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Risk Management and Pillar II: Implementing ICAAP in Italian Credit Cooperative Banks

Journal 35: Zicklin-Capco Institute Paper Series in Applied Finance

Rosaria Cerrone, Michele Maria Madonna

We want to show the relevance of risk management and riskbased functions in banks, as during the recent crisis what has become very clear is that capital requirements for financial institutions were not always adequate given their risks. Under the current set of rules the Internal Capital Adequacy Assessment Process (ICAAP) is a requirement for banks and is necessary to measure the principal risks that each bank must afford and manage. So we first consider the role, functions and requirements of the ICAAP. Banks often tend to calculate the capital buffer they hold by extrapolating figures from previous events, instead of using a forecast risk profile. Using its particular scheme the ICAAP should provide firms with the best capital buffer required, and the best level of funds from stockholders. For this reason we present an overview of the ICAAP methodology and results. In particular we consider the case of credit cooperative banks in Campania, by taking into account their ICAAP schemes and the effects of these new rules and this kind of self-regulation.

The current global financial crisis underscores the need to strengthen risk management and risk-based vision, so that banks can deal more effectively with the increased complexity arising from both financial product innovation and increased interconnectedness between financial institutions. The Basel deadlines, the meaning of Pillar II and the abovementioned international crisis have emphasized the problem of a sound measure of risks.

Risk management and, among others, credit risk and more recent liquidity risk management (Basel III framework) constitute a rapidly evolving discipline. The review of management practices and techniques for identifying, measuring and monitoring risks is closely related to the process of regulatory reform and ongoing changes [Basel Committee on Banking Supervision (2010c, rev. June 2011)].

As for the current crisis, while many causes have been identified, what has become very clear is that in financial institutions capital was not adequate given their risks, and this had allowed over-leveraging as well as by their customers, leading to over-indebtedness and asset price bubbles. The issue therefore underscores inadequate risk management, covering the entire process from the lack of proper risk measurement, especially with regard to complex products as well as liquidity risk, to inadequate risk management and control, and to micro-prudential risk-based supervision [Nijathaworn (2009)].

This is why Pillar II is important, because its essence is to ensure that financial institutions have adequate risk management processes and capital, commensurate with their risk profiles. Moreover, a greater rigor in the use of stress-testing by financial institutions is registering in the current environment of heightened volatility.

The implementation of Pillar II is, however, a challenge, not only in terms of technical and quantitative expertise for reviewing the Internal Capital Adequacy Assessment Process (ICAAP), but also on qualitative aspects, such as how to foster the dialogue between supervised institutions that would enhance the ICAAP and the supervisory authority.

As the ICAAP should be customized for each firm, taking into account the particular risks and information available, we want to consider the extent to which capital management is embedded within a bank, including the extent and the use of capital modeling or scenario analysis and stress testing within the bank’s capital management policy. For this reason we consider the case of credit cooperative banks in Campania, by taking into account their ICAAP schemes and the effects of these new rules and this kind of self-regulation. Analysis of these banks has shown emerging benefits in implementing a risk management process, even if the progress on Pillar II is still continuing. By working closely with all stakeholders, especially with the local Credit Cooperative Federation, prudential guidelines have been issued to establish a comprehensive process of Pillar II implementation, even within the perspective of the full adoption of Basel III risk management criteria.

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