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ICAAP: Background to ICAAP

Basel II (the second international banking regulatory accord) is an international business standard of which its principal message is Capital Adequacy.

Basel II is based on three core pillars requiring minimal capital requirements, regulatory supervision and market discipline.

Foundation of Prudential Regulation

Basel II introduced the three ‘Pillars’ to the regulators’ prudential framework that underpin the Capital Requirements Regulations for banks and other financial institutions.

Since a static capital requirement was viewed as insufficient to cover the risk profiles of varying financial institutions, the need for an individual internal assessment to measure, allocate and attribute risk capital was required. Thus, under Basel II’s second pillar, the Internal Capital Adequacy and Assessment Process (ICAAP) was introduced.

This three pillar model has since been carried forward into Basel III. In summary the requirements of the three pillars can be summarised as follows:

Pillar 1

The minimum capital requirements:

Minimum capital levels as prescribed by the regulators are established to specifically cover credit risk, market risk and operational risk.

Pillar 2

Internal Capital Adequacy Assessment Process (ICAAP):

Firms are required to consider all risks that its business and operations is subject to, over and above the risks laid out in Pillar 1 and to document these considerations within its ICAAP.

Supervisory Review and Evaluation Process (SREP) and Individual Capital Guidance (ICG):

The regulator is also tasked with reviewing and assessing a Firm’s ICAAP. This is done via their Supervisory Review and Evaluation Process (SREP). Should the regulator’s SREP indicate that a firm’s risk profile requires more capital than is currently provided under Pillar 1, then they may request additional capital by setting Individual Capital Guidance.

Pillar 3

Pillar 3 complements Pillars 1 and 2 by invoking market discipline via the firm's public disclosure of additional information - improving transparency - in order to allow market participants to assess capital adequacy and analysis of risk exposures by specific sectors.

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