While The Bank of England intends to limit concurrent stress testing to firms with retail deposits greater than £50 billion, a new emphasis on Internal Capital Adequacy Assessment Process (ICAAP) is making stress testing important for every financial institution in the UK.
The Basel Committee on Banking Supervision (BCBS) issued a new set of rules (Basel III) that builds on its earlier framework (Basel II). The main focus of Basel III is to strengthen Pillar 1, by adding substantial new requirements for capital, liquidity, and funding. But Basel III will take several years to phase in, and in an effort to drive change faster, regulators are now focusing more intently on Pillar 2 and ICAAP.
Mastering ICAAP
We have been conducting ICAAP for banks for several years now, and we have learned a lot along the way. The following essentials should be considered when mastering ICAAP:
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Senior management has to have a comprehensive picture of all material risk types across the enterprise and a good understanding of the relevant underlying drivers at any time.
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Regular, structured, and transparent management reporting should be a part of the processes of the risk strategy, enterprise risk management, and risk committees.
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Moreover, senior management should also have a good understanding of model assumptions and limitations and should get actively involved in identifying the material risk drivers across the businesses and defining potential stress scenarios.
Benefits of ICAAP
The benefits of excellence in ICAAP are clear. Strong compliance is the key benefit, and clear principles in capital calculation and management will help banks avoid regulatory constraints or even penalties.
In addition, banks may be able to leverage other benefits to give themselves a competitive edge. Stress testing can be part of a process that achieves better capital allocation and enhanced risk-adjusted performance measurement. In an environment of tight capital, excellence in ICAAP implementation can help the bank make the most efficient use of this scarce resource.
A best practice approach
Making this happen is a challenge for any risk management function and that’s why many organisations partner with external experts. A good ICAAP process requires strong oversight and a team with a wide range of skills, including data specialists and modellers with direct experience and a deep understanding of the profit dynamics and sensitivities of your portfolio.
The key to success is to successfully integrate the ICAAP process into wider risk management activities, looking for opportunities to improve controls and efficiency. This may be most easily achieved through a combination of internal and external specialist resource. That’s why we offer a consultancy-led approach to determine the optimal path for your organisation.
