Complex bank holdings have been previously noted by the Federal Reserve (the Fed) to be very important during capital planning. Complex Bank Holdings require capital so as to continue to lend to consumers and creditworthy businesses and also to absorb unexpected losses.
For effective functioning and stability of the U.S. financial system, the processes for allocating capital resources and managing the BHC is critical. The importance of the Federal Reserve places on BHCs’ internal capital planning processes has been emphasized by the Comprehensive Capital Analysis and Review (CCAR) and The Federal Reserve’s capital Plan Rule so as to promote resiliency from BHCs.
These enterprises have also focused on the policies and internal practices a firm uses to determine the amount and composition of capital that would be adequate. The Fed’s concern in anticipation for effective planning reflects the importance of the ongoing sustainability of the largest BHCs even under traumatic economic and financial conditions.
Forceful capital planning helps ensure that BHCs’ capital levels are sufficient and able to withstand economic stress in the future. It also ensures that the capital is in a broad range of future financial markets and microeconomic environments.
The Federal Reserve’s Capital Plan Rule requires all U.S.-domiciled BHCs to come up with and maintain a plan for capital that is supported by a strong process for evaluating their capital competency. The Federal Reserve’s supervisory program for evaluating the capital plans is the CCAR.
The Federal Reserve’s valuation of BHCs’ capital planning process includes the risk identification management and measurement that supports the process and stress scenario analysis. The foreword to the Capital Plan Rule outlines the essentials on which the Fed gauges the toughness of a BHC’s internal capital planning.
The Federal Reserve’s expectations for internal capital planning at large and complex BHCs (those subject to the Capital Plan Rule in the CAP principles) are described in this publication which expands more by highlighting the practices considered leading and stronger and also the practices which require improvement. However, these practices should not be considered a safe harbor. Supervisory stress and scenarios tests are not to be viewed as sources for an all surrounding assessment of the possible risks a BHC may encounter.
A full-bodied internal capital planning process should include modeling practices and situations that reflect BHC-specific factors. In this publication, many lagging practices identified fail to reflect the specific factors of BHCs or rely on generic assumptions without considering whether they are the most appropriate for a BHC. The expectations of supervising summarized here are broad and reflect on the key characteristics of a strong and sound capital planning process.
Most importantly, the Fed has tailored expectations for BHCs of different sizes, activities, systemic importance, and operations in various activities of capital planning. Moreover, it has also recognized the encounters facing BFICs that are new to CCAR and, has also recognized that BFICs will continue to develop and enhance their planning systems and processes so as to meet the supervisory expectations.
The purpose of this publication is to (1) assist the audience in understanding the importance the Federal Reserve puts on ensuring that firms have strong capital resources and (2) important aspects of capital planning practices at large and complex U.S. BFICs.
The following sections give detailed information on supervisory expectations and current practices along with dimensions of BFICs’ internal planning processes. The first part discusses foundational risk management and identification of risk exposures, and the next two discussions focus on governance and controls around internal capital planning processes. The fourth and fifth, respectively, discuss the range of current practices that concerns BFI’s capital policies and a summary of the Federal Reserve’s conclusion on the current range of practice at BFICs.
Foundational Risk Management
Risk-identification, measurement, control processes, and management are expected to be present in BFICs. In addition, supervisory assessments of BFICs’ internal capital planning will focus on essential expectations of BFICs as well as governance and internal controls. Weaknesses in these areas may lead to an objection to a BFIC’s capital plan due to a negative supervisory assessment of its capital planning process.
The important lesson from the recent financial crisis is that many financial firms failed to adequately identify risks and the potential exposures from their wide firm activities due to the failure of information technology and management systems (MIS). Many companies failed to put into consideration the full scope of exposures and to scrutinize how the size of these exposures and business activities may evolve as market and economic conditions change.
