Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice
Print- Introduction
- Foundational Risk Management
- Internal Controls
Foundational Risk Management
BHCs are expected to have effective risk-identification, -measurement, -management, and -control processes in place to support their internal capital planning.7 In addition to the assessments of a BHC's stress scenario analysis and stressed loss- and revenue-estimation practices, supervisory assessments of BHCs' internal capital planning will continue to focus on fundamental risk-identification, -measurement, and -management practices, as well as on internal controls and governance. Weaknesses in these areas may contribute to a negative supervisory assessment of a BHC's capital planning process that could lead to an objection to a BHC's capital plan.8
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. This was in part a failure of information technology and management information systems (MIS), the often fractured nature of which made it difficult for some companies to identify and aggregate exposures across the firm. But more importantly, many companies failed to consider the full scale and scope of exposures, and to analyze how the size and risk characteristics of their exposures and business activities might evolve as economic and market conditions changed. Combining a comprehensive identification of a firm's business activities and associated positions across the organization with effective techniques for assessing how those positions and activities may evolve under stressful economic and market conditions, and assessing the potential impact of that evolution on the capital needs of the firm, are critical elements of capital planning. A robust internal capital adequacy assessment process relies on the underlying strength of each of these elements.
Risk Identification
In this Section:
BHCs should have risk-identification processes that ensure that all risks are appropriately accounted for when assessing capital needs.9 These processes should evaluate the full set of potential exposures stemming from on- and off-balance sheet positions, including those that could arise from provisions of non-contractual support to off-balance-sheet entities, and risks conditional on changing economic and financial market conditions during periods of stress. BHCs should have a systematic and repeatable process to identify all risks and consider the potential impact to capital from these risks. In addition, BHCs should closely assess any assumptions about risk reduction resulting from risk transfer and/or mitigation techniques, including, for example, analysis of the enforceability and effectiveness of any guarantees or netting and collateral agreements and the access to and valuation of collateral as exposures and asset values are changing rapidly in a stressed market.
Stronger risk-identification practices include standardized processes through which senior management regularly update risk assessments, review risk exposures and consider how their risk exposures might evolve under a variety of stressful situations. For example, many BHCs maintain a comprehensive inventory of risks to which they are exposed, and refresh it as conditions warrant (such as changes in the business mix and the operating environment) with input from various units across the BHC. Senior representatives from major lines of business, corporate risk management, finance and treasury, and other business and risk functions with perspectives on BHC-wide positions and risks provide input to the process. Consideration of the risks inherent in new products and activities should be a key part of risk-identification and -assessment programs, which should also consider risks that may be associated with any change in the BHC's strategic direction.
Risk measures should be able to capture changes in an institution's risk profile--whether due to a change in the BHC's strategic direction, specific new products, increased volumes, changes in concentration or portfolio quality, or the overall economic environment--on a timely basis. These risk measures should support BHCs' assessments of capital adequacy and may be helpful in capital contingency plans as early warning indicators or contingency triggers, where appropriate.
BHCs should be able to demonstrate how their identified risks are accounted for in their capital planning processes. If certain risks are omitted from the enterprise-wide scenario analysis, BHCs should note how these risks are accounted for in other aspects of the capital planning process (see box 1 for illustration of how BHCs identified and captured certain risks that are more difficult to quantify in their capital planning process). If a BHC employs risk quantification methodologies in its capital planning that are not scenario-based, it should identify which risks each of the methodologies covers, to facilitate comparability and informed decisionmaking with respect to overall capital adequacy. BHCs with lagging practice did not transparently link their evaluation of capital adequacy to the full range of identified risks. These BHCs were not able to show how all their risks were accounted for in their capital planning processes. In some cases, staff responsible for capital planning operated in silos and developed standalone risk inventories not linked to the enterprise-wide risk inventory or to other risk governance functions within their BHCs.
Box 1. Incorporating Risks That Are More Difficult to Quantify
Scenario-based stress testing is a critical element of robust capital planning. However, stress testing based on a limited number of discrete scenarios cannot and is not expected to capture all potential risks faced by a BHC, and therefore, it should serve as one of several inputs to the capital planning process. Given the scope of operations at and the associated breadth of risks facing large, complex BHCs--including the risk of losses from exposures and of reduced revenue generation--they are often exposed to risks, other than credit or market risk, that are either difficult to quantify or not directly attributable to any of the specific integrated firm-wide scenarios that are evaluated as part of the BHC's scenario-based stress testing ("other risks"). Examples of these other risks include reputational risk, strategic risk, and compliance risk. As noted in the section on risk identification, a BHC should identify and assess all risks as part of its risk-identification process and should capture the potential effect of all risks in its capital planning process. A BHC's capital planning process should assess the potential impact of these other risks on the BHC's capital position to ensure that its capital provides a sufficient buffer against all risks to which the BHC is exposed.
There is a wide range of practices around how BHCs account for other risks as part of their capital planning process. Many BHCs used internal capital targets to account for such risks, putting in place an incremental cushion above their targets to allow for difficult-to-quantify risks and the inherent uncertainty represented by any forward-looking capital planning process. Other BHCs assessed the effect of in terms of some combination of reduced revenue, added expenses, or a management overlay on top of loss estimates. BHCs with lagging practices did not even attempt to account for other risks in their capital planning process.
To the extent possible, BHCs should incorporate the effect of these other risks into their projections of net income over the nine-quarter planning horizon. BHCs should clearly articulate and support any relevant assumptions and the methods used to quantify the effect of other risks on their revenue, expenses, or losses.
For those BHCs that did not incorporate the potential impact of these other risks into their capital targets, stronger practices included a clear articulation of which risks were being addressed by putting in place a cushion above the capital target, and how this cushion is related to identified risks. BHCs should clearly support the method they used to measure the potential effect of such risks. Using a simple rule (such as a percent of capital) or expert judgments to determine the cushion above the capital target, without providing analysis or support, is a lagging practice.
References
7. 12 CFR 225.8(d)(2). Return to text
8. 12 CFR 225.8(e)(2). Return to text
9. 12 CFR 225.8(d)(2). Return to text
