7 Principles of an Effective Capital Adequacy Process

The Federal Reserve Bank not only fights inflation, but also unmanaged risk and  systemic risk.

Recently the FED  announced seven new Capital Adequacy Process (CAP) Principles for complex bank holding companies (BHCs).

Although these principles only intend to effect BHC's with a consolidated assets of $50 billion or more, they are in fact a simple and adequate guideline for any Financial Institution (FI) that takes risk management and its stakeholders seriously.

The new principles emphasize that managers, risk managers and actuaries not only have to focus on technical risk, but also on the implementation of a sound risk framework, including an effective risk control and a transparent risk governance.

Here are the Seven Principles of an Effective Capital Adequacy Process:

1. Sound foundational risk management
   The FI has a sound risk-measurement and risk-management infrastructure that supports the identification, measurement, assessment, and control of all material risks arising from its exposures and business activities.
    
2. Effective loss-estimation methodologies
   The FI has effective processes for translating risk measures into estimates of potential losses over a range of stressful scenarios and environments and for aggregating those estimated losses across the FI.
    
3. Solid resource-estimation methodologies
   The FI has a clear definition of available capital resources and an effective process for estimating available capital resources (including any projected revenues) over the same range of stressful scenarios and environments used for estimating losses.
    
4. Sufficient capital adequacy impact assessment
   The FI has processes for bringing together estimates of losses and capital resources to assess the combined impact on capital adequacy in relation to the FI's stated goals for the level and composition of capital.
    
5. Comprehensive capital policy and capital planning
   The FI has a comprehensive capital policy and robust capital planning practices for establishing capital goals, determining appropriate capital levels and composition of capital, making decisions about capital actions, and maintaining capital contingency plans.
    
6. Robust internal controls
   The FI has robust internal controls governing capital adequacy process components, including policies and procedures; change control; model validation and independent review; comprehensive documentation; and review by internal audit.
    
7. Effective governance
   The FI has effective board and senior management oversight of the CAP, including periodic review of the FI's risk infrastructure and loss- and resource-estimation methodologies; evaluation of capital goals; assessment of the appropriateness of stressful scenarios considered; regular review of any limitations and uncertainties in all aspects of the CAP; and approval of capital decisions.

ORSA for European Insurers
A lot of the above mentioned principles are embedded in the 'Own Risk and Solvency Assessment' (ORSA) for European Insurers  as part of Solvency II regulation:

Implementing ORSA
It's our dedicated mission as actuaries to guide management on the implementation of ORSA or any other risk implementation program. And yes... it won't be easy.....

Links & Sources

- FED's 7 Principles Publication

- Solvency II & ORSA

- Dilbert & Risk