Introduction:
The Internal Capital Adequacy Assessment Process (ICAAP) is a com-prehensive internal evaluation conducted by financial institutions to ensure they maintain sufficient capital commensurate with their unique risk profiles. This internal assessment aligns with the bank’s capital policy and strategic objectives, ensuring a robust framework for risk management and capital adequacy. The ICAAP is crucial for understanding and managing the bank’s risks, and it involves a systematic approach to identifying, measuring, monitoring, and controlling these risks.
The ICAAP process serves several critical purposes:
a. Evaluation of Risk Profile and Capital Needs: It provides a thorough analysis of the bank’s current and anticipated aggregate risk profile, determining the necessary capital to cover these risks adequately.
b. Compliance with Regulatory Requirements: It ensures that the bank’s risk profile and capital management processes comply with legal and supervisory standards.
The primary goal of ICAAP is to ensure that the bank has sufficient and appropriate capital to cover all material risks it faces, both now and in the future. This process is ongoing and dynamic, tailored to the bank's size, complexity, and risk level. By adopting a risk-based management approach, the bank can maintain a comprehensive risk management framework, ensur-ing effective identification, evaluation, and mitigation of risks.
The ICAAP is not merely a regulatory requirement but a fundamental component of a bank's risk management strategy. It ensures that the bank is well-prepared to face potential risks and challenges, maintaining financial stability and resilience. By regularly assessing and adjusting its capital needs, the bank can support its growth and strategic initiatives while safeguarding its solvency and market reputation.
One of the most striking features of the Basel II capital adequacy framework is its initial acknowledgment that the minimum capital require-ment calculated within the prescribed methods is not sufficient to protect banks from unexpected losses. The minimum regulatory capital adequacy only provides limited protection for a limited number of risks. The Basel II framework mandates that banks establish an internal capital adequacy sys-tem that comprehensively captures all the risks specific to each bank, in order to achieve economic or optimal capital adequacy that would protect banks from bankruptcy. This system's adequacy must then be reviewed by the supervisory authority. Therefore, calculating a capital adequacy ratio above the minimum 8% in the First Pillar of Basel II does not imply that the bank has the necessary capital level it needs. Perhaps it is precisely for this reason that it should not be surprising that banks with high regulatory capital adequacy ratios found themselves needing rescue within a few days during the global crisis.
The initially calculated minimum capital level is merely a starting point for determining the necessary capital level for the bank to continue its op-erations healthily. In the second stage, risks that were not considered in the minimum capital requirement calculation will be considered, and efforts will be made to reach the capital requirement level deemed optimal for the bank. As a result of ICAAP and Supervisory Review Process (SREP), different levels of minimum capital requirements may be projected for each bank. So, the ICAAP process goes beyond the limited scope of Pillar 1 by requiring a comprehensive assessment of all material risks a bank faces, ensuring that banks maintain adequate capital to support their risk profile and operational resilience.
The SREP, conducted by regulatory authorities, plays a crucial role in this process by providing a comprehensive assessment of a bank's risk profile and capital adequacy, ensuring that the institution's internal assessments are rigorous and aligned with regulatory expectations. The SREP is a com-plementary regulatory tool that critically evaluates the ICAAP submissions by financial institutions. It aims to assess the robustness of banks’ internal risk management and capital planning processes and to ensure that banks maintain sufficient capital to cover their risks under both normal and stressed conditions. By integrating ICAAP and SREP, banks and regulators work together to create a more resilient financial system, capable of with-standing economic fluctuations and systemic shocks.
The SREP evaluates the:
a. Approach the Bank takes to comply with relevant regulatory re-quirements,
b. Risks that the Bank may be exposed to,
