Circular PPB-2007-15-CPB-CPA: Prudential Expectations Regarding the Internal Capital Adequacy Assessment Process (ICAAP)

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+32 2 220 53 42 | +32 2 220 54 93 | www.cbfa.be Prudential Policy for Banks and Insurers PB Brussels, December 18, 2007.

CIRCULAR PPB-2007-15-CPB-CPA TO CREDIT INSTITUTIONS AND INVESTMENT FIRMS INDICATING CERTAIN PRUDENTIAL EXPECTATIONS REGARDING THE "INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS" (ICAAP)

Madam,
Sir,

Pursuant to Article 43, § 2 of the Law of March 22, 1993 [1], Article 90, § 2 of the Law of April 6, 1995 [2], and Title XII of the Regulation of October 17, 2006 relating to the own funds of credit institutions and investment firms, hereinafter referred to as 'the Regulation', each institution must have strategies and procedures, hereinafter referred to as ICAAP (Internal Capital Adequacy Assessment Process), which are reliable, effective, and comprehensive in order to assess and retain the level, type, and distribution of internal own funds that it deems appropriate to continuously cover the risks to which it is or could be exposed. This ICAAP is the system internal to the institution allowing it to assess the adequacy of its own funds taking into account its risk profile and organization. It covers both the individual basis and the consolidated basis, without prejudice to the exemptions provided for in Article XII.1, § 2 of the Regulation. It takes into account, where applicable, the principle of proportionality set out in said Title XII.

To the extent that, in accordance with Principle 9 of Article XII.3 of the Regulation, the ICAAP must be subject to an evaluation by the Banking, Financial and Insurance Commission (CBFA) within the framework of its prudential supervision mission, and since it is at the center of the dialogue between the institution and the CBFA, it is important that each institution be able to provide adequate documentation on the characteristics and significant results of its ICAAP.

This circular provides additional information on how the CBFA intends to apply certain principles set out in Title XII of the Regulation and specifies the procedure defined to collect information concerning the main characteristics and results of the ICAAP of institutions.

This procedure will be tested with a few pilot institutions at the end of 2007 and beginning of 2008, and some of its modalities may be modified to take into account the lessons learned at the end of this exercise.

[1] Law of March 22, 1993 relating to the status and supervision of credit institutions.
[2] Law of April 6, 1995 relating to the status and supervision of investment firms.

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This procedure comprises two parts: on the one hand, the creation of internal documentation or an ICAAP file, and on the other hand, the submission to the CBFA of an annual quantitative report. A scheme summarizing this procedure is included in Annex 1.

The implementation of this procedure does not prejudice any bilateral information exchange agreements already agreed upon regarding ICAAP with certain institutions.

1. The creation of internal documentation or an ICAAP file.

In accordance with the principles defined in Article XII.3 of the Regulation, the structure and development of the ICAAP must be fully documented, under the responsibility of the highest governing body of the institution.

The CBFA therefore expects that each institution has internal documentation preferably assembled in an ICAAP file. This documentation must include the essential elements of the ICAAP, notably the policy and objectives regarding capital adequacy as approved by the highest governing body, the description of the ICAAP process and the methodologies used to measure risks, the results of the ICAAP on which the institution bases its conclusion that it has and will have sufficient own funds to cover these risks, and the measures taken or envisaged to ensure that the level of own funds remains adequate, including measures to mitigate incurred risks. Information on validation processes and work as well as on the review process put in place by the institution should also be included.

In order to reflect the fact that the ICAAP is an internal process specific to the institution, the format, composition, and level of detail communicated in the internal documentation or the ICAAP file are left to the discretion of each institution. The CBFA nevertheless expects them to be proportional to the size, nature, and complexity of the institution's activities.

Therefore, investment firms with limited activities in terms of nature and volume, such as certain wealth management companies, may have internal documentation limited to the most significant elements regarding incurred risks.

Nevertheless, in order to inform you about the information deemed relevant and necessary by the CBFA to assess the adequacy of the implemented ICAAP, you will find in Annex 2 an illustration of the possible structure of the internal documentation or the ICAAP file.

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The creation of internal documentation or an ICAAP file for institutions belonging to groups.

