Managing capital buffers in the Pillar II framework: designing an effective ICAAP/ORSA to manage procyclicality and to reconcile short-term and long-term views of capital

Peter Miu and Bogie Ozdemir

Journal of Risk Model Validation

Abstract: ABSTRACT We discuss the validation and management of the capital buffers within a Pillar II framework. This issue can only be meaningfully discussed from within the all-encompassing Pillar II framework, where both required risk capital and available capital are examined. As the recent "Basel III" proposals are limited to the Basel II Pillar I framework, they are unable to function as intended. We discuss the design of an effective internal capital adequacy assessment process (ICAAP, which corresponds to the own risk and solvency assessment in Solvency II) for managing capital buffers with respect to credit cycles, stress conditions and strategic objectives. We discuss two solutions in Pillar II for the procyclicality issue. The first solution ties the confidence level to the target debt rating more accurately and, by doing so, it retains the benefits of forward-looking risk information while dampening the procyclicality of capital. The second solution decomposes capital into its conditional and unconditional elements to obtain both shorter and longer views of capital adequacy. Decomposition also enables an "apples-withapples" comparison of capital adequacy among financial institutions, which is not possible when only examining Tier 1 capital ratios.

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