Guidelines for Internal Capital Adequacy Assessment Process (ICAAP) – Basel III
The Supervisory Review and Evaluation Process (SREP) is a crucial part of the Capital Adequacy Framework, which itself is built on three pillars. The first pillar deals with the minimum capital ratio. The second and third pillars, which we focus on here, are about supervisory review and market discipline.
The main goal of the supervisory review process is to make sure that financial institutions, specifically All India Financial Institutions (AIFIs), hold enough capital to cover all the risks in their business. It also encourages these institutions to improve their risk management techniques. This involves a detailed internal assessment process, known as the Internal Capital Adequacy Assessment Program (ICAAP). Through this program, AIFIs demonstrate to the Reserve Bank that they have sufficient capital for various risks. This process might include discussions with the Reserve Bank to adjust risk levels or capital if necessary.
The review process addresses several risks. Some of these risks might not be fully covered by the minimum capital ratio under the first pillar. These include risks like interest rate changes in the banking book, credit concentration, liquidity, and reputational risks, among others. AIFIs need to consider these risks because the minimum capital ratio often underestimates them or doesn’t account for them at all.
AIFIs are expected to comprehensively address these risks in their ICAAP. This includes measuring and managing risks like currency-induced credit risk. They should also conduct stress tests for different scenarios. Depending on the results, AIFIs might need to take actions like reducing risk or holding more capital.
Each AIFI should assess its risk exposures through a well-defined internal process and maintain enough capital for these risks. It’s important to note that there’s no single best way to conduct the ICAAP. Practices are still evolving, especially for measuring risks that are hard to quantify, like reputational or strategic risks. The guidelines provided here offer broad principles for AIFIs to develop their ICAAP.
AIFIs should create their ICAAP in line with their size, complexity, risk profile, and operational scope. This program should be approved by their Boards and should complement the calculation of regulatory capital requirements under the first pillar. The ICAAP document should include a capital adequacy assessment, projections of capital requirements for the coming year, and strategies for meeting these requirements. While we provide a suggested format for the ICAAP document, it’s understood that the actual documents may vary in length and format, depending on the specific characteristics of each AIFI.
Financial institutions have faced various challenges over the years. Often, these problems stem from weak credit standards, poor risk management in their portfolios, and not paying enough attention to economic changes that can affect the creditworthiness of their clients.
The financial crisis of 2007-08 highlighted how crucial good credit risk management is for the long-term success of any financial institution. It’s not just about the institution’s stability; it’s also about the stability of the financial system as a whole. This crisis was a clear reminder for All India Financial Institutions (AIFIs) to effectively identify, measure, monitor, and control credit risk. It’s also important for them to understand how credit risk is linked with other types of risks like market, liquidity, and reputational risks. A comprehensive credit risk management program should include setting the right credit risk environment, having a sound process for granting credit, maintaining proper credit administration and monitoring, and ensuring adequate control over credit risk.
The Global Financial Crisis also showed the importance of effective capital planning and maintaining strong capital over the long term. AIFIs need to be prepared for uncertain market conditions. A strong capital position helps them handle potential changes in their strategy and market volatility. Effective capital planning involves assessing the risks they face and how well they manage these risks. AIFIs should evaluate their capital adequacy relative to their risks and consider how economic downturns could affect their earnings and capital. Part of this planning should include thorough, forward-looking stress testing.