Belgian law institutions that are part of a group whose parent company is a Belgian law institution or financial company, whether Belgian or foreign, must also have adequate internal documentation allowing the assessment of the adequacy of the ICAAP at their level. In agreement with the principles set out in Title XII and to take into account the fact that the global methodology of the ICAAP can be defined at the group level, this documentation may however rely on the documentation established at the group level, where applicable, particularly regarding the description of risk measurement methods and capital allocation.

This does not, however, prejudice the fact that the senior management of each institution, where applicable the Management Committee, must formally pronounce itself on the adequacy of the ICAAP objectives and results at its level, in application of the principles set out respectively in Article 43, § 2 of the Law of March 22, 1993 relating to the status and supervision of credit institutions, and in Article 90, § 2 of the Law of April 6, 1995 relating to the status and supervision of investment firms.

In accordance with the principles set out in the commentary of Article XII.1 of the Regulation, this documentation will be taken into consideration by the CBFA to evaluate the extent to which the ICAAP developed at the group level can or cannot constitute a significant basis for the ICAAP of Belgian law institutions, established on an individual or sub-consolidated basis.

These provisions apply mutatis mutandis to branches in Belgium of institutions from countries outside the European Economic Area. However, when these branches benefit from an exemption from capital requirements in accordance with the provisions of Article XIII.2 of the Regulation, the CBFA only expects these branches to inform it about the ICAAP developed at the level of their parent company or the group to which they belong, as well as about how it is transposed at the branch level.

Modalities for updating the internal documentation or the ICAAP file and transmitting it to the CBFA.

The internal documentation or the ICAAP file must be submitted upon explicit request of the CBFA when it initiates the analysis or monitoring of the adequacy of the procedures and systems put in place by an institution.

The CBFA also expects that all relevant information that would not appear in the documentation or the file can be communicated to it quickly.

Since the ICAAP must be subject to regular evaluation, in accordance with Article XII.3, 3°, the CBFA further expects that this internal documentation or ICAAP file be subject to regular updates, and be verified at least once a year and adequately adapted whenever significant modifications are made to the ICAAP.

The institution will ensure to clearly notify the modifications made since the last submission of the internal documentation or the ICAAP file to the CBFA.

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2. Annual ICAAP reporting to the CBFA.

Except for branches of institutions from countries outside the European Economic Area that benefit from an exemption from complying with capital requirements in accordance with Article XIII.2 of the Regulation, each institution must transmit to the CBFA an annual report covering the quantitative results of its ICAAP. This report will be prepared on a consolidated basis when the institution consolidates. Other institutions will report on an individual basis. Exemptions may however be granted in conformity with the principles set out in Article XII.1, § 2 of the Regulation.

When the institution is part of a group subject to the consolidated or sub-consolidated supervision of the CBFA, the institution's reporting may be included in the group's consolidated or sub-consolidated reporting, provided that the necessary information related to the parent company and subsidiaries is clearly identifiable. If the institution's reporting is integrated into the group's reporting, it must be ensured that the information related to the concerned institution corresponds to that approved by its senior management, where applicable the Management Committee, insofar as each institution remains responsible for the results of the ICAAP at its level and the quality of the information transmitted to the CBFA.

This reporting will preferably be based on figures from December 31 but may, where applicable, be established on the basis of another reference date depending on the internal process defined by the institution. It must be submitted annually to the CBFA two and a half months after the chosen reference date. Without prejudice to the following, it must respect the scheme included in Annex 3, namely an introduction and a table detailing the results of the ICAAP by type of risk. Institutions may however provide the numerical results according to their internal reporting but will strive to respect as much as possible the reporting structure proposed in this circular. Thus, the determination of the list of types of risks included in columns 2 and 3 is left to the discretion of each institution insofar as it evaluates materiality and uses different definitions for each of its risks within the framework of its ICAAP. The CBFA nevertheless requires that the reporting cover all significant risks to which the institution is exposed.

The annual ICAAP reporting will be sent directly to the CBFA. It will be analyzed in light of the information contained in the respective internal documentation or ICAAP file of each institution.

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A copy of this is addressed to the commissioner(s), approved auditor(s) of your institution.

Please accept, Madam, Sir, the expression of our distinguished sentiments.

The President,
J.-P. SERVAIS.