Critical elements of capital planning are the combination of the comprehensive identification of a company’s business activities and associated positions across the organization with effective techniques for evaluating how the positions and activities may evolve under stressful economic conditions, and also judge the potential effect of the evolution on the capital needs of the firm.
Risk identification processes of BIFCs should ensure that all risks are appropriately accounted for and should asses the full set of potential exposures reducing from on- and off-balance sheet positions during periods of stress. BHCs should have a repeatable and systematic process to identify all risks and put into consideration the potential impact of these risks on the capital, and also closely evaluate any assumptions about risk reduction resulting from risk mitigation or transfer techniques.
Standardized processes of risk assessments, reviewed risk exposures and how they may evolve under stressful conditions are robust risk-identification practices. Senior representatives of respective offices provide input to the process. The important part of the risk -identification and evaluation programs is the consideration of the risks inherent to new products and activities and those that may change in the BHC’s strategic direction.
Risks measures should be able to capture changes in an institution’s risk profile or changes to the overall economic environment. They should also support the evaluations of the capital adequacy and help in capital emergency plans as early warning indicators or emergency triggers.
BHCs should be able to prove how identified risks are accounted for in their capital planning processes and how certain omitted risks from the enterprise-wide scenario analysis are accounted for in other aspects of the planning process. If quantification methodologies in capital planning that are not scenario-based are used by BHCs, they should match the risks covered so as to facilitate the decision-making and comparability process with respect to the overall capital competence.
BHCs should have a strong internal control framework that helps oversee its internal capital planning processes. This includes comprehensive and regular review by the internal audit, independent and strong model review and validation practices, comprehensive documentation and change controls.
The Scope of Internal Controls
The internal framework of a BHC should address its entire capital planning process, the process of making capital suitability decisions, and the collection and reporting framework. The control framework should ensure that the management of the BHC joins the separated components in a coherent manner and assures that all aspects of the capital planning process function as intended in support of strong capital needs calculations.
The internal audit should play a key role in estimating internal capital planning and its various constituents and should occasionally perform a review of the full process to ensure that the end to end process is functioning in accordance with the supervisory and board of directors’ expectations as in approved policies and procedures. The manner in which scarcities are identified, tracked, and corrected should be reviewed by the internal audit.
BHCs with robust audit practices have a comprehensive, full-bodied review of all components of the capital planning process and those with leading audit practices in their capital planning have strong issue identification and remediation tracking. They also ensured that the audit staff has elevated stature in the firm, strong technical expertise, as well as independence from management.
Independent Model Review and Validation
BHCs should conduct an independent validation and review of all models used in the planning process. Validation staff should be well equipped and informed so as to provide a critical and fair evaluation of the reviewed models.
The review and validation process of the model should include:
- The evaluation of conceptual soundness;
- The ongoing watching that includes the confirmation of processes and benchmarking; and
- An outcome analysis.
BHCs should maintain a record of all models used in the capital planning process, as well as revenue or expense projections. They should also maintain a process to incorporate well-supported adjustments to model estimates when they identify model doubts and weaknesses.
BHCs should conduct sensitivity analyses or benchmark models so as to compensate for the challenges inherent in backtesting stress models and ensure that the validation process covers all assumptions the models used for capital planning purposes.
Supervisory reviews found out that BHCs should give more attention to model risk management including strengthening practices. Some of them displayed stronger practices in their capital planning, including:
- Maintaining an updated record of all models used;
- Ensuring that models have been authorized for their intended use; and
- Being clear about the validation status of all models used for capital planning addressing those that have not been validated.
BHCs with lagging practices were not able to identify and formally review models or assumptions used in the capital planning process. They also did not have confirmation staff that was independent and that could critically evaluate the models.
Policies and Procedures
BHCs should have policies and procedures covering the entire planning process which ensures a consistent and repeatable process for all components of the planning process and should provide transparency to third parties in the process. They should be reviewed and updated annually when warranted. There should also be evidence that management and staff are adhering to policies and procedures, and a formal process for any policy exceptions.
