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ICAAP: Internal Capital Adequacy Assessment Process Crash Course

Capital Adequacy was the principal message of the Basel II framework.  However a static regulator driven capital adequacy measure was deemed insufficient to manage the risk profile and capital requirements of an active bank in today’s risk environment creating the need for an internal and invasive assessment of the capital profile of a bank.  Ideally such a measure would allocate and attribute risk capital to all significant sources of risk, stress test the results and keep the board informed of any expected or projected capital shortfall.

Under Pillar 2 of the Basel II Accord, Internal Capital Adequacy and Assessment Process (ICAAP for short) was introduced with exactly the same objectives.

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.

We first review the historical back ground behind the development of Basel II of which ICAAP is a part:

Internal Capital Adequacy and Assessment Process (ICAAP): Basel II – Background: Great Depression, Regulation Q, Basel I
Internal Capital Adequacy and Assessment Process (ICAAP): Basel II

We then review some of the requirements of the ICAAP process and consider the main sections of an ICAAP report. We also present an extract from a sample ICAAP report showing the Executive Summary and the Approaches used to quantify and aggregate risks.

ICAAP: Process Requirements: Purpose, Pre-requisites, Board of Director Responsibilities and Documentation 
ICAAP: Assessment Requirements: Approach, Nature , Comparative View to MCR and Review Process
Internal Capital Adequacy and Assessment Process (ICAAP): Report – main elements 

ICAAP: Internal Capital Adequacy Assessment – Sample ICAAP report format and table of content

Under the Internal Capital Adequacy and Assessment Process (ICAAP) the bank will make use of internal models to assess, quantify and stress test risk drivers and factors and the amount of capital required to support them. We consider some of the building blocks in a modeling construction process and the risks involved in model building as well as ways to avoid those risks. This discussion is based on the paper “Model Risk” by Emanuel Derman (Goldman Sachs Quantitative Strategies Research Notes – April 1996).

Internal Capital Adequacy and Assessment Process (ICAAP): Modeling Building Process
Internal Capital Adequacy and Assessment Process (ICAAP): Model Risks
Internal Capital Adequacy and Assessment Process (ICAAP): Prevention and Limitation of Model Risks

In order to quantify credit risk for the internal ratings based approach of the Internal Capital Adequacy and Assessment Process (ICAAP) the bank would need to be able to calculate the probability of default (PD). We discuss one methodology of calculating PD which is based on historical behavioral data.

ICAAP Submissions: Probability of Default (PD) Calculation

One forward looking aspect of the Internal Capital Adequacy and Assessment Process (ICAAP) is  stress testing of all risk factors in order to arrive at the capital requirements for the worst case scenario. Stress testing also allows the bank to plan and prepare for unexpected situations that may arise in the future. We look at some of the stress tests that can be applied to credit, market and liquidity risk.

ICAAP Submission: Credit Risk: Stress Test: Non – Performing Loan (NPL) Stress Test
ICAAP Compliance: Credit Risk: Stress Test: Simple Sensitivity Analysis – Increase & Shift in NPL 
ICAAP Compliance: Credit Risk: Stress Test: Simple Sensitivity Analysis – Fall in Forced Sale Value (FSV) of mortgaged collateral 
ICAAP: Credit Risk: Stress Test: How to construct a Transition Matrix 
ICAAP: Credit Risk: Stress Test: How to Determine Expected Classification Rates 
ICAAP: Credit Risk: Stress Test: Profitability Analysis of a bank’s loan portfolio 
ICAAP: Credit Risk: Stress Test: Transition Matrix Stress Test 
ICAAP: Credit Risk: Stress Test: Profitability Analysis Stress Test 
ICAAP: Stress Test: Market Risk 
ICAAP: Stress Test: Liquidity Risk

If you would like to buy this complete course as a PDF file or a Sample ICAAP report as a PDF file or the sample credit risk EXCEL sheet, please see the ICAAP section at our online finance course store. The online finance course store includes easy-to-read-and-work-with downloadable PDF files, excel templates and ready-to-work with models that are shared to illustrate usage and speed up learning and pick-up for advanced financial modeling, forecasting and simulation topics including interest rate forecasting and simulation, value at risk analysis, collateral valuation, asset liability management, ICAAP and other related middle office and risk topics.