What is ICAAP and how do banks run internal capital adequacy assessments?

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AcadiFi · Accepted Answer

ICAAP (Internal Capital Adequacy Assessment Process) is the bank's own rigorous process for identifying, measuring, aggregating, and managing all material risks, and demonstrating that the resulting capital level supports the bank's strategy and risk appetite under normal and stressed conditions.

Typical ICAAP structure:
1. **Risk identification**: map all risk types (credit, market, op, IRRBB, concentration, business, strategic, reputational, climate).
2. **Risk measurement**: quantify each using appropriate methodologies (economic capital models, scenario analysis, expert judgment).
3. **Aggregation**: combine risks into a single economic capital number, considering diversification benefits (often capped by regulators).
4. **Stress testing**: apply baseline, adverse, and severely-adverse scenarios over a 2-3 year horizon.
5. **Capital planning**: project capital ratios under each scenario, show they remain above internal targets and regulatory minimums.
6. **Use test**: demonstrate ICAAP outputs inform real decisions (pricing, limits, capital allocation, M&A).

```mermaid
flowchart TD
  A[Risk Identification] --> B[Measurement]
  B --> C[Aggregation]
  C --> D[Stress Testing]
  D --> E[Capital Planning]
  E --> F[Board Approval]
  F --> G[Use in Decisions]
  G --> H[Annual SREP Review]
```

Example: Kollerfeld Financial submits its annual ICAAP to the ECB. The document runs 400+ pages, covers 14 material risk types, and projects CET1 under a severe recession (GDP −4.5%, unemployment +5%, CRE −35%). The adverse scenario shows CET1 falling from 13.2% to 9.4% — still above the 4.5% minimum + buffers. The SREP team challenges assumptions on IRRBB and requests additional sensitivity analysis.

ICAAP weaknesses commonly cited in SREP letters: inadequate stress severity, missing tail risks, weak data governance, poor board engagement.

What is ICAAP and how do banks run internal capital adequacy assessments?

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