guidance4. Purpose: to demonstrate that the bank can survive a

reasonably severe crisis without breaching minimum capital levels

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Capital stress tests illustrated (1)

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Capital ratios

Time horizon of forecast and stress test

Minimum

Base case forecast

“Gross” stress test

“Net” 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

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Capital stress tests illustrated (2)

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Capital ratios

Time horizon of forecast and stress test

Minimum

Base case forecast

“Gross” stress test

“Net” stress test

Additional capital raised

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Agenda

ICAAP components

Challenges in implementing the ICAAP

Roles of IA and risk management

Ongoing maintenance

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Challenges in implementation

1. Making it relevant for the business (and meeting the use test)

2. Defining risk appetite is not easy!3. Assessment of material risks

a. Comprehensivenessb. Appropriateness of approach

4. Capital forecastinga. How robust is the planning/budgeting process?b. Time horizon?

5. Capital stress testinga. Is the stress scenario appropriate?b. Are mitigating actions credible?

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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

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Agenda

ICAAP components

Challenges in implementing the ICAAP

Roles of IA and risk management

Ongoing maintenance

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Typical roles and responsibilities

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Function RoleRisk 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 •Review, challenge and approve

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Challenges: Risk appetite and risk-bearing capacity

1. Level of senior management/board involvement?2. Is it consistent with past experience?3. Is it consistent with strategic and business plans?4. Proper level of review and challenge at Board level?

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Challenges: Assessment of material risks

1. Was there full involvement of risk owners and risk management?

2. Risk maps fully documented?3. Is it complete based on past experience?4. Has all relevant date been incorporated into the

assessment?5. Is the modelling approach appropriate for the type of risk?6. Has ‘material’ been clearly and properly defined?7. Proper level of review and challenge at senior

management and Board level?8. Arithmetic accuracy of Internal Capital Assessment?

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Challenges: Capital planning

1. Robustness of underlying budgeting/planning process?2. Appropriate time horizon (3-5 years)?3. Sufficient granularity of detail?

a. Components of available capital?b. Proper treatment of dividends etc?c. Different assets classes?d. Different RWA classes?

4. Consistent with past experience?5. Arithmetic accuracy?6. Proper challenge, review and sign-off?

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Challenges: Capital stress testing

1. Is the severity of the stress scenario(s) appropriate?2. Are the results consistent with the scenario(s) adopted?3. Has there been proper involvement of all relevant

departments?a. Strategyb. Economicsc. Business headsd. Riske. Finance

4. Is it consistent with regulatory expectations?5. Are management mitigating actions credible?6. Arithmetic accuracy?

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Challenges: Use test

1. How effectively is the ICAAP embedded into day-to-day management processes?

a. Capital allocationb. Capital budgeting and rationingc. Performance measurementd. Pricinge. Compensationf. Investor communicationsg. Risk management (limits etc)

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Challenges: Overall ICAAP governance

1. Was there a single ‘owner’ of the ICAAP to drive a consistent, comprehensive approach?

2. Was there the right level of involvement of other stakeholders?

a. BUs, Risk, Finance, Strategy, Economics, etc?3. Has senior management/the Board been actively involved

in review and challenge?4. Was there a formal sign-off process?5. Any involvement of external parties to develop/review the

ICAAP?a. Skills and qualifications?b. Any issues raised by them not addressed?

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Agenda

ICAAP components

Challenges in implementing the ICAAP

Roles of IA and risk management

Ongoing maintenance

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PwC

Ongoing maintenance

1. ICAAP should be refreshed at least annually2. More frequently if:

a. Significant M&A or disposalsb. Significant changes in corporate structurec. Material changes in regulatory requirements (e.g.

Basel III)d. Crisis occurs

3. If no major changes, it is a ‘refresh’, not a ‘re-do’4. IA needs to review the process to ensure that:

a. All elements have been reviewed to ensure relevancyb. Capital planning and stress testing updatedc. Proper review, challenge and approval

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Thank you

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