Under ICAAP requirements a bank needs to have in place internal procedures and processes to ensure that it possesses adequate capital resources in the long term to cover all of its material risks. These processes and procedures together are known as the Internal Capital Adequacy and Assessment Process or ICAAP for short.
Large bank holding companies in the US are required to submit on an annual basis a board of directors approved comprehensive capital plan to the Federal Reserve. The plan is a long run (2-year/ 9-quarter) forward looking quantitative and qualitative review of the firm’s internal capital adequacy assessment processes and capital resource management strategies.
Key components of the plan include:
- Description of regulatory capital base, key contractual terms of capital instruments and management plans to retire, refinance or replace the instruments over the planning period
- Description of capital distribution plan over the 2-year horizon, including actions taken to reduce distributions in adverse environments
- Description of processes and policies used to determine the size of the dividend and stock repurchases under difference operating conditions
- An assessment of the potential losses, earnings and other resources that may be used to absorb losses in stressful environments and how these losses may impact the firm’s capital adequacy and capital needs, i.e. the sensitivity of the bank’s projected capital ratios was tested for changes to loss and earnings estimates.
- An assessment of post-stress test capital requirement for a firm to ensure that it continues operating and meeting its obligations and functioning as a credit intermediary
If economic or financial conditions deteriorate as compared to those assumed when drawing up the original plan, or if there is a change in the firm’s risk profile, business strategy or corporate structure, then the firm is required to submit a revised comprehensive capital plan with revised capital distribution proposals.
Currently the Federal Reserve assesses these plans in 5 areas on a firm specific as well as horizontal (industry wide) perspective. These include:
a.Quantitative and qualitative reviews of the robustness of the firm’s capital adequacy assessments, planning and allocation of capital resources processes including firm wide risk measurement and management practices. This consists of whether the firm is able to calibrate and maintain an internal target level of capital over time and the effectiveness of implementation risk policies and procedures, governance over internal capital adequacy assessments, comprehensiveness of capital plans and planning processes.
b.The acceptability and appropriateness of the capital distribution policy over the planning horizon. This is done to ensure capital actions are well supported by capital resources and are consistent with the firm’s capital plan under a number of financial and economic scenarios, its internal capital adequacy processes and corporate governance as well as Federal Reserve expectations.
c. An assessment of the plans for repaying any US government investment made before increasing or renewing capital distributions to shareholders
d. Stress testing to assess the firm’s ability to absorb losses for a range of economic, financial market and operational events. This includes the ability of the plan to capture all material risks under stressed conditions by way of translating risk exposures into potential loss estimates. The outputs assessed are quarterly projections of a firm’s regulatory capital ratio over a 9-quarter planning horizon under three scenarios (a firm generated baseline most likely scenario, a firm generated stress scenario and an adverse supervisory stress scenario generated by the Federal Reserve). The latter scenario covers an additional 4 quarters. In addition the largest firms are also required to estimate losses under a very conservative global market shock scenario.
e. An assessment of the plans for meeting the enhanced capital requirements in Basel III and Dodd-Frank Act. To assess the impact of Basel III requirements the firms needed to provide forecasts of regulatory and capital ratios using the fully-phased in target capital levels for at least a two year period. The firms were also required to provide their strategies for taking account of certain provisions of Basel III and Dodd-Frank Act such as strategies for restricting or precluding certain capital instruments, improving risk modeling, changing business focus or operations that impacted risk weighted assets, leverage ratio assets or capital.
Areas c) and e) are relevant for the firms as long as these issues continue to impact the firms’ capital adequacy, planning and management processes. In the future the Federal Reserve may identify and evaluate other areas of assessment. Also assessments of areas a), b) and d) will continue to evolve as financial and economic conditions change and new ways of measuring and managing risk evolve over time.
Firms are required to submit a significant amount of support analysis and data to help in the evaluation of their plans.
Basel III: Basel II Framework Revisions
Basel III aims to resolve the weaknesses and fill in the loopholes of the current Basel II framework that became apparent in the recent financial crisis. Basel III introduces significant reforms to the Basel II framework addressing both firm-specific risk as well as system-specific systemic risk factors. These reforms will come into full effect in January 2019 but there is a long period of transition into the revised framework that will begin from January 2013. These improvements should lead to a stronger capital position for the global financial system which should help it withstand significant periods of economic stress as experienced in the recent past which resulted in numerous bank failures and huge taxpayer bailouts.
On a micro-prudential, firm specific level the Basel III changes include a much stricter definition for capital including a capital conservation buffer and limitations on bonus and dividend distributions, stronger liquidity requirements, and improved & enhanced levels of risk coverage.
Basel III: Enhancements to Basel II: Firm-specific changes
Basel III also incorporates a macro-prudential system-wide layer, introducing measures such as a Leverage Ratio, a countercyclical capital charge to address the pro-cyclicality present within the Basel II framework, and specific requirements for systemically important financial institutions (SIFIs) and systemically important markets and market infrastructures (SIMIs) such as the OTC derivatives market.
Improvements to the process also include a much larger role for stress testing to capture risks of tail events and other systemic risk factors.
Basel III: Enhancements to Basel II: System-wide changes & Increased Stress Testing
