Capital Policy

As noted earlier, a capital policy is the principles and guidelines used by a BHC for capital planning, capital issuance, and usage and distributions. A capital policy should include internal capital goals; quantitative or qualitative guidelines for dividends and stock repurchases; strategies for addressing potential capital shortfalls; and internal governance procedures around capital policy principles and guidelines.²² The capital policy, as a component of a capital plan, must be approved by the BHC's board of directors or a designated committee of the board.²³ It should be a distinct, comprehensive written document that addresses the major components of the BHC's capital planning processes and links to and is supported by other policies (risk-management, stress testing, model governance, audit, and others). A capital policy should provide details on how a BHC manages, monitors, and makes decisions regarding all aspects of capital planning. The policy should also address roles and responsibilities of decisionmakers, process and data controls, and validation standards. Finally, the capital policy should explicitly lay out expectations for the information included in the BHC's capital plan.

A capital policy should describe targets for the level and composition of capital and provide clarity about the BHC's objectives in managing its capital position. The policy should explain how the BHC's capital planning practices align with the imperative of maintaining a strong capital position and being able to continue to operate through periods of severe stress. It should include quantitative metrics such as common stock dividend (and other) payout ratios as maximums or targets for capital distributions. The policy should include an explanation of how management concluded that these ratios are appropriate, sustainable, and consistent with its capital objectives, business model, and capital plan. It should also specify the capital metrics that senior management and the board use to make capital decisions. In addition, a capital policy should include governance and escalation protocols that are clear, credible, and actionable in the event an actual or projected capital ratio target is breached.

The policy should describe processes surrounding how common stock dividend and repurchase decisions are made and how the BHC arrives at its planned capital distribution amounts. Specifically, the policy should discuss the following:

• the main factors and key metrics that influence the size, timing, and form of capital distributions
• the analytical materials used in making capital distribution decisions (e.g., reports, earnings, stress test results, and others)
• specific circumstances that would cause the BHC to reduce or suspend a dividend or stock repurchase program
• factors the BHC would consider if contemplating the replacement of common equity with other forms of capital
• key roles and responsibilities, including the individuals or groups responsible for producing the analytical material referenced above, reviewing the analysis, making capital distribution recommendations, and making the ultimate decisions

BHCs should establish a minimum frequency (at least annually) and other triggers for when its capital policy is reevaluated and ensure that these triggers remain relevant and current. The capital policy should be reevaluated and revised as necessary to address changes to organizational structure, governance structure, business strategy, capital goals, regulatory environment, risk appetite, and other factors potentially affecting a BHC's capital adequacy. BHCs should develop a formal process for approvals, change management, and documentation retention relating to their capital policies.

Weak capital policies were typically characterized by a limited scope. They only addressed parts of the capital planning process, did not provide sufficient detail to convey clearly how capital action decisions will be made, were not well integrated with or supported by other risk and finance policies, and/or did not contain all of the elements described above (e.g., clearly defined capital goals, guidelines for capital distributions and capital composition, etc.). In some cases, the capital policy was overly generic and not tailored to the BHC's unique circumstances. For example, the policy appeared to be restating supervisory expectations without concrete examples or BHC-specific considerations. In other cases, the more detailed procedures were not presented to the board, thus limiting the board's ability to understand the analysis underlying its capital planning decisions.

Capital Goals and Targets

BHCs should establish capital goals aligned with their risk appetites and risk profiles as well as expectations of internal and external stakeholders, providing specific goals for the level and composition of capital, both current and under stressed conditions. Internal capital goals should be sufficient to allow a BHC to continue its operations during and after the impact of stressful conditions. As such, capital goals should reflect current and future regulatory capital requirements, as well as the expectations of shareholders, rating agencies, counterparties, creditors, supervisors, and other stakeholders.

