The ICAAP process: what it is, why it matters and its main challenges

What it is about

The ICAAP determines how much capital is needed to cover all material risks: those of Pillar 1 and the additional risks of Pillar 2, such as credit concentration risk and interest rate risk in the banking book. It has two components: one looks at the current situation, with the volume of risk-weighted assets and the total capital ratio, usually at each year-end; the other looks ahead, based on the budget projected for at least three years, to support growth plans.

The guest is José Manuel Desviat, an economist with a master’s degree in Banking Management, with more than 30 years of experience in global risk management, financial regulation and capital in the financial sector. The session covers the importance of the ICAAP as a self-assessment of capital adequacy for internal management, its role in the supervisory assessment under Pillar 2, the main challenges in implementing a robust ICAAP, and proportionality for smaller institutions.

The webinar also argues that, in the recovery after the health crisis, capital adequacy will become more relevant, because capital is one of the scarcest resources of financial institutions and using it well can provide a competitive advantage.

Session summary

The speaker explains the ICAAP, the internal capital adequacy assessment process, as a tool for strategic management and not just for compliance. He starts from the fact that capital is what protects the institution from the variability of its results and that there is an optimal level of risk for maximizing risk-adjusted return. He describes the process: critically assessing the business model, the risk profile (including risks beyond minimum regulatory requirements, such as concentration, structural interest rate, conduct and cyber risk), the strength of internal governance, information systems and the process itself, translating risks into capital and comparing it with available capital.

He stresses that the assessment is not static: it must be forward-looking, with capital planning and stress tests under several scenarios, and that liquidity risk is covered by a parallel process because capital does not mitigate it. He explains how the supervisor uses the ICAAP under Basel’s second pillar to set a capital add-on, and that its quality depends above all on corporate governance led by the board. For small institutions, he presents the Bank of Spain’s simplified guide. The questions covered how the pandemic affected loss models, structural changes by sector, the realistic time needed to set up the process (more than a year), dialogue with the supervisor and the fact that capital relief measures were little used.

Topics covered

• The ICAAP as a tool for strategic capital management
• Risk profile: beyond the risks of Basel’s first pillar
• Internal governance, information systems and process quality
• Economic capital, regulatory capital and available capital
• Capital planning and stress tests with a forward-looking view
• Basel’s second pillar and the supervisor’s review
• Questions: pandemic, small institutions, timelines and capital relief