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From Banking and Finance Law Daily, August 19, 2013

Holding company capital planning processes need improvement, Fed paper says

By Richard A. Roth, J.D.

While the largest bank holding companies have made progress in establishing sound capital planning processes, there is room for improvement in some areas, according to a paper published by the Federal Reserve Board. All of the 18 BHCs that participated in the Fed’s 2013 Comprehensive Capital Analysis and Review (CCAR) fell short of at least one aspect of what the Fed identified as leading practices, according to Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice.

The Fed’s Capital Plan Rule (12 CFR 225.8) requires U.S. BHCs with $50 billion or more in total consolidated assets to have both a capital plan and a process for assessing their capital adequacy. The paper describes the CCAR as the Fed’s supervisory program for assessing the required capital plans.

The purpose of the paper is to set out the Fed’s supervisory expectations for these BHCs’ internal capital planning. It describes both what the Fed considers to be leading practices and practices that are deemed to be weak or unacceptable. The paper also warns that adopting the identified leading practices should not be seen as offering a safe harbor. What are considered to be leading practices will evolve based on new data and practices, changing economic conditions, and new risks posed by new businesses and products.

Fed supervisory scenarios and stress tests are useful, but they should not be considered to be a comprehensive analysis of all of the risks that a BHC could face, the paper adds. In fact, a BHC’s reliance on an internal capital planning process that replicates the stress tests is designated a weak practice because it does not adequately account for the specific factors that affect the specific company.

Foundational risk management. “A key lesson from the recent financial crisis is that many financial companies simply failed to adequately identify the potential exposures and risks stemming from their firm-wide activities,” the paper says. When a BHC assesses its capital needs it must be able to identify all of the risks it faces. A company’s processes should look carefully at assumptions about the effects of risk-transfer and risk-mitigation strategies as well.

The paper emphasizes that a BHC’s capital planning process should account for all of the risks the company has identified, including those that might be difficult to quantify. The failure to do this in a transparent manner was one of the weak practices cited by the paper.

Internal controls. An internal capital planning process must be governed by a strong internal control framework, according to the paper. This requires a regular, comprehensive review by internal audit, independent model review and validation, and comprehensive documentation of the entire process. The paper calls specifically for more attention to model risk management, noting that some BHCs could not identify all of the models being used and did not adequately review or validate those models.

Governance. The effectiveness of a BHC’s practices depended on how well its board of directors understood the company’s risks and exposures, the paper notes. Strong practices included board members with the experience needed to evaluate the information they received from senior management.

According to the paper, BHCs with weaker practices did not give their board members adequate information to assess proposed capital distributions or the credibility of internal capital planning processes.

BHC senior management should recognize and account for the imprecision and uncertainty that can arise from predicting future outcomes, the paper says.

Capital policy. A BHC’s capital policy comprises the principles and guidelines it uses for capital planning, issuance, usage, and distributions, the paper says, and it must be set out in a comprehensive, written document. The policy should set targets for the level and composition of the BHC’s capital and metrics for capital distributions, and explain how those were determined. Weak policies are too general or too limited, the paper says.

A capital policy should include both goals and targets. The capital goal should be high enough to allow the BHC to continue its operations during and after periods of stress. The capital target should be higher than the goal, to ensure that the company’s capital will not fall below the goal during a period of stress. Setting goals based on regulatory minimums without considering a BHC’s specific situation is deemed to be a weak practice.

The policy also needs to describe the actions the BHC will consider to remedy capital position deficiencies. Weak plans included few options or did not consider whether those options would work during a period of stress, the paper observes.

Scenario design. The paper notes that there was a broad range of practices BHCs used in designing their stress scenarios. However, a stress scenario should reflect each BHC’s own business activities and related risks, and companies with stronger practices did that better. Using a stress test that simply reflects a generic economic weakening comparable to what is set out in the supervisory severely adverse scenario is inadequate, the paper says.

A BHC’s scenario needs to address all material risks it could face. There should be a transparent link between the scenario’s variable and the sources of risk to the BHC. There also should be a clear narrative describing how the scenario addresses the BHC’s risks and vulnerabilities.

Estimating losses, revenue, and expenses. Estimates of losses, revenue, and expenses under stress conditions are fundamental to stress test scenarios. The paper goes into considerable detail as to what a BHC should consider in making these estimates. This includes the use of both internal and external data, as well as expert adjustments. Estimation processes should be well documented.

Specific factors to be considered include:

  • retail and wholesale credit risk;
  • available-for sale and held-to-maturity securities risk;
  • operational risk;
  • market risk; and
  • counterparty risk.

BHCs also should estimate the effects of stress conditions on both non-interest income and non-interest expense, the paper says.

Effects on balance sheets and risk-weighted assets. Capital planning requires a BHC to project the effects of a scenario on its on- and off-balance sheet positions and on its risk-weighted assets over the span of the scenario, according to the paper. The company also must be able to maintain an adequate allowance for loan and lease losses over the scenario’s term.

Common weaknesses. The paper concludes by noting five specific weaknesses found in BHC capital planning processes:

  • being unable to show how all risks were accounted for;
  • using stress tests or models that did not reflect a BHC’s particular situation;
  • generating loss, expense, or revenue projections that did not fully reflect the effect of stressed conditions or were not robust, transparent, or repeatable;
  • adopting policies that did not articulate goals and targets, did not justify those goals and targets, or provide enough detail about how the BHC would respond to changing circumstances; and
  • using inadequate governance or controls, especially for risk identification, measurement, and management.

IndustryNews: CapitalBaselAccords FederalReserveSystem

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