BHCs should also establish capital targets above their capital goals to ensure that capital levels will not fall below the goals during periods of stress. Capital targets should take into consideration forward-looking elements related to the economic outlook, the BHC's financial condition, the potential impact of stress events, and the uncertainty inherent in the capital planning process. The goals and targets should be specified in the capital policy and reviewed and approved by the board.²⁴

In developing their capital goals and targets, particularly with regard to setting the levels of capital distributions, BHCs should explicitly take into account general economic conditions and their plans to grow their on- and off-balance-sheet size and risks organically or through acquisitions. BHCs should consider the impact of external conditions during both normal and stressed economic and market environments and other factors on their overall capital adequacy and ability to raise additional capital, including the potential impact of contingent exposures and broader market or systemic events, which could cause risk to increase beyond the BHC's chosen risk-tolerance level. BHCs should have contingency plans for such outcomes.

Additionally, BHCs should calculate and use several capital measures that represent both leverage and risk, including quarterly estimates of regulatory capital ratios (including tier 1 common ratio) under both baseline and stress conditions. BHCs with weaker practices in this area did not clearly link decisions regarding capital distributions to capital adequacy metrics or internal capital goals.

Weak practices observed in this area included establishing capital goals based solely on regulatory minimums and the ratios required to be considered well-capitalized without consideration of a BHC's specific capital needs given its risk profile, financial condition, business model and strategies, overall complexity, and sensitivity to changing conditions. Some BHCs did not recognize uncertainties and limitations in capturing all potential sources of loss and in projecting loss and revenue estimates, which reduced the BHCs' ability to establish effective capital goals and targets. Other BHCs were not transparent about how they determined the capital goals and targets in their capital policies.

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Capital Contingency Plan

BHCs should outline in their capital policies specific capital contingency actions they would consider to remedy any current or prospective deficiencies in their capital position.²⁵ In particular, a BHC's policy should include a detailed explanation of the circumstances--including deterioration in the economic environment, market conditions, or the financial condition of the BHC--in which it will reduce or suspend a dividend or repurchase program or not execute a previously planned capital action. The policy also should define a set of capital triggers and events that would correspond with these circumstances. These triggers should be established for both baseline and stress scenarios and measured against the BHC's capital targets in those scenarios. These triggers and events should be used to guide the frequency with which board and senior management will revisit planned capital actions as well as review and act on contingency capital plans. The capital contingency plan should be reviewed and updated as conditions warrant, such as where there are material changes to the BHC's organizational structure or strategic direction or to capital structure, credit quality, and/or market access.

Capital triggers should provide an "early warning" of capital deterioration and should be part of a management decisionmaking framework, which should include target ranges for a normal operating environment and threshold levels that trigger management action. Such action should include escalation to the board, potential suspension of capital actions, and/or activation of a capital contingency plan. Triggers should also be established for other metrics and events that measure or affect the financial condition or perceived financial condition of the firm--for example, liquidity, earnings, debt and credit default swap spreads, ratings downgrades, stock performance, supervisory actions, or general market stress.

Contingency actions should be flexible enough to work in a variety of situations and be realistic for what is achievable during periods of stress. The capital plan should be prepared recognizing that certain capital-raising and capital-preserving activities may not be feasible or effective during periods of stress. BHCs should have an understanding of market capacity constraints when evaluating potential capital actions that require accessing capital markets, including debt or equity issuance and also contemplated asset sales. Contingency actions should be ranked according to ease of execution and their impact and should incorporate the assessment of stakeholder reactions (e.g., impacts on future capital-raising activities).

Weak capital contingency plans provided few options to address contingency situations and/or did not consider the feasibility of options under stressful conditions. Plans with overly optimistic assumptions or excessive reliance on past history (in terms of both possible contingency situations and options to address those situations) were also considered weak, as were plans that lacked support for the feasibility and availability of possible contingency actions. Other weak practices included establishing triggers based on actual results but not on projected results, or based on minimum regulatory capital ratios only with no consideration of the expectations of other stakeholders including counterparties, creditors and investors, or of other metrics or market indicators.

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References

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