The Basel Accord is a set of internationally accepted financial regulations that focus on the risk and capital management procedures of credit institutions. The Basel Accord is developed in the city called Basel in Switzerland. The Accord is then introduced to each member state who implement the guidelines as a set of financial service regulations via their Central Bank. The key to the Accord is to ensure that the rules are consistently implemented and applied in 90% of the banking assets of the world. This ensures a level playing field and a consistent regulatory approach as financial institutions transact globally and nationally.
Basel II is Three Pillars
Basel II has three pillars: minimum capital, supervisor review and market discipline:
- The First Pillar is the calculation of the credit institution’s capital adequacy ratio using a regulatory framework, including co-efficient and guidelines for internal risk and capital estimation models provided by the regulator.
- The Second Pillar is guidelines that require the credit institution to describe the risk and capital management procedures used with the organization. The credit institution must also explain the quantitative approaches that are used to assess risk and estimate capital.
- The Third Pillar are guidelines about the credit institution’s public disclosures of risks and capital that are the results of the estimations in Pillar 1 and Pillar 2 and also qualitative disclosures about the strengths and weaknesses of the risk and capital processes.
ICAAP is Part of Pillar 2
Internal Capital Adequacy Assessment Process (ICAAP) is the process used by the credit institution in Pillar 2 to provide a structure to describe all the quantitative methodologies and qualitative descriptions of the risk and capital management processes.
ICAAP consists of describing:
- Risk Appetite Statement (including the Strategic Planning Process and the Risk and Capital Strategy of the credit institution)
- Significant Risk Identification Procedures of all material risks (this includes the qualification criteria)
- Risk Management Procedures (including identification, assessment & estimation, control & monitoring, mitigation and reporting)
The assessment and estimation areas also include the description of the risk estimation models or techniques used.
The control and monitoring procedures include the risk limits and limits management system.
- Capital Management Procedures (including the capital estimation and aggregation models, the allocation approaches, the risk limits based on the allocated capital)
- Stress-testing, Scenario Analysis and Sensitivity Analysis Procedures (including the stress-testing of the risk and capital results)
- Reporting (including the reporting of results of all the above procedures to the Board of Directors and senior management)
- Intern Audit (including the third line of defence and the annual independent review of all ICAAP procedures and estimation methodologies