Although it has been more than a decade since the Basel Committee on Banking Supervision (BCBS) first launched the Internal Capital Adequacy Assessment Process (ICAAP), firms continue to make fundamental errors in calculating their regulatory capital.
These errors can be expensive for organizations – often resulting in regulators adding on additional capital requirements after their review of a firm’s ICAAP.
8 errors that firms are continuing to make are:
- Using Pillar 1 (P1) as the minimum capital
This is a common misconception. In reality, the minimum capital is P1 + Pillar 2A (P2A). P2A capital calculations are meant to include all risks not captured in P1 or not fully captured in P1. Market risk + credit risk + operational risk together are the definition of P1 and are not part of P2A. Additional risks can include conduct risk not captured in P1, pension obligation risk, liquidity risk, third party risk, group risk, restructuring risk, and concentration risks not captured in credit risk calculations. One straight-forward way to calculate P1 + P2A is to mathematically model risk and control self-assessments (RCSAs) at a high level, and then add in the credit and market risk components of P1.
- Believing capital is the higher of Pillar 1 or scenarios
This is also an often-made error. Total regulatory capital is actually calculated based on P1 + P2A + Pillar 2B (P2B). P2B is capital based on stress testing and scenarios for exceptional, plausible loss events the firm may encounter. The entire P2B process should be well-documented, from how the scenarios are selected through to the business impacts of the modelling outcomes.
- Thinking total capital is either Pillar 2A or Pillar 2B
Actually, P2A contains the capital required but missed in P1. P2B is to ‘cover’ the exceptional events that may happen to a firm, and is added to P1+P2A. It does not, in this sense, contain the risks within P2A.
- Calculating ICAAP only for the regulator
Regulators expect the ICAAP to be calculated for and used by the business. They also expect it to be regularly included in board meetings and senior management team discussions. Key stakeholders should need to know how much capital the business requires to support the risks that it runs both now and in the future. Just using the regulatory bases for capital calculation can show that either the firm does not know its risks and capital needs better than the regulator, or that the firm simply cannot be bothered to think about its capital needs. In either case, the result is usually a heavy capital add-on.
- Making the ICAAP document too big to be useful
Regulators do not appreciate having a huge tome dumped on their desk, in which it is difficult to find the information they need to do their jobs. Worse, they often assume that a chunky, poorly-organized ICAAP is an attempt to hide bad news about a firm. Regulators want to see ICAAPs of 50 pages, but an ICAAP of 70-80 pages is reasonable. Detail should be included in a series of appendices at the back.
- Doing the ICAAP once a year
At minimum, the ICAAP should be reviewed at least quarterly. A few firms do it monthly. When the ICAAP is calculated more frequently, it can actually be used by the business, senior management and the board to inform decision-making. For example, capital needs can be planned for more accurately in line with the evolution of the organization. Calculating the ICAAP once a year sends a poor signal, as regulators assume then that the ICAAP is being done purely as a compliance exercise.
- Basing the capital calculation on the regulator’s methodology
The ICAAP is the firm’s internal capital adequacy assessment. It’s not the regulator’s. The regulator makes its own assessment, which takes account of the firm’s assessment. The firm should develop its own methodology. Using the regulator’s methodology shows a lack of interest in the firm’s survival and a lack of imagination as to what can happen to a firm.
- Using a FOR wind down scenario to calculate capital
Some firms (limited scope firms) are able to use the fixed overhead requirement (FOR) for part of their regulatory capital calculation. However, it can easily take more than three-to-six months to wind a firm down. Firms that are relying on the FOR for part of their ICAAP calculation should also consider how much capital is required for the firm to truly wind down, i.e. how much capital is required after the majority of the business has moved to a competitor. Firms should also be clear that they really are willing to close if an exceptional event occurs.
Getting the firm’s ICAAP right can add tremendous value to the organization, improve regulatory relationships, and contribute to future profitability. There are a number of ways to make the ICAAP process run more smoothly, as a repeatable, sustainable process.