Capital-constrained markets, volatile conditions and the continuing threat of a prolonged credit crisis require bankers to raise the bar on risk identification and management.
A formidable challenge for many institutions is how to leverage and comply with the internal capital adequacy assessment process, a core component of the Basel II accord.
Treasury Secretary Timothy Geithner's call for new stress tests for some of the nation's largest banking companies has added uncertainty while ratcheting up the focus on identifying and quantifying risk to a new level.
The ICAAP requires banks to develop internal procedures and systems to ensure they possess adequate capital resources in the long term, taking into consideration all material risks. These procedures and systems are applicable to all banks required to comply with Basel's Pillar 2, regardless of their size and complexity.
The process is moving front and center in the banking sector as governments and institutions work to regain stability and avoid a repeat of the past year's events. Banks, however, confront challenges on two fronts.
The first challenge is gaining an end-to-end understanding of risk or exposure across the enterprise. This is complicated by the siloed nature of financial and risk information in various departments or divisions. This understanding, however, is critical to using the ICAAP to manage risk and, ultimately, improve performance.
The second challenge is ensuring compliance with ICAAP requirements in the absence of detailed guidance from regulatory bodies.
How can banks ensure compliance while harnessing the ICAAP's power? A core set of best practices can guide them in their journey. First and foremost among these is a steadfast and systemwide commitment to risk management — starting in the boardroom and permeating throughout the institution.
Transparency and visibility across the enterprise are also essential to ensuring that banks identify and quantify all risk and test the appropriate scenarios.
The third best practice involves leveraging proven tools and models as a head start toward ensuring visibility and compliance. This approach also reduces the expense, trial-and-error and time requirements of building proprietary solutions.
Under the ICAAP, banks must identify, rank, quantify and report on all types of risk they face. The challenge for many banks begins with identifying the complete range of material risks they face — an arduous task, considering the complexity of large banking institutions.
Adding to the challenge, the Bank for International Settlements has not provided a comprehensive list of risks to be addressed, leaving banks to use their best judgment.
Risk identification requires thorough analysis of a bank's activities, business units, regulatory and market environments, historical scenarios and more. End-to-end enterprise visibility, as well as the involvement of a team that spans the bank's lines of business, product sets, geographies and processes, are essential to identifying areas of risk, which might include economic capital, market, credit, interest rate, operational, reputational and even pension risk.
After identifying risk, banks must quantify and manage it. They must select processes and controls appropriate to their environment and the materiality of identified risks. Industry-tested tools that leverage simulation-based value at risk models can provide an accurate and robust approach for risk quantification.
For example, external economic capital solutions provide best-in-industry methods for quantifying multiple risks. Since credit, market and operational risk make up the most material risks, economic capital solutions have the added benefit of recovering the cost of implementing the models from their business benefits at a relatively early stage.
The ICAAP also mandates that financial institutions develop an appropriate stress-testing framework for the various risks they face. Stress testing, however, has often been relegated to afterthought status, with the goal of providing the numbers regulators require, instead of building thoughtful scenarios that yield valuable data and actionable insights. Banks should be prepared for this environment to change, particularly in light of the Treasury secretary's recent comments.
To ensure compliance and leverage the ICAAP to manage risk, stress testing must move to center stage and undergo a complete transformation. Today institutions may have separate tests for liquidity and credit risk, but the tests may have different levels of granularity, limiting their value. Organizations require robust scenarios that they can apply across the organization to various risk types to enable a true snapshot of overall risk under multiple conditions, as well as a platform for consistently managing this process.
The bottom line is that stress testing must be directly integrated with the bank's capital planning and management functions.
Finally, banks face several challenges in implementing the required reporting and monitoring processes and systems. These challenges include identifying the granularity for each risk type, monitoring procedures and systems for each risk, and reporting templates and frequency. A fully automated reporting framework with specified generation schedules and predefined reports covering risk identification, assessment, quantification, aggregation and allocation can facilitate compliance.
Banks can use technologies based on industry standards, such as business process execution language, for defining work flows that require multiple-user processing. They can also establish efficient monitoring processes by configuring automated alerts for various levels in the organization and various thresholds for different risks.
The Basel ICAAP requirements, though complex in nature, offer banks an opportunity to gain new levels of visibility into and control over their material risk. Those that adhere to three core tenets — organizationwide commitment to risk management, enterprisewide visibility and the use of industry-proven and flexible tools — will be better positioned when market conditions inevitably turn around.