What is the ICAAP?

The Basel II Directive: CRD is EU wide and requires the relevant regulated companies to be able to demonstrate, that they have a Capital Adequacy Assessment Process (ICAAP) in place. This is a cornerstone obligation of Pillar 2 of these EU regulations.  

This is a tool for the Board and the Regulator to assess and evaluate risk exposures or indeed, risks which they may be exposed to and ensure the level of capital determined via regulatory calculations (Pillar 1) is adequate. The FSA will review the ICAAP and have the power to demand a higher level of capital if the Senior Management of the firm cannot demonstrate a robust approach to and embedding of the ICAAP.

The FSA is under some pressure to demonstrate that it is fulfilling its supervisory role. It is facing criticism that it failed to oversee that banks had sufficient capital to deal with the risk exposures taken. It is therefore keen to ensure it does not make the same mistake. ICAAP submissions are being highly scrutinised.

The FSA has provided ICAAP templates but leave the detail evaluation and requirements to each firm to describe. Their reasoning for this is clear, if frustrating. It is for a firm’s management to have a risk management process, and part of that is determining the appropriate level of capital to hold. It is for the firm’s management to evidence integration (the ‘I’ in ICAAP) within the firm’s operations and management processes. It is for the FSA to validate the ICAAP is reasonable, based on the submission made by the firm.

From statements by the regulator and firm’s it seems that the following are common deficiencies:-

1. The ICAAP submission does not contain enough description of the firm’s governance arrangements. Many internal policy, strategy, and operational control documents will be targeted at the firm’s management team. They therefore make huge assumptions about the nature of the business. If these are merely copied across into the ICAAP submission without background comment, then the FSA is unable to determine if these documents reflect dynamic risk management arrangements.
2. The ICAAP submission does not demonstrate that the results of risk assessment and capital management have been based on rationale that is clear, linked to the appetite for risk of the firm and articulated effectively. The ICAAP submission is not a 'one-off' record keeping exercise and the FSA will not accept that it has been integrated within normal management procedures until Management can demonstrate as such.
3. The ICAAP submission is incomplete. Often a firm will have control policies and procedures but they do not consider this part of their Capital Adequacy Process. For example their may be new product control procedures but these are not referred to in the ICAAP. Ironically, this is often because they are so integrated, and so embedded in management thinking, that they cannot think of them as part of the wider ICAAP without significant prompting.

The FSA view is that consultants can help in this process. They can facilitate firm’s review of their ICAAP (i.e. the embedded management processes) and can also facilitate the preparation of the ICAAP submission.

In review of the process, consultants can help ensure all major risks are identified, and suitable controls put in place. In preparation of the submission, they can ensure that firms address all of the elements expected by the FSA. Their role is both the rapid spread of best practice, and helping firms communicate with the FSA or indeed pan EU regulators

There is one element of caution in using consultants. The FSA stresses they need to see evidence of an integrated process. If the FSA receives a well-written pro-forma submission, they will probe the senior management team to ensure that the submission reflects actual day-to-day management processes. Consultants can therefore assist and facilitate management in their thinking about capital adequacy, and they can collate and review the submission. However, the capital adequacy assessment process must be fully owned and operated by the management team.

The ICAAP has become a key risk management tool during 2008. We have seen a growth in the requirements to facilitate firms through regulatory reviews as well as support the submission process itself. We have developed internal toolkits to expedite the process and have specialists to hand with front line exposure in this field who will deliver effective solutions to help firms manage their responsibility.

Gordon Easden
Fund Services, FusionExperience