Navigating ICAAP's evolution

April 2025                          

Recent OSI findings have raised the bar for the ECB's expectations around the ICAAP. Key challenges for banks include clarifying the role of the risk function, incorporating ESG risks, and implementing a full economic valuation of the balance sheet. On the upside, a more robust ICAAP will boost banks’ resilience at a time of increasing economic volatility.

The Internal Capital Adequacy Assessment Process (ICAAP) is how banks ensure they are always adequately capitalised. Management boards receive frequent ICAAP reports, based on normative and economic perspectives, and draw on these when making business decisions.

There have been no formal changes to regulation in this area since the ECB issued its ICAAP guide in 2018. However, the findings issued to several banks after recent on-site inspections (OSI) have clarified and elevated the ECB’s expectations. Based on conversations with banks and insights obtained from market observation, we believe the three following areas are particularly in focus.

The introduction of the normative perspective reinforced the integration of capital adequacy into business planning activities. Banks typically draw on a range of credit, finance, and risk expertise to develop the baseline and adverse scenarios that shape quarterly updates to their capital planning.

Recent OSI findings suggest that some banks are not meeting the ECB’s expectations around the risk function’s responsibilities for this process. Risk teams are expected to assume responsibility for designing adverse scenarios, as well as providing effective and independent challenge of other functions’ work. For example, it is up to risk functions to ensure that adverse scenarios are rigorous, address banks’ main vulnerabilities, and are a suitable expression of banks’ risk appetite.

A robust ICAAP depends on maintaining effective segregation of duties. Risk functions need to clearly demonstrate how they avoid conflicts of interest, such as Treasury and Risk teams jointly developing and reviewing elements of the ICAAP methodology.

Recent publications like the EBA Guidelines on the management of ESG risks and the ECB’s Guide on climate-related and environmental (C&E) risks are raising expectations for emerging risks to be integrated into capital adequacy assessments. Banks face several obstacles to incorporating these risks into the normative perspective’s scenario analysis, the economic perspective’s capital requirements , and the analysis of business model resilience outlined in the EBA’s draft Guidelines on Scenario Analysis. For example:

• By definition, there is no relevant historical data for banks to use when modelling emerging risks. Transition risks such as stranded assets have only recently begun to be quantified, and OSI findings have criticised reliance on historic data that do not reflect current and future risks. The lack of historic data also means that regression models cannot be used for forward-looking risk modelling. Banks need to postulate and develop new modelling techniques. For example, the EBA’s draft Guidelines suggest that targeted analyses of transmission channels can be used to identify links between C&E risks and credit trends.
• All new modelling techniques require appropriate review and validation, but the lack of historical data makes back testing impossible. Banks therefore need to develop and demonstrate alternatives to traditional validation methods.

To date, banks have often used their accounting or regulatory capital as a starting point for determining internal available capital for the ICAAP’s economic perspective. They now face growing pressure from the ECB to adopt a more rigorous approach and review the economic value of every balance sheet item. Some specific expectations include:

• Making a thorough assessment of all costs , such as servicing and overheads, when calculating the economic value of assets.
• Considering locked-in funding costs, non-maturity deposit modelling, and the pricing of subordinated debt when valuing liabilities.
• Explicitly analysing and documenting all balance sheet items and deductions from Pillar I capital, such as deferred tax assets, whether these are appropriately reflected in available internal capital based on an economic view or if adjustments need to be made.

Meeting these expectations will pose significant challenges, for example if lower creditworthiness leads to a reduction in the fair value of liabilities, generating a notional - and prohibited - increase in available internal capital. The resulting changes could also have a major impact on banks’ capital adequacy assessments.

In conclusion, banks face several practical and methodological challenges from the ECB’s evolving expectations for the ICAAP. For leading institutions, ICAAP is no longer a matter of pure regulatory compliance. Robust capital adequacy planning is crucial to navigating periods of uncertainty, and the first quarter of 2025 has brought unprecedented shifts in the European and global economic outlook.

This is a great time for banks to review their ICAAP practice and governance – not only to meet supervisory expectations, but also to strengthen resilience and optimise strategic positioning.