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Annex 1:

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Annex 2: Illustration of the structure of the internal documentation or the ICAAP file

1. Scope of the ICAAP
   This section should contain the list of entities covered by the ICAAP, distinguishing regulated from non-regulated entities and specifying whether they are European or not, included in the Pillar 1 scope or not, and what the respective supervisory authorities are.

2. Own Funds Objectives
   This section should contain:

• Information on the objectives pursued, and their justification, in terms of own funds levels (for example: obtaining an external rating, return for shareholders, protection against unforeseen events, etc.), desired composition of own funds and, where applicable, distribution of own funds within the group.
• On this basis, information on the general level of risk appetite ('risk appetite') and where applicable by type of risk if it differs from the general appetite.
• Information on the frequency of review and approval by the institution's management of policies regarding capital adequacy and risk appetite.

3. Organization Part, Methodology, Validation and Review
   3.1. Description of the ICAAP Process
   This section should provide an overview of the ICAAP process by linking the institution's risk management, governance, activity planning, and capital management. It should cover the procedures and systems used by the institution to identify, manage, and monitor its risks according to its risk appetite.

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Depending on the size, nature, and complexity of each institution's activities, this part should contain the following information:

• How the ICAAP process is structured, specifying the procedures used and the departments involved in activity planning, risk measurement, and capital management, making links between these different elements;
• When and at what frequency, the assessment of own funds needs and the adequacy of available capital is carried out;
• What are the different reporting lines for ICAAP results, including the involvement of senior management and the highest governing body;
• How the ICAAP is used within the institution, and notably how it integrates into decision-making processes;
• Details on the degree of dependence and trust placed in external providers;
• Test and control procedures applied to the methods and procedures used as well as to the calculation of ICAAP results.

3.2. Measurement of Material Risks and Aggregation and Allocation Methodology
This section should provide a summary of the risk identification and measurement process and how the institution judges their materiality.

Depending on the size, nature, and complexity of each institution's activities, this part should specify the following elements:

• For each risk, describe the methodology and risk assessment assumptions:
  Generalities:
• For each risk, provide a definition, describe the chosen assessment approach and explain the reasons for this choice.
• Clarify the assumptions used in calculation approaches and the limitations of these approaches.
  When internal models are used, specify the assumptions and parameters used (particularly the confidence interval and time horizon), the sensitivity of these models to the chosen assumptions or parameters, and the data used for their calibration. When scenario analyses or other methods are used, describe the manner in which the severity level of the scenario was chosen. Describe how risks related to the chosen assessment approach, for example the use of models, are taken into account.
• Describe validation techniques for the methods used and their results; communicate information on work conducted to validate the approaches used, whether internal or external.

Comparison of Risk Assessment between ICAAP and Pillar 1:

• When the approach or models used for calculating capital needs differ between the ICAAP and Pillar 1, explain the methodological differences and in parameters. Explain their impact on capital measures. Explain and give an estimate of the impact of potential 'management actions'.
• The methodologies and assumptions used to aggregate the results of different risks to obtain a global assessment of capital needs. Specify notably:
  o Whether diversification effects within and between risks are taken into account, and how these effects are evaluated, including under stress conditions (for example by excluding 'management actions') and ideally taking into account the institution's portfolio composition. The institution could also compare the results obtained by setting all correlations to their maximum and minimum. o Whether diversification benefits between legal entities are taken into account and how potential restrictions on the free movement of capital between different entities in the group during financial stress are taken into account (comment on all restrictions on management's ability to transfer capital to main subsidiaries (exchange restrictions, political risk, regulation)).
• The method or methods for allocating economic capital needs to the different business lines and legal entities of the group.

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3.3. Review of the ICAAP
This section should specify the frequency and describe the process for reviewing the adequacy of the ICAAP both at the level of risk measurement and the determination of own funds needs.

4. Business Strategy
   This section should provide a general summary of the establishment's business/corporate plan which could provide a prospective view of its future activities (growth plans, new products or markets, new distribution channels, etc.) and the risks associated with them.

5. Evaluation of Current Own Funds and Risks and Planning
   This section should contain the results of the ICAAP on which the institution's management bases its conclusion that it has and will have sufficient own funds to cover its current and future risks. It should describe the process for determining the adequacy of available capital, specifying for example if and how elements such as the risk inherent in any approach (including risk related to the use of models), weaknesses in the institution's risk management procedures, systems, and controls, differences between capital requirements and internal capital, and the different objectives sought by holding capital, etc., are taken into account.

