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By Rakis Christoforou BBA, CPA/ABV/CFF, CGMA, ACFE
The purpose of the Internal Capital Adequacy Assessment Process (ICAAP) and Pillar 2 in the Basel II framework is to ensure that financial institutions including investment Firms have sufficient available capital to meet the minimum capital requirements, even under stressed scenarios.
Pillar 2 covers two main processes: the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP).
The capital impact of Pillar 2 for Cyprus Investment Firms (CIFs) is likely to be significant. At the same time Pillar 2 and the ICAAP present a unique opportunity for these firms to strengthen risk and capital management.
Calculating Capital Adequacy from Pillar 1 to Pillar 2
CIFs need to use as a starting point the minimum capital calculated under Pillar 1. The next step is to identify and calculate risks not fully covered under Pillar 1 as well as the risks under Pillar 2, as follows:
 Risks under Pillar 1 (Credit Risk, Market Risk and Operation Risk);
 Risks not fully covered under Pillar 1 (Concentration, Residual , Securitisation, Settlement, Foreign Exchange );
 Risks under Pillar 2 (Liquidity, Business, Legal and Compliance, Reputational, Strategic, Group, Other).
ICAAP Characteristics
ICAAP includes everything from the daily risk management to the more strategic capital management. Moreover, a greater rigour in the use of stress-testing by financial institutions is registering in the current environment of heightened volatility. Characteristics of ICAAP include:
• ICAAP is by nature forward-looking.
• The ICAAP process requires changes in the definition of risk appetite, tolerance and strategy by taking advantage of the new regulatory requirements.
• Sound identification and quantification of all material risks, allowing the determination of an economic capital measurement consistent with the investment firm’s risk profile and offering protection to the firm’s own funds.
• A correct attribution of roles and responsibilities to different process owners fosters the consciousness that the ICAAP process involves the whole structure of the institution.
• Although some institutions at first considered their ICAAP as a regulatory compliance exercise, they must now leverage on Pillar 2 to strengthen and to promote the full integration of risk, liquidity and capital management within strategic planning and business operations.
Pillar 2 Challenges
The implementation of Pillar 2 is, however, a challenge, not only in terms of technical and quantitative expertise for reviewing the ICAAP, but also on qualitative aspects, such as how to foster the dialogue between CIFs that would enhance the ICAAP and the Supervisory Review and Evaluation Process (SREP) under the authority of the Cyprus Securities and Exchange Commission (CySEC).
The ICAAP should be customised for each firm, taking into account the particular risks and information available in order to consider the extent to which capital management is embedded within an investment firm, including the extent and the use of capital modeling or scenario analysis and stress testing within the firm’s capital management policy.
Analysis of investment firms abroad has shown emerging benefits in implementing a risk management process, even if the progress on Pillar 2 is still continuing. By working closely with all stakeholders, prudential guidelines could be issued to establish a comprehensive process of Pillar 2 implementation.
Conclusion
If there is one thing that the recent financial crisis has highlighted, it is the importance of a risk management framework which is able to deal with risk types beyond those included within Basel II Pillar 1, i.e. credit, market and operational risks. In the light of the Pillar 2 requirements, financial institutions including CIFs are obliged to strengthen their firm-wide risk management to foster the development of a robust risk and capital management process.
The Supervisory Review and Evaluation Process (SREP) under the authority of CySEC is soon expected to start requesting for the submission of ICAAP reports, explaining how CIFs implemented and embedded the ICAAP process.
Rakis Christoforou is the first qualified Accountant in Cyprus to hold the Certified in Financial Forensics (CFF) and Accredited in Business Valuation (ABV) certifications. He is a member of many accounting associations including the Institute of Certified Public Accountants of Cyprus (ICPAC). He is also the Vice Chairman of the ICPAC’s Economic Crime and Forensic Accounting (ECFA) Committee. Rakis delivered a workshop recently on Risk Management at CIIM.
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