Capital is the foundation of the banking system to help facilitate economic growth and provide a buffer against potential shocks that may arise. Capital planning is an ongoing, dynamic, forward‐looking process that aligns the bank’s mission, goals, and objectives within the context of risk. It incorporates changes in strategic focus, risk tolerance, business plan, and other factors and helps the Board identify vulnerabilities, concentrations, and manage overall risk to capital adequacy.
Over the last five years, bank failure rates spiked to levels last seen during the Savings and Loan crisis of the late 80’s and 90’s. Given this backdrop, new focus has been placed on capital planning and contingencies. The Federal Reserve now conducts an annual Comprehensive Capital Analysis and Review (CCAR) that includes Dodd‐ Frank Act stress testing (DFAST). Dodd‐Frank also changed the rules about using trust‐preferred securities as capital for certain banks and began limiting certain bank activities. Basel 3 brought forth the introduction of a new capital ratio called the Common Equity Tier 1 that is fundamentally different than the other existing risk based ratios.
Bank asset size may determine which regulatory requirements apply to your bank. Banks over $10bln are subject to CCAR, DFAST, BASEL 3 and the majority of the new rules. Bank’s less than $500mln are less likely to be subject to the new rules. Even though your bank may not be formally subject to some of the rules, all banks have been known to experience the trickledown effect from regulators incorporating capital planning and capital stress testing as Matters Requiring Attention in examinations.
Identifying Material Risks
During the first step of the capital planning process bankers should identify and evaluate material quantifiable risks. These would include credit, operational, interest rate, liquidity, and price risk. Any one of these risks in isolation can lead to capital deterioration. The combination of any of these risks would expedite capital erosion. Other risks may need to be qualified, such as reputation and strategic risk. The bank should be keen to identify and report projected increases in these risk categories. Early alerts can prompt management to take action and ensure proper capital levels, or manage the balance sheet to reduce the undesirable exposure.
Planning and Stress Testing
Next, the bank should prepare a strategic plan outlining action items in order to achieve goals set by the board of directors. Well‐defined forecasts for asset quality, asset‐liability mix, equity multipliers, and capital sources and uses would be part of the plan. Common sources of capital would include retained earnings, gain on asset sales, and an equity raise. Uses of capital would include dividend payments, losses on asset sales, net operating losses, asset impairment, regulatory deductions, etc.
Banks should understand the impact from changing interest rate and economic environments on management’s plan and estimate how capital is impacted from an increase in loan loss reserve, price volatility from investments, or from miss‐matched asset‐liability cash flows. Growth in asset classes can lead to undesirable concentrations that may be difficult to exit in a timely manner, and new business lines often have large up‐front costs that could impact earnings in the short run. Scenario analysis could be used to test and stress for changes in interest rate and credit risk.
Lastly, the bank’s Capital Plan should consider contingency back‐ups to maintain proper capital adequacy. Issuance of common equity, preferred equity, holding company debt, retained earnings, and balance sheet size and mix are all contingent sources of capital relief. However, bank structure and available resources will drive this process and its solutions. For example, a mutual may have a harder time accessing capital than a publicly traded commercial bank.
Banks with inadequate capital contingencies possess a higher risk of liquidity erosion. Counterparties including Federal Home Loan Bank, Federal Reserve Bank, Correspondent Banks, Public Funds, Broker CD issuers, and others could reduce or eliminate access to funding sources if capital adequacy is not commensurate with safety and soundness requirements.
The bank should monitor and provide feedback to the Board to ensure integrity of the capital planning process and capital adequacy assessment. Effective Capital Plan documentation would include roles and responsibilities of key parties, assumptions and methodologies used, risk exposures, asset concentrations, stress testing results, and measures taken to mitigate risks to capital adequacy. The board should review the capital planning process and capital adequacy goals at least annually to ensure that sufficient capital levels exist to meet the board’s strategic vision.
Taylor Advisors, Inc. is a balance sheet consulting firm and a registered investment advisor based in Louisville, Kentucky. We are not a brokerage firm, but a team of asset liability analysts and balance sheet consultants to community-based financial institutions. Our service is quite simple. We help banks improve or maintain profitability while managing various risks – what we call Balance Sheet Management (BSM). BSM consulting entails providing advice, strategies, monitoring, and most importantly, education in many areas: investments, asset/liability, liquidity/funding, and risk management.
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