This section should provide:

• Confirmation that the institution holds an adequate amount and quality of capital for its planning horizon when its dividend policy and the potential impact of a moderate economic slowdown are taken into account.
• A comment on the main issues deserving more in-depth analysis, or requiring work or decisions from the institution.
• The dates:
  o Of the last review of the ICAAP; o Of the last approval of the ICAAP and its results.

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• A table listing the main results of the ICAAP based on the annual reporting scheme transmitted to the CBFA (see Annex 3).

This section should also provide a view on:

• The material risks to which the establishment is exposed as well as the current and future level of capital required by these risks, given the own funds objectives. It should describe why their level is considered acceptable, or alternatively what are the planned actions to mitigate these risks by explaining the methods used for this purpose.
• The current situation of own funds and the establishment's projections on its capital resources given its business plan. It should also describe the means put in place to manage capital.

Depending on the size, nature, and complexity of each institution's activities, this part could include:

• The capital position describing current and planned capital, its composition, as well as dividend plans, and how the establishment intends to manage its capital prospectively.
• The risk position describing the amount of current and planned risks.
• The consideration in capital planning of the impact of 'management actions' in determining capital needs and the demonstration of the application of its actions in the past and assurance that they, or other more adequate ones, will be applied in the future.

6. Results of Stress Tests
   The establishment should use stress tests to evaluate how its situation would evolve under stress conditions. This section should describe the stress tests used [3] and present their results as well as how the establishment would manage its activity and capital at minimum in the event of a moderate recession to ensure compliance with its regulatory capital requirements (minimum Pillar 1).

When the establishment relies on 'management actions' to reduce the amount of required own funds, the results of the stress tests should anticipate the inability to control and implement these actions. A justification of the realism of these actions should be provided.

When the establishment takes into account diversification effects between risks and legal entities, the assumptions used should also be subject to stress tests.

[3] At least one stress test must correspond to a moderate recession or a moderate weakening of activities or markets related to these activities, in line with the requirements of Title VI of the own funds regulation.

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7. Improvements to the ICAAP
   This section should describe the future modifications to the ICAAP envisaged or planned by the establishment.

Annex 3: Structure of Annual ICAAP Reporting

1. Generalities

• Notification of any modifications made to the ICAAP since the last reporting and implying a modification in the interpretation of the figures transmitted in the table below. Example: new definition of risk types or modification of the entities or risks covered in the ICAAP, new methodologies or assumptions, etc.
• If applicable, list of group entities not covered in this reporting, both for the calculation of capital requirements under Pillar 1 and for the ICAAP calculation of capital needs.
• The list of risks not covered by capital holdings.
• If used: the definition of the impact of diversification by risk type as taken from the table below.

2. Numerical Table

Reference date chosen:

Pillar 1 Capital Requirements	ICAAP Capital Needs	Diversification Impact 4
Pillar 1 Risks
Credit Risk
Operational Risk
Market Risk
Total Pillar 1 Risks
Pillar 2 Risks
Risks related to Pillar 1 but not covered in Pillar 1
Concentration Risk (for all risks)
Residual Risk arising from the use of risk mitigation techniques
Intraday Risk
Securitization Risk
Etc.
Other Pillar 2 Risks
Reputation Risk
Interest Rate Risk in the Banking Book
Settlement Risk
Staff Pensions
Insurance Risk
Liquidity Risk
Etc.
Business Environment Risk
Strategic Risk
Capital Risk
Model Risk
Etc.
Total Pillar 2 Risks
Adjustments (e.g., if the institution intends to apply inter-risk diversification, etc.)
Additional Capital to Cover Stress Testing
Total ICAAP Capital Needs
Equity: Total
Available Capital (according to internal definition)
Surplus

4 Optional by risk type and to be defined by the institution based on the method used internally for the calculation of ICAAP results. For example: on a consolidated basis, this figure could measure, by risk type, the impact in terms of internal capital needs of diversification between entities and/or between business lines included at this level; on a legal entity basis, this figure could measure by risk type, the impact of diversification linked to the exposures of the concerned entity.