Guidelines for the SREP of RBI and ICAAP of AIFIs– Basel – III
The Basel capital adequacy framework is built on three pillars. The first pillar sets the minimum capital requirements, including operational, market, and credit risk. The second pillar, the Supervisory Review Process (SRP), focuses on establishing and reviewing risk management systems in AIFIs. The third pillar aims for increased transparency through expanded disclosure requirements for AIFIs.
The SRP under the second pillar is based on four key principles. Firstly, AIFIs should assess their capital adequacy against their risk profile and maintain appropriate capital levels. Secondly, supervisors review and evaluate these assessments and strategies, ensuring AIFIs comply with regulatory capital ratios. If unsatisfied, supervisors can take action. Thirdly, AIFIs are expected to hold capital above the minimum regulatory ratios. Finally, supervisors should intervene early to prevent capital from falling below required levels and demand quick action to restore capital if needed.
The ICAAP and SREP are two critical components of the second pillar. AIFIs are responsible for assessing their capital adequacy in relation to their risk profile and maintaining capital levels above the minimum regulatory ratios. Supervisors, on the other hand, review and evaluate AIFIs’ ICAAP, compliance with regulatory capital ratios, and can require AIFIs to hold extra capital. They also intervene early to prevent capital levels from dropping too low and demand quick corrective actions.
Capital is essential for the safety and soundness of financial institutions. While Pillar 1 establishes a minimum threshold, supervisors need a more comprehensive assessment that considers each AIFI’s specific risks. The Reserve Bank expects AIFIs to maintain capital above the minimum levels, reflecting their individual risk profiles. The SREP involves a thorough evaluation of an AIFI’s overall capital adequacy, considering their compliance with regulatory requirements, the quality of their ICAAP, and their risk management processes.
The SREP will be part of the Reserve Bank’s inspection of AIFIs. It evaluates the adequacy and effectiveness of an AIFI’s ICAAP and the derived capital requirements. The Reserve Bank will understand an AIFI’s capital management processes and strategies through this evaluation. If necessary, the SREP may involve discussions with the AIFI’s top management. Independent external experts may also review specific aspects of an AIFI’s ICAAP.
Pillar 1 capital requirements include a buffer for uncertainties. However, AIFI-specific uncertainties are treated under Pillar 2. The Reserve Bank may require AIFIs to maintain a buffer above the Pillar 1 standard for various reasons, including competitive advantages, business changes, risk exposures, and market conditions. The SREP under Pillar 2 may also review the AIFI’s risk management measures, especially for significant currency-induced credit risks.
The ICAAP should be prepared at every level within an AIFI group and encompass the institution-wide risk profile. It should include active Board and senior management oversight, appropriate policies, procedures, and limits, comprehensive risk identification, measurement, mitigation, monitoring, and reporting, and robust internal controls.
The Board and senior management are responsible for designing and implementing the ICAAP, defining the institution’s risk appetite, and ensuring effective policies and controls. They should understand the AIFI’s major business lines and ensure that risk management systems are effective. The risk function should be independent and report directly to the CEO or Managing Director and the Board.
AIFIs should have detailed policies setting specific limits on principal risks and procedures providing guidance for implementing broad business strategies. These policies should recognize economic substance, be consistent with the AIFI’s goals and financial strength, and clearly delineate accountability and authority.
The ICAAP should include regular, accurate, and timely information on the AIFI’s risk profile, support aggregation of risks across business lines, and be adaptable to changes in risk assumptions. It should also be capable of capturing limit breaches and ensuring follow-up actions.
Regular independent reviews should validate the ICAAP, ensuring it reflects the major risk sources and complies with internal policies. The Board should set the risk tolerance level, and the ICAAP outcomes should be periodically submitted to the Board and the Reserve Bank. The Board should assess whether the ICAAP processes achieve their objectives and make necessary adjustments.
The ICAAP should be an integral part of the management and decision-making culture, guiding capital allocation, credit decisions, product pricing, and business decisions. It should be forward-looking, considering future developments and ensuring adequate capital for the AIFI’s activities.
The ICAAP should be risk-based, setting capital targets consistent with the AIFI’s risk profile and operating environment. It should include stress tests and scenario analyses to evaluate potential vulnerabilities and the impact of unlikely but plausible events on the AIFI.
AIFIs using model-based approaches for their ICAAP should demonstrate well-documented model specifications, reliance on historical data, robust validation of model inputs and outputs, stress testing of the model, and the adequacy of skills and resources to operate and maintain the model.