Ensuring Integrity of Results
Internal controls which ensure the integrity of the reported results and the review, approval, and documentation of all material changes to the capital planning process and its components should be in the possession of the BHC. It should ensure that such controls exist at all levels of the planning process. Specific controls should be in place to:
- Provide for resolution and data integrity processes for all key reports;
- Ensure that the MIS is strong to support capital analysis and decision-making, with enough elasticity to run ad-hoc analysis as needed;
- Ensure that reports provided to senior management and the board contains the correct level of detail and are accurate; and
- Address the presentation of aggregate, enterprise-wide capital planning results which describe manual adjustments made in the aggregation process.
A strong practice in this area ensures that good information flows to support decisions.
A clear documentation for all aspects of the capital planning process which contains detailed and accurate information that describes the BHC’s practices provide relevant information for decision-making and allows for change and review.
The board and senior management, which manage the capital planning process by ensuring the periodic review of the BHC’s risk infrastructure, should come up with an inclusive capital planning process which is consistent with the risk appetite framework.
Board of Directors
The board of directors in a BHC has accountability and responsibility for planning and making informed decisions on capital actions, distribution, and adequacy of the capital. It should also have enough information to understand material risk and exposures of the BHC so as to support its decisions on planning and adequacy.
Information to the board about the capital adequacy should include a pro forma basis, measures of the capital under current conditions, and should be framed against the targets established by the BHC. It should also have enough details to help the board calculate the appropriateness of business activities, scenarios, and the strategic direction.
The information should be detailed enough so as to help the board understand weaknesses in the process and challenge any reported results before making capital decisions. Summarized information about mitigation strategies is important to the board so that it may address important limitations and take action when weaknesses are identified.
BHCs with robust practices had boards that were informed and that understood the risks and other things that affected the capital adequacy, and also knew major drivers of the loss and revenue changes under the scenarios. This made them have the correct expertise and level of engagement to evaluate the information provided by the senior management and know that internal planning results should be viewed as part of a possible range of results. These boards discussed weaknesses identified and how to tackle them, and also the sufficient range of potential stress conditions noted during the capital adequacy calculations.
A BHC’s capital plan is required to be approved by the board of directors under Capital Plan Rule.19, as adequate reporting on important areas of the analysis should be provided by the management. Those firms with robust practices compiled information on the issues identified gave their boards decisions of the sensitivity of capital levels and gave information about past capital planning performance.
Weaker practices provide insufficient information to the board of directors which does not identify and address important assumptions to support the planning process. In some cases, the board does not get informed about the governance of the internal planning process, making it difficult to assess the strength of the planning process and whether it is reliable.
The senior management ensures that effective controls are in place and that the capital planning activities permitted by the board are implemented in an acceptable manner.
The senior management should provide informed recommendations to the board. It should also ensure that proposed capital goals have enough support, reflect the expectations of stakeholders, and identify weaknesses and potential limitation and how to solve them.
The senior management recognizes the vagueness and frequency of uncertainty in predicting future outcomes. Therefore, it maintains an ongoing assessment of all capital planning areas by identifying and documenting any weaknesses, uncertainties, limitations, and assumptions during the planning process. It also develops remediation plans and makes more cautious adjustments to the capital plan. Finally, the senior management includes key assumptions in reports by sometimes providing an analysis to show the sensitivity of capital to different outcomes.
BHCs are supposed to document choices on the adequate capital actions taken by the board of directors and senior management by discussing the information used to reach the decision. The final decision should be recorded and retained in accordance with the company’s policies. BFICs with weak documentation practices had brief and opaque minutes and some of them did not even formally document the decision.
The capital policy is the principles and guidelines used by BFICs for capital planning, issuance, and distribution. It should include:
- The capital goal;
- The quantitative/qualitative guidelines for stock purchase/dividends;
- Address potential capital fallbacks; and
- Internal government procedures.
