ICAAP - Capital Adequacy Assessment Process |
By the 1990s the risk assessment methods of the most progressive banks had significantly surpassed the rather taxative approach to calculating regulatory capital (Basel I). However, the Basel II regulation to be introduced at the beginning of next year enables banks to use more sophisticated methods, as institutions may determine the regulatory capital they need on the basis of their own risk management and risk measurement systems.
Basel II, however, is more than just a new way of calculating regulatory capital, as it is built on two more pillars. In addition to rules concerning the calculation of regulatory capital in relation to credit, market and operational risks, in line with Pillar 2 financial institutions are required to demonstrate to the regulator that they have internal risk assessment and management information systems in place to efficiently assess their economic capital requirement (ICAAP - Internal Capital Adequacy Assessment Process).
ICAAP is a procedure ensuring that executive bodies:
- appropriately identify, measure, aggregate and monitor the risks incurred by the institution,
- possess the capital coverage determined by internal regulations that is sufficient for the fundamental risks the institution is exposed to,
- have an adequate risk management system in place, which they continuously develop in accordance with the risk factors identified.
The biggest Latvian banks have already developed their own advanced systems of regulatory capital compliant with Basel II and regulators not only review capital adequacy at these banks but also the adequacy and coherence of their procedures. This is undertaken to ascertain that the internal risk assessment and risk management methods of the banks as well as the indicators used in internal procedures are in accordance with the capital requirement they reported. Due to the aforementioned methodology differences it is initially likely that different procedures in terms of ICAAP will be more easily approved. However, in a few years, the increasingly advanced and improved systems – and of course regulators growing more familiar with them – are expected to result in more demanding requirements.
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