ICAAP, Pillar 2A and Pillar 2B

ICAAP

The Internal Capital Adequacy Assessment Process (ICAAP) is the process in which the Board and management of the bank oversees and regularly assesses:

• the bank’s processes, strategies and systems;

• the major sources of risk to the bank’s ability to meet its liabilities as they fall due;

• the results of internal stress testing of these risks;

• the bank’s own assessment of the additional capital (Pillar 2A and Pillar 2B) over and above the regulatory minimum (Pillar 1); and

• the amounts and types of financial and capital resources, and whether or not these are adequate to cover the nature and level of the risks to which the bank is exposed over the next three to five years.

The ICAAP document sets out the framework for the bank’s internal governance, and the operation of the risk and capital management arrangements. In particular, the document sets out:

• the internal governance structure and assurance framework;

• the risk management framework;

• the key risk areas that are relevant to the bank;

• the adequacy of capital resource and the type of capital in relation to the overall risk profile and hence the bank’s overall ability to meet its liabilities as they fall due; and

• the way in which the ICAAP is used in the business.

The ICAAP document has to be produced on a proportionate basis, taking into account the size, nature and complexity of the bank’s activities. It should set out the approach taken by the bank to identifying material risks, the impact of such risks and the capital required over a three/five year forward-looking horizon. The ICAAP document is one of the key inputs used by the regulators in the Capital Supervisory Review and Evaluation Process (C-SREP).

Pillar 2A

The Prudential Regulation Authority (PRA) in the latest Supervisory Statement (SS31/15 - The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP) - updated July 2020) has outlined the regulators expectation of banks undertaking an ICAAP exercise. The PRA has clearly mentioned that banks merely attempting to replicate the PRA’s own methodologies, will not be carrying out its own assessment in accordance with the ICAA rules. 

In PRA's Policy Statement (PS17/15 - Pillar 2A capital requirements and disclosure - updated August 2015) and Statement of Policy (The PRA’s methodologies for setting Pillar 2 capital - updated February 2020), the regulator has provided a unique insight into their internal methodologies in evaluating the banks Pillar 2A and Pillar 2B capital requirements. It should be noted that bank's should only use this as a guidance, and should not be a replacement for the bank's own internal assessment and evaluation of its risks and additional capital requirement. At the very minimum bank's should consider the following risks in evaluating its additional Pillar 2A capital requirement:-

1. Credit and counterparty credit risk - including a comparison with the Internal Risk Based (IRB) benchmark

2. Market risk - the additional market movement or potential position risk that is not adequately covered under Pillar 1

3. Operational risk (conduct)  - using both historic conduct losses and conduct related scenarios

4. Operational risk (non-conduct) - using both historic operational losses and scenario based analysis

5. Credit concentration risk - this should consider aspects of single name, geography and sector concentration

6. Liquidity risk - the potential haircut likely to be incurred, in the event of a stress, to realised the high quality liquid assets (HQLA) and/or utilising the counterbalancing capacity

7. Interest Rate Risk on the Banking Book (IRBB) - this can be evaluated based on a 200 basis point (or appropriate shift) in the yield-curve, and evaluating the Net Present Value (NPV) sensitivity [covering duration risk], and a separate analysis should be included for basis and optionality risks as well

8. Pension obligation risk - in the event the bank provides a defined benefit pension scheme

9. Group risk - this is a significant risk for subsidiaries of foreign banks, where there is significant reliance on the Parent bank for business and potential reputational contagion

Pillar 2B (PRA Buffer)

The PRA buffer, which is over and above the total capital requirement (TCR = Pillar 1 + Pillar 2A) and the Combined buffer (Capital Conservation Buffer + Countercyclical Buffer + Systemic buffer), is expected to absorb losses in the event of a severe stress. The PRA buffer is expected to avoid duplication with the Combined buffer.

In terms of evaluating the Pillar 2B (PRA Buffer), it is our view that the PRA's (or similar) annual cyclical stress (ACS) or scenario for banks not participating in ACS can be used as the foundation for calculating the capital planning buffer. This capital planning buffer can then form the basis for identifying any additional capital buffer requirement.

The PRA buffer (own assessment) should be reduced by the amount of the Combined buffer, otherwise it will make the PRA buffer akin to a 'buffer-on-buffer' (i.e. double counting the capital requirement). For example, if the bank’s own assessment of the buffer needed under stress is £10 million, and the Combined buffer is £4 million, then the PRA buffer should be set at £6 million.