The capital policy is approved by the BFIC’s board of directors. It should provide detail on how the BFIC’s manages, monitors, and decides on all aspects of capital planning. The roles of decision-makers, process/data controls, and validation standards should be addressed.
It should describe the composition/target level of capital and give clarity on the BFIC’s objectives in terms of capital management. It should explain how the BFIC’s capital planning align with the imperative of keeping a strong capital position and continue to work in times of server stress, including quantitative metrics and an explanation on how management concluded the appropriate ratios.
More so, the capital policy includes a governance protocol that is credible, clear, and actionable. The policy describes common stock dividend and repurchase decisions. The policy should discuss: main factors and key metrics influencing the size/time/capital distribution, analytical materials used in making capital distribution decisions, specific circumstances that would cause the BHC to reduce/suspend a dividend, factors the BHC would reflect if contemplating the spare, key roles and responsibilities. When the capital policy is reconsidered, the BHC should ensure the triggers remain relevant.
The capital policy should be revised to cater for changes in the organizational structure. Approval, management change, and document retention of capital policies should be developed by the BHC. Weak capital policies are characterized by a limited scope. They address a section of the capital planning process that provides little detail on how capital decisions are made. Sometimes, the capital policy is overly generic and not tailored to a unique instance.
Capital Goals and Targets
Capital goals should be established by the BHCs along with their risk appetites/profiles and expectation from shareholders. The internal capital should be enough for operating during and after stressful conditions and the capital goals should show current and future regulatory capital requirements. BHCs should ensure capital level would not fall below the goals in stress period by establishing targets above and beyond their goals.
The target should be specified, reviewed, and approved by the board. In capital goals, the development of general economic conditions is taken into account. BHCs should consider the impact of external conditions in both stressed and normal economic environment and the ability to raise more capital. BHCs should also calculate and use a variety of capital measures that present both risk and leverage.
However, BHCs with weaker practices did not link clearly the decisions regarding the capital distribution to adequate metrics. Weak practices seen here included establishing capital goals based only on controlling minimums and the ratios necessary to be considered well-capitalized without thought of the BHC’s exact capital needs. Some BHCs did not identify limitations and uncertainties in knowing all potential sources of loss. Some other BHCs were not clear on how they came up with the capital targets and goals in their capital policies.
Capital Contingency Plan
In their capital policies, BHCs should outline the exact actions they would think of to remedy to any current insufficiency in their capital position. Particularly, BHCs’ policy should include a thorough explanation of the triggers/events in which they will reduce/suspend a dividend or not execute a capital action which was previously planned.
The triggers should be given for both stress and baseline scenarios which should be used to guide the number of times in which the board will revisit scheduled capital actions. The capital plan should be revised and updated as situations warrant. Capital triggers should give a prior warning of capital decline and be part of the framework. Triggers should also be made for other events and metrics that measure or affect the economic condition of the firm. Possible actions should be realistic and flexible to work in many conditions that are achievable during stress periods. When preparing the capital plan, BHCs have to recognize that some capital raising/preserving methods may not be effective during periods of financial stress.
The ranking of possible actions should be by the ease of execution and their impact should be sorted by the stakeholders’ reactions. Poor capital contingency plans have few options to address possible events or do not consider viable options in stressful conditions. Plans that rely mainly on past history are over-optimistic and also considered weak. Another weak practice includes establishing triggers based on actual results.
BHC Scenario Design
The BHC needs to use an appropriate BHC-developed stress scenario. There should be a process in the BHC for designing enterprise scenarios that reflect the BHC’s unique business activities. Some BHCs use internal models whereas others use vendor-defined macroeconomic scenarios. There are BHCs that use third-party scenarios by tailoring the third party to their own exclusive weakness. BHCs should contain a scenario selection process that brings together a wide range of internal stakeholders. Even though BHCs should submit one stress scenario for the CCAR, it should have a range of scenarios for the overall capital planning process.
