Internal Capital Adequacy Assessment Process (ICAAP) for NBFCs

Ashish M. Shaji

10 Sep, 2022

Banks must follow the internal capital adequacy assessment process in order to perform risk assessment. The RBI has placed the ICAAP requirement for middle layer NBFCs also which will be applicable from October 2022. As per the present regulatory framework, NBFCs must perform stress testing on only securitisation exposures or pool of loans taken from other institutions. So now the NBFCs in the middle layer and upper layer will be required to undertake a thorough internal capital assessment by taking into account various risks associated with their business. NBFCs can internally determine the methodology to be followed for the internal assessment as per a Board approved policy.

Internal Capital Adequacy Assessment Process (ICAAP) – Brief Overview

Basel II lays down three pillar approach to risk and capital management for banks. Pillar I specifies the basic details about minimum regulatory capital requirement, Pillar II lays down about the requirement from banks and regulators to fulfil the capital adequacy requirements and Pillar 3 provides banks’ disclosure requirements.

The RBI’s revised framework for NBFCs states that NBFCs must make a thorough internal assessment of the capital requirement, commensurate with their business risk. The revised framework for NBFCs further state that the internal assessment process needs to be in accordance to the ICAAP prescribed for commercial banks under Pillar 2. It further provides that the internal capital assessment shall factor in credit risk, market risk, operational risk and all other residual risks according to the internally determined methodology. The internal assessment methodology of capital is required to be proportionate to the scale and complexity of operations in accordance to their Board approved policy.

The internal capital adequacy assessment process for NBFCs can be guided by the Master Circular – Basel III Capital Regulations till specific directions in this regard are issued by RBI.

What is the objective of ICCAP for NBFCs?

As per the RBI circular on revised scale based framework, the main objective of internal capital adequacy assessment process is to ensure availability of adequate capital to support all business risks and also to inspire NBFCs to develop and use better internal risk management techniques to monitor and manage their risks. It will facilitate an active dialogue between supervisors and NBFCs on the risk assessment and monitoring and also mitigation.

In simple words, ICAAP refers to an analysis which assists the financial institution like NBFCs to determine whether the regulatory capital maintained by them is adequate to absorb relevant risk poised due to their operations.

The RBI has proposed ICAAP for NBFCs considering the fact that NBFCs are growing in size, and their interconnectedness with other segments of financial system has also developed. Also, the risk management of these NBFCs is similar to its commercial bank counterparts. Moreover, the need for ICAAP also arises due to the impact of pandemic which has reduced the consumption demand. This in turn has reduced the credit growth and the profitability of NBFCs has also dipped in 2021. 

Principal Components of ICAAP

The broad principles of ICAAP as per Basel III circular are as follows:

• The internal capital adequacy assessment process must be forward looking in nature and it should consider the expected / estimated future developments;
• The main consideration in ICAAP should be to address risk faced by an NBFC. It should take care of both quantifiable and non-quantifiable risk;
• The ICAAP should also include stress tests and scenario analysis. The stress test helps in determining the risk posed to an entity in various stress scenarios and gives an idea about the entity’s capability to deal with it.
• RBI doesn’t expect the usage of complex econometric models for internal assessment of their capital requirements however, there are certain prerequisites of the model. They include:
• Well documented model specifications;
• Robust system for validation of the model inputs and outputs;
• A system of stress testing.

Authority for Analysis

The ultimate responsibility for the sound functioning and financial condition of the bank lies with the banks’ board. Although the operationalisation of a risk management framework may be delegated to senior management, the board needs to review and approve the main objectives of the internal capital adequacy assessment process and agree on the main assumptions of Risk Identification & Risk Measurement. The board needs to define strategy and approach for ICAAP and monitor it and make changes as and when required.

The board has the following responsibilities:

• Set up risk tolerance level;
• Adopt and support internal controls;
• Ensure that the senior management- have a risk framework in place to assess and manage risk exposures, develop a system to monitor risk exposure, establish a method to monitor compliance with internal policies.
• Ensure that an appropriate strategic plan is implemented, which should provide for the current and future capital requirements, anticipated capital expenditure, and desired level of capital.

ICAAP Document Inclusions

 The inclusions to be made in the ICAAP document includes the following:

• A section shall comprise of organizational and historical financial data;
• Another section would comprise of the present financial position and shall also include the prospective changes;
• Capital adequacy specifying the risk appetite;
• Another section will explain the testing that ICAAP has been subjected to (to include testing processes);
• Information on the scope of capital management embedded in the decision making process.

Conclusion

Considering the systematic risk associated with NBFCs, there is a compelling need for NBFCs to follow the internal capital adequacy assessment process. NBFCs should implement their ICAAP in the prescribed manner and establish their capital assessment and risk management processes and methods in line with the regulatory needs. NBFCs need to make a realistic internal assessment of risk (credit, market, operational and all other residual risks). The ICAAP policy^[1] and the framework made by the NBFCs will be subject to regulatory oversight.

Read our Article:RBI issues Master Circular on Bank Finance to NBFCs