3. Major Building Blocs of the ICAAP
3.1 Bank's Role and Responsibility for the ICAAP
Banks have to convince SAMA that their ICAAP process is comprehensive, rigorous and includes capital commensurate with their risk profile as well as strategic and operational planning. The banks must compose and assemble the specific ICAAP process and methodology based on the objective and requirements imposed by SAMA and on the specific strategic and operational plans set by their Board of Directors. Consequently, banks must have a clear understanding on SAMA's expectations in terms of the definitions, concepts and benchmarks in order for an effective assessment and follow-up by it. An important and obvious example is the manner in which both the risks and the capital are defined.
3.2 SAMA's Role and Responsibility in the ICAAP Process
SAMA is responsible for establishing the frequency and nature of the review, while the Banks are to establish their actual implementation processes and methodology as per SAMA's guidelines.
Thus, while the two processes involved are closely integrated through the Supervisory Review Process, at the same time there is an express division of responsibilities. SAMA's role has the final word in this process as it makes its risk assessment of the banks and, where reason exists, imposes additional requirements on the banks or requires enhanced risk management systems, additional stress testing, etc.
One of the alternative courses of action available to SAMA is to establish a higher capital requirement than that calculated by the bank itself. The level of capital needed is based on the calculation of the capital requirement with respect to credit, market and operational risks based on the explicitly established calculation rules which are laid down within the scope of Pillar 1. However, a supplement could be required as additional capital which, in light of other types of risks (Pillar 2), which may arise within the scope of the internal capital adequacy assessment process. Consequently, this is not the only tool (to set a higher capital requirement) and it will not necessarily be the first choice, in that capital should not be a substitute for adequate risk management. On the other hand, a demand for more capital may be justified even for those banks with high, but well-managed risk exposures.
3.3 ICAAP as a Part of Pillar 2
The basic idea is that banks shall, within the framework of Pillar 2, identify all of the risks to which they are exposed. This involves a wider spectrum of risks than those that form the basis for the minimum capital adequacy calculation within Pillar 1, i.e. These include any additional Pillar 1 risks, i.e. credit risks, market risks and operational risks. It involves, among other things, at least the following*:
■ Strategic risk - arising from a bank's strategies and changes in fundamental market conditions which may occur;
■ Reputational risk - the risk of adverse perception of image in the market or the media, etc.
■ Liquidity risk - the risks of difficulties in raising liquidity or capital in certain situations;
■ Concentration risk - exposures concentrated on a limited number of customers, industries, certain sectors or geographic area, etc. entailing vulnerability; and
■ Macro Economic and Business cycle risk - through lending or otherwise a bank may be vulnerable to business cycle risks or environmental changes
■ Interest Rate risk - relevant to the banking book.
These risks, as well as the risks that are addressed within the scope of Pillar 1 are, of course, to a certain degree inter-dependent and to a certain extent, capture various aspects of the same risk classification. For example, a bank, which incurs major credit losses, is probably more exposed to the risk of damage to its reputation and, can be also more easily affected by problems in raising capital.
Consequently, there can be no doubt that Pillar 2 is one of the most important new features in Basel II, and within its scope, banks and SAMA must work together to achieve a comprehensive assessment of risks, risk management, and capital requirements.
Interest rate risk in the banking book:
The measurement process should include all material interest rate positions of the bank and consider all relevant repricing and maturity data. Such information will generally include current balance and contractual rate of interest associated with the instruments and portfolios, principal payments, interest reset dates, maturities, the rate index used for repricing, and contractual interest rate ceilings or floors for adjustable-rate items. The system should also have well-documented assumptions and techniques.
Regardless of the type and level of complexity of the measurement system used, bank management should ensure the adequacy and completeness of the system. Because the quality and reliability of the measurement system is largely dependent on the quality of the data and various assumptions used in the model, management should give particular attention to these items.
Liquidity risk: Liquidity is crucial to the ongoing viability of any banking organization. Banks’ capital positions can have an effect on their ability to obtain liquidity, especially in a crisis. Each bank must have adequate systems for measuring, monitoring and controlling liquidity risk. Banks should evaluate the adequacy of capital given their own liquidity profile and the liquidity of the markets in which they operate.
(Refer to Paragraph 741 of International Convergence of Capital Measurement and Capital Standards – June 2006)
* Other risks not specifically covered here are described in component 2 of the Document under item #4.3.