MiFID Investment Firm's Internal Capital Adequacy Assessment Process (ICAAP)

Under the Investment Firm Regulation (‘IFR’) (EU) 2019/2033, regulated investment firms are required to maintain effective arrangements, strategies, and processes for assessing and maintaining the appropriate amounts, types, and distribution of internal capital and liquid assets, in line with their business model and associated risks. Firms calculate their capital requirements based on the minimum capital requirements outlined in Part III of the IFR and by evaluating the need for additional capital or own funds through the Internal Capital Adequacy Assessment Process (ICAAP).

Own Funds/Capital Requirements
Investment firms must at all times maintain own funds exceeding the highest of the following:

(a) Fixed overheads requirement (calculated in accordance with Article 13 of the IFR).
(b) Permanent minimum capital requirement (in accordance with Article 14 of the IFR).
(c) K-factor requirement (calculated in accordance with Article 15 of the IFR).

This is the regulatory minimum, known as “Pillar 1.” Firms are also expected to evaluate the need for additional own funds or “Pillar 2” requirements through the ICAAP.

ICAAP Structure

A firm’s ICAAP should typically include the following key sections:

Stress Testing

Firms must conduct stress testing as part of the ICAAP process to assess the potential impact of adverse scenarios on capital and liquidity. The stress testing should cover three types of scenarios:

• Scenario 1 – Idiosyncratic
  A firm-specific stress event is designed to test the capital requirements to a severe but plausible extent. This stress test aligns with the firm’s identified material risks.
• Scenario 2 – Macroeconomic
  A macroeconomic stress event to test capital requirements to a severe but plausible extent under conditions beyond the firm’s control that could negatively impact its financial position.
• Scenario 3 – Combined
  A combination of the idiosyncratic and macroeconomic scenarios. Typically, it is more severe than either of the individual stress events.

Common Pitfalls

Firms often receive similar feedback from regulators regarding their ICAAP. Common issues identified in regulatory responses include:

• Risk Identification & Qualification Process
  The ICAAP should clearly outline how risks are identified, with appropriate signposting to references to internal documentation. Each risk should be quantified clearly and based on relevant guidance. Firms should also ensure that K-factors are properly considered during this process.
• Governance:
  The ICAAP must describe both firm-wide governance and the specific governance processes related to ICAAP.
• Risk Data, Aggregation & IT Systems:
  The ICAAP should detail the framework and processes used to collect, store and aggregate risk data, including the flow of data from subsidiaries to the group, if applicable.

How We Can Help

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