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Regulatory Capital and Modeling
89
and mitigate risks. In particular, it will “review the arrangements, strategies, processes
and mechanisms implemented by a firm to comply with its regulatory requirements”
(Prudential Regulation Authority, supervisory statement 31/15), taking into account the
nature, scale and complexity of a firm’s activities. Finally, it will evaluate any further
risks revealed by stress testing.
As part of a SREP, regulators evaluate the sufficiency of the firm’s capital to
cover its risk. Common across the U.S. and Europe, the evaluation has different
names and varies depending on the realities and processes in each geography and each
industry:
■
In Europe, the evaluation of capital sufficiency for banks and financial firms is
called ICAAP (internal capital adequacy assessment process).
■
In the insurance industry, it is called ORSA (own risk and solvency assessment).
■
In the U.S., the process is CCAR (comprehensive capital analysis and review).
For all risks, operational or otherwise, the solvency assessment of a financial firm
requires the identification of key threats and scenarios for large loss events, and the
assessment of the firm’s resilience to internal and external shocks that would lead to
changes in the operating environment and to the business plan and profitability. This
is what the market refers to as stress testing, presented in the next section.
Alongside solvency assessment, regulators use the SREP to form a view of the
firm’s governance arrangements, its corporate culture and values, and the ability of
managers to perform their duties, namely through effective, comprehensive and reliable
risk reporting.
C A S E S T U D Y : I C A A P O F A N I N V E S T M E N T F I R M
Figure 8.3 is a replicate, with changed numbers, of the summary table of an
ICAAP report prepared by one of my clients. The firm is mid-size, active in
the UK, and its main exposure comes from market risk. With the management
and a team at my firm, we reassessed the firm’s capital for all risks – credit,
market and operational – both in day-to-day conditions and in stressed mar-
ket conditions. We compared the results to the firm’s pillar 1 capital require-
ments, calculated in standardized method for all risks. The results showed a
comfortable level of capital surplus, even when accounting for stressed market
conditions, and an additional capital buffer for other risk types not covered by
pillar 1, such as concentration risk, group risk and reputation risk. The regu-
latory outcome of the assessment did not lead to any additional capital from
the firm.
(
Continued
)
90
RISK ASSESSMENT
Capital surplus available
65,000
12,000
17,000
6,000
6,000
20,000
2
8
,000
16,000
15,000
8
,000
7,000
8
,000
6,000
17,000
12,000
37,000
Internal assess
m
ent
(pillars 1 & 2) – nor
m
al
Internal assess
m
ent
(pillars 1 & 2) – stressed
Pillar 1
4,000
5,000
Capital planning buffer
Operational risk – high end
Operational risk – low end
Credit risk corporate – nor
m
al
Credit risk retail – nor
m
al
Global stress testing
Market risk
F I G U R E 8 . 3
Case study: ICAAP for an investment firm – summary results
S T R E S S T E S T I N G
Stress testing in operational risk can be confusing as it potentially refers to four differ-
ent types of exercise: sensitivity stress testing, risk scenarios, macro-economic scenar-
ios and reverse stress testing.
S e n s i t i v i t y S t r e s s T e s t i n g
This relates mainly to testing the robustness of a model by changing the value of the
parameters. In pillar 2 or SREP exercises, sensitivity stress testing can be applied to the
parameters underpinning projections of sales and revenues; a change in those parame-
ters may very well affect the business plan of the firm and its future profitability and,
hence, solvency.
S c e n a r i o S t r e s s T e s t i n g
This focuses on possible yet unlikely tail events – in every risk type – for which the
losses would need to be covered by capital. In credit risk, it can relate to the failure of
a large institutional client; in market risk, to a crisis; in operational risk, to a business
Regulatory Capital and Modeling
91
disruption or a large systems crash. Scenario stress testing is very similar to the pro-
cess presented in the previous chapter. In CCAR, the analysis and review process used
in the U.S., more attention is dedicated to legal risk and compliance scenarios than
in Europe – a consequence of the legal and regulatory differences between the U.S.
and Europe.
M a c r o e c o n o m i c S t r e s s T e s t i n g
Each year, regulators provide international financial institutions – those which face
potential systemic impact – with one or two macroeconomic shock scenarios, in order
for them to assess their solvency level should these scenarios materialize. This is the
core of the CCAR exercise in the U.S. Smaller regulated firms are also encouraged
to stress test their capital level in case of a global economic shock. The stress-testing
structure adopted by one of these firms for its SREP is illustrated in the case study.
C A S E S T U D Y : E U R O P E A N I C A A P – E X A M P L E O F
S T R E S S- T E S T I N G S T R U C T U R E
Figure 8.4 outlines an example of stress testing on global, financial and
non-financial scales.
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