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Best Practices in Managing Internal Capital Adequacy

Guaranteeing a Solid Base of Capitalization

Cooked down to its essence, the convulsion that overtook the international banking system in 2008 came down to institutions lacking adequate capitalization. The failure of Lehman Brothers — due to its holdings in the subprime market not being sufficiently counterbalanced with available capital — was the first domino. Merrill Lynch, AIG, the Royal Bank of Scotland, and a host of other institutions could have been next if central banks had not stepped in.

In the aftermath of the Great Recession, it became apparent that banks needed to maintain capital adequacy so that such a high-stakes situation did not reoccur.

Implementing best practices in Internal Capital Adequacy — the capital adequacy process (CAP) — is now a core responsibility for bank managers.

Best Practices for ICAAP Planning:

Internal Controls

Such a CAP will include comprehensive internal controls based on the following:

  • Focused oversight by the board of directors and senior management, including regular examination of methodology and financial infrastructure.
  • Continual assessment of capital goals and the independent validation of modeling.
  • Continual evaluation of the scenarios — the uncertainties that are a fact of life — that are being employed in “stress tests” (i.e., avoiding a “garbage in, garbage out” situation).
  • Institutional approval of capitalization processes.
  • Rigid documentation of decision-making.
  • Regular internal auditing.

Board of Directors:

The board of directors holds primary responsibility for implementing the thorough and robust maintenance of Internal Capital Adequacy. The priorities and goals of the institution are set at the top and filter down. The board should demand — and fully review — information on at least a quarterly basis and at any other times when required.

Stress Testing Scenarios:

Policies put in place by the board must be carried out completely by senior management. This includes true stress tests that lean towards the “worst case scenario,” not the “best case.” It is imperative that Internal Capital Adequacy measurables are robust enough to produce valid results.

Decision-making process:

The decisions approved by senior management must be properly documented. Key decisions about capital actions must include the detailed criteria on which these decisions were made. This will provide transparency, institutional memory — and bring more discipline to the decision-making process itself.

Risk measurement and Modeling:

The CAP process should be played out in its entirety, including risk measurement and modeling that produces accurate loss and resource estimates, a detailed process for creating reports that are forwarded to the board and senior management, and ultimately a coherent set of components that ensure that the CAP is fully functional. The policies and procedures need to be detailed and continually monitored for compliance.

Independent Review & Validation:

The overall CAP program should receive a validation and independent review. The staff doing the internal auditing should have the technical know-how and independent stature within the organization to produce a truly autonomous result.

Takeaways

There are obviously costs to implementing a successful CAP. Not only the direct outlays, but also the fact that maintaining capital is expensive and limits the amount of short-term profitable risk that an institution can take on.But the fact is that being able to weather extreme shocks is profitable in the long run. Just consider Lehman Brothers, once the fourth-largest investment bank in the United States and now a historical footnote.

Uncertainty is a fact. Internal Capital Adequacy is a crucial system that incorporates preparation for uncertainty into the core operations of an institution. The banking model is not the tech startup model; wild swings in quarterly report figures are not the basis for a sound bank. A successful CAP system will provide stability and a reliable supply of bank credit for whatever aspect of the economy the bank serves.