Scenario Design and Severity
A bank holding a company-designed stress situation should show the company’s unique vulnerabilities that show firm-wide risk exposure. The stress scenario should show major economic conditions tailored specifically for idiosyncratic risks. A BHC stress scenario that simply contains a generic fading of large financial conditions similar in size to the supervisory severely adverse scenario doesn’t meet expectations.
The assumptions that specifically benefit the BHC should not be featured in the BHC scenarios. BHCs may have business models or important business activities that produce liabilities that are missing in the supervisory severely adverse scenario. The stress scenario incorporated in a BHC’s capital plan should place considerable stresses on its ability to produce revenue and engross losses.
A BHC includes a set of variables in the scenario addressing all material risks coming from its exposure. A business line could face stress from many sources. The BHC scenario should contain relevant variables and not simplify pro forma economic projections.
Estimation Methodologies for losses, revenues, and expenses
BHC capital plan should include estimates of projected revenues, expenses, losses, and reserves.
Projections of losses, revenues, and expenses below theoretical stressed situations serve as the main building blocks of the enterprise-wide scenario analysis. BHCs must understand uncertainties in their estimates. Overall, BHCs estimate revenues, losses, and expenses, which are supported by evidence that should be transparent and repeatable. BHCs are expected by the Federal Reserve to use models as the basis of their estimate.
Establishing a Quantitative Basis for Enterprise-Wide Scenario Analysis
Estimation of revenue, expenses, and losses should be taken from internal data as part of an enterprise-wide scenario analysis. In some circumstances, a BHC might also use some external data to strengthen the scenario. A number of quantitative approaches can be used by a BHC to estimate costs, income, and losses.
Every BHC must estimate its revenue, losses, and expenditure at adequate granularity, hence identifying the main risk drivers. While BHCs often split their portfolios and actions along functional areas, the leading exercise is to determine divisions based on common risk features. The granularity of divisions mainly depends on the size, composition, and type of the BHC’s portfolio.
BHCs should distinctly estimate revenues, losses, or expenses for portfolios or business lines that are delicate to different risk drivers. The effect of falling property values differs materially due to the difference in structure between the two portfolios. BHCs with leading practices have shown clearly the basis for selecting certain risk drivers over others while those with lagging practices have shown the opposite. Models require a number of assumptions for their implementation.
The connection between large economic variables and expenses, revenues, or losses could differ considerably in the hypothetical stress scenario from what is perceived historically. The Federal Reserve expects BHCs to supplement traditional tools with more types of analysis. Core assumptions are clearly linked to outcomes by sensitivity analyses. Using outcomes from different estimation methods as a reference point is another way BHCs can gain comfort around their main model estimates.
BHCs have a consistent framework for evaluating the results of the different methods used. They may also need to rely on third-party models. An off-the-shelf vendor model frequently needs some level of specific analysis to prove that it produces estimates appropriate for the BHC.
In understanding the range of possible results of vendor models, a sensitivity analysis is helpful. The validation should be in accordance with SR 11-7 guidelines. Some BHCs produced annual projections for definite revenue, expense, or losses items and then equally spread them over the four quarters of each year. However, this practice does not show a cautious estimate of the expected quarterly trail of capital, net revenue, and losses. Hence, it is only acceptable when a BHC can clearly show that the predictable item is very uncertain.
1) A BHC model’s review and validation process should NOT include which of the following?
- An evaluation of the conceptual soundness
- Ongoing monitoring that includes verification processes and benchmarking
- Policies and procedures
- An outcomes analysis
The correct answer is C.
The process of reviewing and validating a BHC model must have an evaluation of conceptual soundness. In addition, there should be an ongoing monitoring that includes verification processes and benchmarking. Furthermore, an outcomes analysis needs to be done. However, there are no policies and procedures in the model review and validation processes.