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  1. 1. Developing an effective ICAAP Chris Matten 31 May 2011 ww.pwc.com
  2. 2. PwC Agenda CAAP components hallenges in implementing the ICAAP oles of IA and risk management ngoing maintenance 2
  3. 3. PwC 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” oard and senior management oversight ound capital assessment • Policies and procedures … to measure … all material risks • Process to relate capital to level of risk omprehensive assessment of all risks onitoring and reporting 3
  4. 4. PwC 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 regularly VI. The ICAAP should be risk-based VII. The ICAAP should be comprehensive VIII. The ICAAP should be forward-looking IX. The ICAAP should be based on adequate measurement and assessment processes X. The ICAAP should produce a reasonable outcome 4
  5. 5. PwC ICAAP components 1. Description of risk governance 2. Statement of risk appetite i. Link to risk limits ii. Link to strategy 3. Comparison with risk-bearing capacity 4. Assessment of material risks 5. Comprehensive risk capital model (economic capital?) 6. Capital forecasts and stress tests, showing: i. Regulatory capital ii. Risk or economic capital iii. Physical capital iv. Available vs required capital 7. Capital allocation process and policies 8. Use test - embedded in business processes 5
  6. 6. PwC 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 6
  7. 7. PwC Statement of risk appetite - example 7 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
  8. 8. PwC Statement of risk-bearing capacity 1. Board-level document 2. Quantifies the ability of the institution to absorb risks 3. 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 8
  9. 9. PwC In organisational terms 9 Actual Risk Profile Target Risk Profile Risk-bearing capacity Risk Appetite 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 Credit Risk Market Risk Op.s Risk Int. rate Risk Liquidity Risk Etc. Individual risk measures
  10. 10. PwC Assessment of material risks 1. Banks need to assess all material risks 2. Should be fully documented 3. 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. Managed c. Mitigated 5. Develop a risk map to cover all risks 6. Can be based on different approaches a. Regulatory capital b. Economic capital models c. Stress tests/scenario analysis d. Single-point estimates 10
  11. 11. PwC 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. 11
  12. 12. PwC Capital stress tests 1. Pillar 1 stress tests a. “tail” test b. Sensitivity analysis 2. Pillar 2 stress tests a. Capital stress test b. Additional scenarios for pillar 2 risks 3. Level of severity? – look to regulatory guidance 4. Purpose: to demonstrate that the bank can survive a reasonably severe crisis without breaching minimum capital levels 12
  13. 13. PwC Capital stress tests illustrated (1) 13 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
  14. 14. PwC Capital stress tests illustrated (2) 14 Capital ratios Time horizon of forecast and stress test Minimum Base case forecast “Gross” stress test “Net” stress test Additional capital raised
  15. 15. PwC Agenda CAAP components hallenges in implementing the ICAAP oles of IA and risk management ngoing maintenance 15
  16. 16. PwC 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. Comprehensiveness b. Appropriateness of approach 4. Capital forecasting a. How robust is the planning/budgeting process? b. Time horizon? 5. Capital stress testing a. Is the stress scenario appropriate? b. Are mitigating actions credible? 16
  17. 17. PwC 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 17
  18. 18. PwC Agenda CAAP components hallenges in implementing the ICAAP oles of IA and risk management ngoing maintenance 18
  19. 19. PwC Typical roles and responsibilities 19 Function Role Risk 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
  20. 20. PwC 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? 20
  21. 21. PwC 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? 21
  22. 22. PwC 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? 22
  23. 23. PwC 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. Strategy b. Economics c. Business heads d. Risk e. Finance 4. Is it consistent with regulatory expectations? 5. Are management mitigating actions credible? 6. Arithmetic accuracy? 23
  24. 24. PwC Challenges: Use test 1. How effectively is the ICAAP embedded into day-to-day management processes? a. Capital allocation b. Capital budgeting and rationing c. Performance measurement d. Pricing e. Compensation f. Investor communications g. Risk management (limits etc) 24
  25. 25. PwC 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? 25
  26. 26. PwC Agenda CAAP components hallenges in implementing the ICAAP oles of IA and risk management ngoing maintenance 26
  27. 27. PwC Ongoing maintenance 1. ICAAP should be refreshed at least annually 2. More frequently if: a. Significant M&A or disposals b. Significant changes in corporate structure c. 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 relevancy b. Capital planning and stress testing updated c. Proper review, challenge and approval 27
  28. 28. Thank you his publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, [insert legal name of the PwC firm], its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2011 PricewaterhouseCoopers Limited. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Limited which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.