Internal Capital Adequacy Assessment Process (ICAAP)

Manila Bulletin

MANILA, Philippines - Common topic among bankers nowadays is ICAAP. What is ICAAP? ICAAP or the Internal Capital Adequacy Assessment Process is the process by which banks assess their capital adequacy relative to their risk profile. The objective is for the banks' Board of Directors and senior management to ensure that the banks maintain an appropriate level of capital commensurate to their exposure to credit risk, market risk, operational risk and all other material risks to which banks are exposed.

On January 15, 2009, Bangko Sentral ng Pilipinas or BSP, the primary supervisory body of Philippine banks, issued Circular No. 639 containing guidelines on how banks must align with the Basel II requirements effective January 1, 2011. The Basel II is composed of three pillars:

I. Minimum capital requirements

II. Supervisory review

III. Market discipline

I. Minimum Capital Requirements

This is the first pillar where banks would need to maintain a minimum regulatory capital amount that covers three main risks - credit, market and operational risks. Banks start with the credit risk (counter-party's failure to meet the terms of the contract) component calculation using a standardized approach and progress to internal ratings based approach. In the standardized approach, the risk weight is applied on the basis of the rating of the counter-party and the maturity profile of the exposure. In the internal ratings based approach, the values of probability of default, loss given default, exposure at default and maturity are used in the computation for capital charge. The values are estimated using historical data of the bank's credit portfolio.

The market risk (risk to earnings or capital arising from market-making, dealing, and position- taking in interest rate, foreign exchange, equity and commodities markets) component relies on Value-at-Risk (VAR) approaches to compute the risk of the exposure. VAR shows that for a selected portfolio, how much you stand to lose, over a certain period and with a certain probability.

The operational risk (risk to earnings or capital arising from fraud, error, inability to deliver products and services, maintain a competitive position and manage information) component is calculated using either a basic indicator approach or a standardized approach or an advanced measurement approach. The basic indicator approach allows the bank to compute operational risk as the average of the positive annual gross income figures for the past three years to calculate the capital charge. The standardized approach considers the banks' major business lines and the capital for operational risk for each of these major business lines is computed as a percentage of the bank's gross income from that particular line of business. In the advanced measurement approach, the banks will employ their own empirical models to calculate the required capital for operational risk.

II. Supervisory Review

This is the second pillar and deals with the regulatory response to the first pillar and provides a framework for dealing with the residual risks such as compliance risk, concentration risk, strategic risk, reputational risk, liquidity risk, interest rate risk in the banking book, and legal risk that are not covered in the minimum capital requirements. The supervisory review process ensures that banks have considered all material risks in the business and requires banks to develop and use better risk management techniques in monitoring and managing their risks.

All risks that are material to the bank need to be quantified and stress tested. The relevant procedures supporting the assessment process, the results or target capital requirements that are commensurate with the bank's risk profile and control environment are communicated through an ICAAP document that are firstly reviewed and approved by the Board, and then to the supervisory regulatory body and the market.

The BSP, as regulator, evaluates the ICAAP document to see how well banks assess their capital needs in relation to their risks. It expects banks to operate above and hold more than the minimum capital requirements. If there were deficiencies identified in the process and/or capital, during the periodic examination of banks, BSP, as the supervisor would intervene and prompt, decisive action and directives would be communicated to the Board to reduce the risk or restore the capital.

III. Market Discipline

This is the third pillar and it details the obligations of the bank to disclose information to all stakeholders. The clients and shareholders should have sufficient understanding to comprehend how the bank manages its risks. The purpose is to allow more transparency and let the market have a better idea of the banks risk positions so that they can deal with the bank in a better way.

On March 31, 2009, Philippine banks submitted their first trial ICAAP Document to BSP which was followed by a series of dialogues with some banks. However, the schedule of dialogues was disrupted in the last quarter of 2009 by the super typhoon Ondoy destruction that affected some banking business operations and personal properties of bank personnel.

As such, the second trial ICAAP Document submitted on January 31, 2010 was a reprieve to some banks to re-assess their respective ICAAP model founded on an integrated approach of capital planning, risk management framework and business strategic planning. Then the second round table dialogues of the second trial ICAAP Document resumed with the regulators satisfied to formalize the ICAAP implementation across all banks effective January 31, 2011.

The first trial ICAAP Document employed a simplified risk charge based approach. However the simplified risk charge based approach did not consider items that had carried different risks to the banks, and thus, were simply subjected to the same risk charge. As the ICAAP appreciation and the level of execution were evolving, the regulators encouraged banks to develop their own internal ICAAP model to calculate the minimum capital requirements. Cognizant that the banks were faced with other material risks more than the simplified credit risk and market risk capital requirements, the well-diversified banks had to compute for the different families of risk affecting their balance sheets. It was the Basel II accord which addressed some of these concerns, by introducing the concept of operational risk capital and provided capital requirements for new products that were previously not handled in the original capital accord. It took what is now regarded as the third and final step towards capital requirements that were reflective of credit, market and operational risk.

In PNB, we take the ICAAP very seriously. Series of meetings and discussions were held by senior management with most Board committee chairmen. Incidentally, PNB's Audit committee chair is "just" the former managing partner of SGV, Gloria Tan Climaco; the Risk Management Committee chair is "just' former BSP advisor to PNB and former president of Land Bank Doy Casuela; and the Chairman of Trust is "just" the former Deputy Governor of the Central Bank Fely Miranda. At the recent ICAAP meeting with the BSP, it was like PNB President Eugene Acevedo was doing a "revalida" especially with the insightful questions and comments by Deputy Governor Nesting Espenilla and Dr. Noet Ravalo and with the active participation of other BSP senior officials - Dolly Yuvienco, Leny Silvestre, Judith Sungsai and Resty Cruz.

In a world where capital is neither free or may be scarce, the new paradigm is risk based pricing.

With the implementation of Basel II accord (recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against all types of risks) and the removal of traditional barriers, managing a bank across geographic boundaries, bankers need to think more carefully about the capital impact of options. This cannot be done until we include and accept risk capital based resource allocation in our mindset, our pricing, our decision-making and our regulatory reporting processes. This will introduce a significant new cost component in our pricing - both in terms of contributed capital costs as well as in terms of investments in technology, infrastructure, process improvement and change management.

Those of us who do well in accepting and implementing these new frameworks will succeed as financial institutions and bankers. The positive results will be seen simply in the increase in net profits and the rise in share price.

ICAAP is ultimately a commitment that must be beyond compliance and more of a disciplined approach to ensure that the bank's targeted capital position is adequate to cover the various risks that the bank may be exposed including other material risks that the bank may encounter in a sphere of forward looking scenarios reflective of changes in internal and external factors and considering changes in economic and business cycles. The guiding principles in implementing ICAAP is not only applicable to banks but can also be an effective discipline that may be used by business enterprises.

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Ms. Tarriela is the Chairman of Philippine National Bank. She was formerly Undersecretary of Finance and the first Filipina Vice President of Citibank NA.