c. Risk that the Bank poses to the financial system,
d. Further risks revealed by stress testing.
In summary, the ICAAP is an essential process for banks, providing a structured approach to managing risk and capital adequacy. It enables banks to align their capital resources with their risk profiles, ensuring they can withstand adverse conditions and continue to operate effectively. By em-bedding the ICAAP into their risk management framework, banks can achieve greater resilience, regulatory compliance, and strategic success (Al-tintas, 2018).
Furthermore, ICAAP plays a crucial role in moderating the cyclical movements of bank capital, which is vital for maintaining financial stability across economic cycles. By requiring banks to dynamically assess their cap-ital needs and build adequate buffers during economic upturns, ICAAP helps mitigate the pro-cyclical tendencies of traditional capital management practices. This counter-cyclical approach ensures that banks are better pre-pared to absorb losses and continue lending during economic downturns, thereby supporting economic stability and preventing deep recessions (for the cyclicality, Huizinga and Leaven (2019); BCBS (2017))
The process involves rigorous stress testing and scenario analysis, al-lowing banks to anticipate potential capital shortfalls and take pre-emptive actions to bolster their capital base. This proactive stance reduces the need for sudden capital adjustments in response to economic fluctuations, thereby smoothing out capital movements across economic cycles. By maintaining a more stable level of capital, banks can avoid the sharp contractions in lend-ing that often exacerbate economic downturns and lead to credit crunches.
Moreover, ICAAP's emphasis on comprehensive risk management and regulatory discipline ensures that banks adopt a forward-looking perspective in their capital planning. This approach not only supports consistent lending practices but also helps institutions to manage their risk exposure more ef-fectively, reducing the volatility of capital levels and promoting a more re-silient banking system. The integration of ICAAP with broader regulatory frameworks, such as Basel III and Basel IV, reinforces these benefits, ensur-ing that banks maintain adequate capital levels that reflect the true risk envi-ronment.
Beyond its direct impact on banks, the ICAAP process also provides valuable insights that can inform monetary policy decisions. By promoting a detailed understanding of the risk profiles and capital needs of financial institutions, ICAAP contributes to a clearer picture of the overall health and stability of the banking sector. This information is crucial for central banks and regulatory authorities as they assess the effectiveness of monetary policy measures and their potential impacts on financial stability.
During periods of economic expansion, ICAAP helps ensure that banks build capital buffers, which can be drawn upon in times of economic stress. This counter-cyclical capital management aligns with broader monetary policy goals of maintaining financial stability and mitigating the risk of boom-bust cycles. By encouraging prudent capital planning and risk man-agement, ICAAP helps create a more resilient banking sector that can sup-port economic growth even during periods of monetary tightening or eco-nomic downturns.
Additionally, the forward-looking nature of ICAAP, with its emphasis on stress testing and scenario analysis, provides central banks with a valuable source of information about potential vulnerabilities in the financial system. This information can be used to fine-tune monetary policy, ensuring that it is responsive to emerging risks and capable of supporting sustained economic stability. By facilitating a more informed and proactive approach to monetary policy, ICAAP helps create a regulatory environment that is better equipped to navigate the complexities of modern financial systems and support long-term economic growth.
In essence, ICAAP's role in the cyclical management of bank capital is a testament to its importance in the broader context of financial stability and economic resilience. By fostering a proactive and dynamic approach to capi-tal adequacy, ICAAP helps banks navigate the complexities of economic cycles, ensuring they remain robust and capable of supporting sustainable growth.
The book at hand is not a textbook or an academic thesis but aims to be a comprehensive guide to ICAAP and extensively draws on the author's personal knowledge and professional experience, as well as the valuable studies cited in the bibliography.

