Internal

Capital Adequacy
Assessment Process
Overview & Core Concepts

By Jawwad Ahmed Farid

I N T E R N A L C A P I T A L A D E Q U A C Y A S S E S S M E N T P R O C E S S O V E R V I E W & C O R E C O N C E P T S

CONTENTS

INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP)................................................. 5

1.

GLOSSARY: DEFINITIONS AND TERMINOLOGY ..................................................................... 5

1.1 Unconditional and Conditional Transition Matrix ............................................. 5

1.2 Homogeneity ........................................................................................................ 5
1.2 Probability of Default (PD) .................................................................................. 5
1.3 Stressed PD............................................................................................................ 5
1.4 Loss Given Default (LGD) .................................................................................... 5
1.5 Stressed LGD ......................................................................................................... 6
1.6 Exposure at Default (EAD) .................................................................................. 6
1.7 Stressed EAD ......................................................................................................... 6
2. BACK GROUND ............................................................................................................... 6
2.1
2.2
2.3

3.

The Great Depression and Regulation Q .......................................................... 6

Basel I & Amendments to the Capital Accord ................................................. 7
Basel II .................................................................................................................... 7
a. Minimum Capital Requirements ................................................................ 8
b. Supervisory Review ..................................................................................... 8
c. Market Discipline ......................................................................................... 8
d. Thoughts going forward ............................................................................. 9
INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP) REQUIREMENT ..................... 9

4.

ICAAP REPORT .............................................................................................................. 12

4.1
4.2
4.3
4.4
4.5

Executive Summary ............................................................................................. 12

Internal Capital Adequacy ................................................................................ 12
Aggregation ......................................................................................................... 12
Capital Planning .................................................................................................. 13
Sample ICAAP ...................................................................................................... 13
ICAAP Document Review ................................................................................ 14
Methodology ..................................................................................................... 15
Risk Aggregation ............................................................................................... 17
PROCESS AND RISKS OF MODEL BUILDING ......................................................................... 19

5.

5.1 Introduction .......................................................................................................... 19

5.2 The Model Building Process................................................................................. 19
5.3 Model Risks ............................................................................................................ 20
5.4. Prevention / Limitation of Model Risks ............................................................... 21
6. CALCULATION OF PROBABILITY OF DEFAULT ....................................................................... 21
7.
7.1

7.2

STRESS TESTING ............................................................................................................... 22

Credit Risk.............................................................................................................. 22
Non-performing loan (NPL) stress test ............................................................. 22
Simple Sensitivity Analysis .................................................................................. 23
Transition matrix stress test ................................................................................ 25
Profitability Analysis Stress Test .......................................................................... 27
Market Risk ............................................................................................................ 28
Simple Sensitivity Analysis .................................................................................. 28
Worst case MTM Stress Tests.............................................................................. 28

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I N T E R N A L C A P I T A L A D E Q U A C Y A S S E S S M E N T P R O C E S S O V E R V I E W & C O R E C O N C E P T S

7.3

Liquidity Risk .......................................................................................................... 29

Simple Sensitivity Analysis .................................................................................. 29
REFERENCES .......................................................................................................................... 31
ANNEXURE: COMPARISON OF ICAAP REQUIREMENTS THE ICAAP IMPLEMENTATION PROCESS OF
VARIOUS CENTRAL BANKS ...................................................................................................... 32
DISCLAIMER .......................................................................................................................... 42

Please do not photocopy or distribute without permission. All rights reserved Alchemy Software Pvt Limited.
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