The Recession and its subsequent rate of bank failures underscore the need for banks of all sizes to invest in developing a capital plan. The Recession taught many institutions that whatever processes had been in place for managing capital were not sufficient. Often, they either failed to include forward-looking analyses, or the forward-looking analysis outlined in capital policy may not have gone to far enough extremes. The result was insufficient capital.
The BASEL Committee, in a January 2014 article, acknowledged four components of a capital planning process:
1. Internal control and governance
2. Capital policy and risk structure
3. Forward-looking review
4. Management framework for preserving capital
While the FASB is trying to encourage forward-looking credit risk measures through their proposed CECL model, due out this year, banks can incorporate now a stress testing analysis that provides insight into the potential impact credit performance may have on capital.
An objective of capital planning, according to the Basel document, is to enable the bank to continue to “meet its obligations to creditors and other counterparties, and continue to serve as a credit intermediary before, during and after a stressful scenario.” To be sucessful, the bank must have a command of the potential impact to capital during each of these scenarios and have a plan for how to react. Stress testing can arm the management team with this information and substantiate the institution’s intended capital level changes (either an increase or decrease, depending upon stress test results).
And if it does not seem like a big enough priority previously, the ability to manage and substantiate capital plans will become all the more important in 2015, now that Basel III is in effect.
If, in a given Adverse scenario, the bank’s Tier 1 Risk Based Capital (RBC) falls from 6.5 percent to 5.8 percent, for example, that bank would transition from being Adequately Capitalized based on regulatory thresholds to Undercapitalized. Perhaps in a Severely Adverse scenario, Tier 1 RBC drops further to 3.9 percent. Should that Severely Adverse scenario actually occur, the bank would be Significantly Undercapitalized and in need of immediate action.
Clearly, the bank does not jump from 6.5 percent to 3.9 percent overnight; there will be a period of decline. And it’s during that period of decline that a concrete capital plan, which specifies the metrics the institution tracks and the thresholds that trigger capital action, can help the bank to head-off trouble.
It’s recommended that the scenarios used in a stress testing analysis – and the severity of the stress factors – is created with the help of several departments within the bank, drawing on past performance and regulatory examples. The Dodd Frank scenarios, while they do not necessarily apply to community banks with less than $10B in assets, can provide some guidance.
Armed with information on capital performance in different stressed situations, the bank’s management team can make informed recommendations that could include any combination of the following:
1. closer monitoring of market information,
2. adjusting strategic and capital plans to mitigate risk,
3. changing risk appetite and risk tolerance levels,
4. limiting or stopping loan growth or adjusting the portfolio mix,
5. adjusting underwriting standards,
6. raising more capital
7. selling or hedging loans to reduce the potential impact from such stress events.
Find out more in this whitepaper: How Regulators Gauge Capital Adequacy Under Stress.