CONTENTS
Contents V
Introduction 1
1. Navigating the Financial Landscape Through ICAAP and Stress Testing 7
2. Key Pillars of the ICAAP Process 19
2.1. Capital Allocation and Capital Planning: 23
3. Normative Perspective of ICAAP: 26
3.1. Normative Capital Requirements: 29
a. Pillar 1 Capital Requirements: 32
b. Pillar 2 Capital Requirement and Guidance: 35
c. Basel 3 Capital Buffers: 38
3.2. Normative Capital Resources: 40
a. Common Equity Tier 1 (CET1) Capital: 41
b. Additional Tier 1 Capital: 42
c. Tier 2 Capital: 43
d. Minority Interest: 45
e. Capital Deductions: 45
4. Pillar 2 Risks: 46
a. Interest Rate Risk in the Banking Book (IRRBB): 47
b. Credit Concentration Risk: 49
c. Residual Risk: 50
d. Other Pillar 2 risks: 51
5. Economic Perspective: 51
5.1. Risk Quantification under the Economic Perspective: Economic Capital 55
5.2. Common Economic Capital Models: 60
a. Credit Risk: 60
b. Market Risk: 61
c. Operational Risk: 61
d. Other Pillar 2 risks: 62
5.3. Deficiencies of the Economic Capital Models: 63
6. Stress Testing: 66
6.1. Stress Testing Scenario Preparation Phase: 72
a. Embracing Macro-Economic Variables for Robust Scenario
   Construction: 73
b. Strategic Scenario Selection and Weighting for Precision and
   Efficiency: 73
c. Navigating Uncertainty with Prudent Judgment: 74
6.2. Stress Testing under Normative and Economic Perspective: 74
6.2.1. Solvency Stress Tests: 75
a. Scenario Development: 76
b. Impact Assessment: 76
c. Capital Adequacy: 77
d. Stress Testing Framework: 77
6.2.2. Credit Risk: 77
6.2.3. Net Interest Income: 80
6.2.4. Market Risk and Counterparty Credit Risk: 83
6.2.5. Operational Risk: 86
6.2.6. Other P&L items: 87
6.2.7. Capital: 89
6.3. Reverse Stress Testing: 91
6.3.1. Objectives of Reverse Stress Testing: 91
6.3.2. Methodology of Reverse Stress Testing: 92
6.3.3. Applications of Reverse Stress Testing: 93
7. Navigating the Landscape: Connecting ICAAP with the
Basel IV / Capital Requirement Regulation 3 94
7.1. Credit Risk – The revised Standard Approach: 98
a. External Credit Assessments and Internal Analysis: 98
b. Exposure Values and Credit Conversion Factors: 98
c. Derivative Products and Risk Weighting: 99
d. Types of Exposures and Treatment: 99
e. Unrated Corporates and SCRA: 100
f. Asset Classification and Specialized Lending: 100
g. Real Estate Financing: 101
h. Risk Mitigation Instruments: 101
7.2. Evolving Landscape of Internal Ratings-Based Approach 102
a. Changes to the Scope of Application: 102
b. Changes to the Minimum Risk Parameters: 103
c. Clarifications on Parameter Estimation: 103
7.3. Changes to the Market Risk Framework: 104
7.4. Output (Capital) Floor (OF): 104
7.5. New Standardised Measurement Approach for Operational Risk: 107
Conclusion: 110
a. ECB Guidance: Setting the Benchmark: 110
b. Normative Perspective: Bridging Regulation and Internal Risk
Management 111
c. Economic Perspective: Ensuring Long-Term Viability 112
d. Stress Testing: Building Resilience Through Scenario Analysis 114
e. CRR3 and Basel IV: Adapting to New Regulatory Changes 114
Concluding Remarks: The Future of ICAAP: 115
Bibliography: 117

Barkod

: 9789758899258

Yayınevi

: Gözlem Yayıncılık

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ISBN

: 9789758899258

Dili

: İngilizce

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Basım Yeri

: Ankara

Baskı Sayısı

: 1. Baskı

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Diğer

: Dr. Ozan Çağlar
A market professional with over 15 years of experience, currently working at Deloitte on risk management and audit fields. He is a specialist in capital and liquidity management, dealing with ICAAP, ILAAP, SREP, Basel 3.1, IFRS-9, and also the Risk Appetite Framework. For a detailed resume, you can scan the QR code on the side.