Introduction

The Federal Reserve has previously noted the importance of capital planning at large, complex bank holding companies (BHCs). Capital is central to a BHC's ability to absorb unexpected losses and continue to lend to creditworthy businesses and consumers. It serves as the first line of defense against losses, protecting the deposit insurance fund and taxpayers. As such, a large BHC's processes for managing and allocating its capital resources are critical not only to its individual health and performance, but also to the stability and effective functioning of the U.S. financial system. The Federal Reserve's Capital Plan Rule and the associated annual Comprehensive Capital Analysis and Review (CCAR) have emphasized the importance the Federal Reserve places on BHCs' internal capital planning processes, and on the supervisory assessment of all aspects of these processes, which is a key element of a supervisory program that is focused on promoting resiliency at the largest BHCs.¹

These initiatives have focused not just on the amount of capital that a BHC has, but also on the internal practices and policies a firm uses to determine the amount and composition of capital that would be adequate, given the firm's risk exposures and corporate strategies as well as supervisory expectations and regulatory standards. BHCs have long engaged in some form of capital planning to address the expectations of shareholders, creditors, customers, and other stakeholders. The Federal Reserve's interest in and expectations for effective capital planning reflect the importance of the ongoing viability of the largest BHCs even under stressful financial and economic conditions. Even if current assessments of capital adequacy suggest that a BHC's capital level is sufficient to withstand potential economic stress, robust capital planning helps ensure that this outcome will continue to hold in the future. Robust internal capital planning can also help ensure that BHCs have sufficient capital in a broad range of future macroeconomic and financial market environments by governing the capital actions--including dividend payments, share repurchases, and share issuance and conversion--a BHC takes in these situations.

The Federal Reserve's Capital Plan Rule requires all U.S.-domiciled, top-tier BHCs with total consolidated assets of $50 billion or more to develop and maintain a capital plan supported by a robust process for assessing their capital adequacy.² CCAR is the Federal Reserve's supervisory program for assessing the capital plans. In 2013, CCAR covered 18 BHCs that participated in the 2009 Supervisory Capital Assessment Program (SCAP).³ The Federal Reserve's assessment of a BHC's capital planning process includes an evaluation of the risk-identification, -measurement, and -management practices that support the BHC's capital planning and stress scenario analysis, an assessment of stressed loss and revenue estimation practices, and a review of the governance and controls around these practices. The preamble to the Capital Plan Rule outlines the elements on which the Federal Reserve evaluates the robustness of a BHC's internal capital planning--also referred to as the capital adequacy process, or "CAP." These principles are summarized in figure 1.⁴

Figure 1. Seven principles of an effective capital adequacy process
Principle 1: Sound foundational risk management	The BHC has a sound risk-measurement and risk-management infrastructure that supports the identication, measurement, assessment, and control of all material risks arising from its exposures and business activities.
Principle 2: Effective loss-estimation methodologies	The BHC has effective processes for translating risk measures into estimates of potential losses over a range of stressful scenarios and environments and for aggregating those estimated losses across the BHC.
Principle 3: Solid resource-estimation methodologies	The BHC has a clear denition of available capital resources and an effective process for estimating available capital resources (including any projected revenues) over the same range of stressful scenarios and environments used for estimating losses.
Principle 4: Sufficient capital adequacy impact assessment	The BHC has processes for bringing together estimates of losses and capital resources to assess the combined impact on capital adequacy in relation to the BHC’s stated goals for the level and composition of capital.
Principle 5: Comprehensive capital policy and capital planning	The BHC has a comprehensive capital policy and robust capital planning practices for establishing capital goals, determining appropriate capital levels and composition of capital, making decisions about capital actions, and maintaining capital contingency plans.
Principle 6: Robust internal controls	The BHC has robust internal controls governing capital adequacy process components, including policies and procedures; change control; model validation and independent review; comprehensive documentation; and review by internal audit.
Principle 7: Effective governance	The BHC has effective board and senior management oversight of the CAP, including periodic review of the BHC’s risk infrastructure and loss- and resource-estimation methodologies; evaluation of capital goals; assessment of the appropriateness of stressful scenarios considered; regular review of any limitations and uncertainties in all aspects of the CAP; and approval of capital decisions.

This publication describes the Federal Reserve's expectations for internal capital planning at the large, complex BHCs subject to the Capital Plan Rule in light of the seven CAP principles. It expands on previous articulations of these supervisory expectations by providing examples of observed practices among the BHCs participating in CCAR 2013 and by highlighting those practices considered to be stronger or leading practices at these firms. In addition, it identifies practices that the Federal Reserve deems to be weaker, or in some cases unacceptable, and thus in need of significant improvement. However, practices identified in this publication as leading or industry-best practices should not be considered a safe harbor. The Federal Reserve anticipates that leading practices will continue to evolve as new data become available, economic conditions change, new products and businesses introduce new risks, and estimation techniques advance further.

While the supervisory scenarios and supervisory stress tests that are required under the Dodd-Frank Act ⁵ play an important role in CCAR, ⁶ they are not meant to be and should not be viewed as providing for an all-encompassing assessment of the possible risks a BHC may face. A robust internal capital planning process should include modeling practices and scenario assumptions that reflect BHC-specific factors. In certain instances, these practices and assumptions may differ considerably from those used by the Federal Reserve. Indeed, designing an internal capital planning process that simply seeks to mirror the Federal Reserve's stress testing is a weak practice. Many lagging practices identified in this publication involve modeling approaches or BHC stress scenarios that fail to reflect BHC-specific factors or that rely on generic assumptions or "standard" modeling techniques, without sufficient consideration of whether those assumptions or techniques are the most appropriate ones for the BHC.

The supervisory expectations summarized here are broad and reflect, at a general level, the key characteristics of a sound and robust internal capital planning process. While certain aspects of the detailed discussion that follows may be less relevant to individual BHCs based on their business mix and risk profile, the core tenets espoused are broadly applicable to all BHCs subject to the Capital Plan Rule.

Importantly, the Federal Reserve has tailored expectations for BHCs of different sizes, scope of operations, activities, and systemic importance in various aspects of capital planning. For example, the Federal Reserve has significantly heightened supervisory expectations for the largest and most complex BHCs--in all aspects of capital planning--and expects these BHCs to have capital planning practices that are widely considered to be leading practices. In addition, the Federal Reserve recognizes the challenges facing BHCs that are new to CCAR and further recognizes that these BHCs will continue to develop and enhance their capital planning systems and processes to meet supervisory expectations.

The purpose of this publication is two-fold. First, it is intended to assist BHC management in assessing their current capital planning processes and in designing and implementing improvements to those processes. Second, it is intended to assist a broader audience in understanding the key aspects of capital planning practices at large, complex U.S. BHCs and the importance the Federal Reserve puts on ensuring that these firms have robust capital resources.

The sections that follow provide greater detail on supervisory expectations and the range of current practice across several dimensions of BHCs' internal capital planning processes. The first section discusses foundational risk management, including identification of risk exposures. The next two sections focus on controls and governance around internal capital planning processes. The fourth section covers expectations and the range of current practice concerning BHCs' capital policies--the internal guidelines governing the capital action decisions made by a BHC under a range of potential future conditions for the firm and for the macroeconomic and financial market environments in which it operates. The subsequent three sections focus on the key elements of BHCs' internal enterprise-wide scenario analysis: design of the stress scenarios and modeling the impact of the scenarios on losses, revenues, balance sheet composition and size, and capital. The final section summarizes the Federal Reserve's conclusions on the current range of practice at BHCs.

References

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