The Monetary Board (MB) approved on December 19 the guidelines for universal and commercial banks’ Internal Capital Adequacy Assessment Process (ICAAP). The ICAAP refers to the process carried out by banks in determining what they think is the appropriate level of capital to hold. Under the guidelines, banks should consider a number of factors in their assessment, among others, their risk profile, their business plans, and possible changes in the operating environment. In other words, the ICAAP should be tailored to a bank’s circumstances and needs.
Currently, banks are required by the Bangko Sentral ng Pilipinas (BSP) to maintain a risk-based capital adequacy ratio (CAR) of at least 10 percent. However, since it only accounts for credit risk, market risk and operational risk, the ICAAP clearly goes beyond this requirement. The risk assessment must now consider risks not captured and not fully captured by the current capital framework such as credit concentration risk and those posed by contingent exposures. Banks must also ensure they have capital to support any expansion plans, and weather downturns in the market. Other considerations may include external rating goals and market reputation.
Banks may follow different methodologies for their ICAAP. At the minimum, the BSP expects banks to adopt an ICAAP based on the minimum regulatory capital requirement, and where applicable, assess extra capital proportionate to the other risks that are not covered by this computation. They can also apply other approaches if they are able to collect the necessary information and to calculate the necessary inputs in a reliable manner. Three measures are suggested in the guidelines. For the structured approach, banks will need to set the internal capital requirement at a starting point of zero capital and then build on capital due to all risks and external factors. The allocation-of-risk-taking approach, on the other hand, entails that banks start with their actual capital and break it down to all its material risks. The amount of capital provided for each risk category is determined by the current and envisaged amount of risk in each category, a risk buffer and the risk appetite. Lastly, there are formal economic capital models, which are expected to be used eventually by banks that will move to the advanced approaches in determining the minimum regulatory capital requirement, or those that have substantial derivatives and structured products transactions (i.e., those that have expanded dealer authority).
Alongside the internal capital assessment guidelines, the MB likewise approved the BSP’s approach to the evaluation of banks’ ICAAP, called the Supervisory Review Process (SRP). Although this process focuses on the BSP’s work, the guidelines are being laid out since banks will have an interest in how their capital adequacy would be assessed. The review of the banks’ ICAAPs will entail a dialogue between BSP personnel and bank management. Should the BSP find that the ICAAP is insufficient, or that the bank does not have enough capital, prudential measures will be recommended, ranging from improving internal controls, to reducing its risks, to holding additional capital.
Banks shall be required to submit a trial ICAAP document to the BSP by end-March 2009. Thereafter, they shall submit the ICAAP document on an annual basis every January beginning 2010.
The approval of the guidelines for ICAAP and SRP is in line with the BSP’s commitment to adopt Basel II, the international standard for capital adequacy drafted by the Basel Committee on Banking Supervision. The said document consists of three pillars, namely, minimum capital requirements, the supervisory review process, and market discipline. The BSP adopted the first and third pillars through the issuance of Circular No. 538 dated 4 August 2006. This requires universal and commercial banks to compute their capital adequacy ratios based on the more risk sensitive provisions of Basel 2 beginning July 1, 2007. At the same time, the banks are required to disclose greater information relating to their risk exposures and capital in order to enable the public to better assess banks’ capital adequacy. The ICAAP and the SRP, on the other hand, address the principles of the second pillar.
The BSP’s implementation of the ICAAP and SRP guidelines is also in line with the recommendations of the Financial Stability Forum for bank supervisors to strengthen Pillar 2 frameworks to improve resilience of institutions in light of current market conditions.